In this thesis I present a new framework for investigating the environmental im- pact of and optimal policies for biofuel production. The model captures the interactions between fossil fuel and biofuel in addition to the dynamic nature of the carbon cycle. Compared with the social planner optimum, two external effects that the market fails to integrate are exposed; the negative environmental impact of emission from fuel consumption, and the benefits of carbon capture through growth in the crops used for biofuel production. It is then shown that these deficiencies can be corrected through a common carbon price, where emission is taxed and carbon capture is subsidized. The socially optimal solution can also be reproduced using a tax/subsidy scheme on fossil fuel and biofuel production. The last part of the thesis investigates the effects of the most commonly used policy instrument for biofuels; a blending mandate. It is shown that a blending mandate will, as desired, tend to increase the use of biofuel and lower fossil fuel production. The optimal tax on fossil fuel, in the presence of a blending mandate, is then derived. If the total benefits of biofuel are high enough to compensate for the environmental damage of the direct emissions, the tax on fossil fuel should be lower than the first-best tax.