Carbon Pricing and Fuel Switching by Firms: Theory and Evidence

Abstract

What determines the effectiveness of carbon pricing in reducing CO2 emissions? Prior research points to the importance of firm-level technology adjustments but provides limited evidence on the specific technologies involved. We develop and estimate a model of heterogeneous firms’ fuel choices to quantify the importance of fuel switching. The model explains three empirical findings from Swedish microdata: (1) fuel choices vary both across and within industries, (2) fuel switching accounts for a large share of the decline in manufacturing emissions between 2004 and 2020, and (3) higher carbon taxes have led firms to switch away from fossil fuels toward electricity and biofuels. Counterfactual analysis suggests that carbon pricing is effective in reducing manufacturing emissions, with fuel switching explaining roughly half of this effect. Market share reallocation toward cleaner firms further reduces emissions but increases the adverse impact on output. The cost of carbon pricing varies considerably across industries, due to differences in the firms’ abilities to replace fossil fuels with efficient alternatives.