Optimal Subsidies for Capital Replacement and the Green Transition

We analyze optimal subsidies for the replacement of durable assets in a model with heterogeneous producers, endogenous capital-embodied innovation, and environmental externalities that depend on capital vintages.

We analyze optimal subsidies for the replacement of durable assets in a model with heterogeneous producers, endogenous capital-embodied innovation, and environmental externalities that depend on capital vintages. We characterize the constrained-efficient allocation assuming a planner chooses capital replacement subject to the equilibrium evolution of innovation. Optimal subsidies equal the sum of two terms: (i) the difference in present discounted value of damages associated with old vs. new capital and (ii) the social value of innovation induced by capital replacement, net of the associated markup distortion. We generalize this formula to the case of new technologies, such as electric vehicles. We calibrate the model using empirical evidence on several types of capital, including aircraft and vehicles, and simulate the optimal transition. Initially, optimal subsidies are steeply increasing in the age of the replaced asset. In the long run, they are determined by the trade-off between innovation and markups.