Climate policy for coordinated industrial investments

Abstract

Decarbonizing the basic materials industry requires coordinated investments across value chains, a challenge that standard policy instruments cannot resolve. We develop a stylized model in which indirect network effects between upstream abatement input providers and downstream output producers give rise to multiple equilibria: a noinvestment trap and a coordinated high-investment equilibrium. Standard environmental policy instruments such as carbon pricing and non-discriminatory subsidies can optimize a local equilibrium but cannot guarantee convergence to the coordinated one. Applying subsidies at sufficient scale for coordination overshoots the optimum; a similar outcome may arise for a cap-and-trade system, while carbon taxes cannot guarantee the coordinated equilibrium. Targeted subsidies, awarded only to firms below a cost threshold on either side of the market, implement the first-best coordinated equilibrium without distorting it. A more sophisticated variant excludes the lowest-cost firms, who invest voluntarily once others lead, thereby subsidizing fewer firms. These results are robust to imperfect observability and imprecise targeting, provided errors remain limited. Our findings provide formal support for selective industrial policy as a means of overcoming coordination failures in industrial decarbonization. Decarbonizing the basic materials industry requires coordinated investments across value chains, a challenge that standard policy instruments cannot resolve. We develop a stylized model in which indirect network effects between upstream abatement input providers and downstream output producers give rise to multiple equilibria: a noinvestment trap and a coordinated high-investment equilibrium. Standard environmental policy instruments such as carbon pricing and non-discriminatory subsidies can optimize a local equilibrium but cannot guarantee convergence to the coordinated one. Applying subsidies at sufficient scale for coordination overshoots the optimum; a similar outcome may arise for a cap-and-trade system, while carbon taxes cannot guarantee the coordinated equilibrium. Targeted subsidies, awarded only to firms below a cost threshold on either side of the market, implement the first-best coordinated equilibrium without distorting it. A more sophisticated variant excludes the lowest-cost firms, who invest voluntarily once others lead, thereby subsidizing fewer firms. These results are robust to imperfect observability and imprecise targeting, provided errors remain limited. Our findings provide formal support for selective industrial policy as a means of overcoming coordination failures in industrial decarbonization.