Cap-and-Trade Programs and Innovation for Climate Safety
Margaret Taylor1
1Richard and Rhoda Goldman School of Public Policy
University of California, Berkeley
2607 Hearst Avenue
Berkeley, CA USA 94720-7320
tel: 011-510-642-1048
fax: 011-510-643-9657
Abstract [Needs revision]
Analysts generally agree that considerable technological innovation will be necessary to reduce greenhouse gas (GHG) emissions to “safe” levels while minimizing economic impacts. Market failures related to both environmental pollution and innovation reduce the likelihood that the private sector will provide that innovation without public intervention. Meanwhile, cap-and-trade programs (CTPs) for GHG reductions are rapidly becoming the world’s dominant climate policy instrument. This paper assesses the innovation effects of the three most prominent CTPs in existence that have lengthy-enough operations for evaluation and strong similarities to climate CTPs. It shows that in each CTP, lower-than-expected pollution prices emerged that led to smaller-than-expected markets for a wide range of emissions reduction technologies. Further, in two of the three CTPs, significant cancellations of technology orders already in process compounded the reduced market expectations for these technologies during CTP operations. In addition, the paper shows that dramatic declines occurred in patenting activity – the most widely used indicator of the levels of inventive effort involved in developing technologies for later sale – in all of the identified technologies when CTPs were operating, as compared to periods of time that were dominated by more traditional environmental regulation. The paper concludes by raising concerns about whether CTPs will be able to induce the levels of pre-commercial inventive activity necessary to achieve climate safety without careful policy design and complementary policy efforts.
Classification Codes and Keywords
Keywords: Environmental Policy, Innovation, Emissions Trading, Climate Change
JEL codes: Q54, Q55, Q58.
1 Introduction
Analysts generally agree that the process of reducing greenhouse gas (GHG) emissions to “safe” levels, while minimizing economic impacts, will require considerable technological innovation.[1] Large portions of global GHGs are emitted by key sectors of the economy; for example, electric power (24% of global emissions), transportation (14%), industry (14%), and agriculture (14%), when combined, contribute 66% of global emissions [1]. In comparison, “safe” GHG levels have been set at 50-80% below 1990 total emissions by 2050 in recent initiatives by the European Union, Canada, Japan, and California. These are very ambitious goals, both in terms of the absolute GHG levels required and the speed at which those levels need to be reached, particularly when one considers the long operating life of many major individual emissions sources, such as power plants. But the specter that even these ambitious targets will be inadequate to ensure climate safety is being raised by the latest findings of an accelerating growth rate of atmospheric carbon dioxide (CO2), faster-than-predicted ice melts, and growth in China's CO2 emissions that is outpacing previous estimates [2; 3; 4].
Market failures related to both environmental pollution and innovation decrease the likelihood that the private sector will provide the necessary levels of “climate-safe” innovation without public intervention.[2] A critical question, therefore, is which policy approaches will best serve to foster that innovation. This question is largely unanswered by empirical scholarship on environmental innovation, however, despite more than thirty years of renewable energy, energy efficiency, and environmental policy experience to draw on.
In the meantime, climate policy is rapidly evolving, and cap-and-trade programs (CTPs) for GHG mitigation are becoming the world’s dominant climate policy instrument, with the European Union (EU), Australia, over half of both the U.S. States and Canadian Provinces, and one Mexican State either operating or developing programs.[3] The primary economic case for the use of CTPs is one of static efficiency; previous CTPs have demonstrated that the instrument is capable of facilitating pollution reductions to meet relatively short-run caps at low cost in cases in which there are available technological options. But there is another important factor driving the emerging dominance of CTPs in climate policy: the claim that CTPs are better than other policy instruments in providing an “incentive for innovation” [e.g. 8].[4]
This “dynamic efficiency” claim stems from the conclusions of theoretical environmental economics studies, dating back to [9], that compare and rank such instruments as taxes, subsidies, CTPs, and traditional environmental regulation regarding their incentives for innovation. The majority of these studies in the 1970s-90s supported the dominance of CTPs above other policy instruments on dynamic efficiency grounds [e.g., 9; 10; 11; 12; 13]. Another set of studies, however, that is for the most part more recent than these consensus studies, have portrayed a more ambiguous situation [e.g., 14; 15; 16; 17; 18; 19; 20]. As reviewed in [21], the majority of more recent authors “support the view that grandfathered permits [the dominant allowance allocation approach in CTPs] provide lower incentives [for innovation] than emission taxes and also question the notion that market-based instruments, specifically emission trading, are generally superior to direct regulation.” Significantly, [15] states that there is “no unambiguous case for preferring any of these policy instruments,” because assumptions about such things as innovation costs, appropriability concerns, the shape of environmental benefit functions, and market structure are critical to the outcomes of the models.[5]
In light of the political impact of the earlier literature and what seems to be a dissolving consensus about its conclusions, a brief overview is in order. The dominant modeling approach analyzes the incentives of a polluting firm facing a binary choice between “its existing technology and the possibility of one single (exogenously given) new technology” [18]. In light of this choice, studies typically consider firm incentives for “innovation” in pollution control under different policy scenarios, where innovation is defined to represent both the invention and the commercialization of a new product or process. Most studies consider diffusion as well, either as an assumption or as a variable; as pointed out in [19], the assumption of complete diffusion of the new technology across all the firms in an industry [e.g., 10; 11] can be critical to modeling outcomes. In most of the studies, innovation incentives are determined by accounting for “innovator” rewards and costs. Following [11], rewards are attributed to three sources: (1) savings regarding the direct cost of abatement (examples are equipment expenses and operating costs); (2) savings related to transfer losses associated with abatement (i.e., payments made by the firm, such as emission taxes); and (3) gains related to payments made to the firm (examples include emission subsidies and patent royalties). Costs are the funds necessary to develop and implement the technology, which are termed “R&D expenditures” [18].
A number of concerns have been raised about the validity of the dominant modeling approach and its assumptions, some of which are highlighted here. First, both [18] and [22] point out that the representation of so-called “command and control” regulation for comparative purposes is inadequate, given the greater use in environmental law of such performance standards as limits on emissions per unit output or input. Second, several studies raise issues about the potential disincentives for innovation that may arise from the dynamic nature of pollution prices in a CTP [e.g., 15; 16; 19; 20]. They point out that allowance prices in a CTP are likely to drop when marginal abatement costs fall with technology adoption by a subset of early-mover polluting firms, thereby reducing the incentives for later firms to similarly adopt new technologies. Third, some studies focus on the modeling treatment of polluting firms under CTPs, which typically does not differentiate between sellers of allowances (i.e., polluters who emit less pollution than their allowance allocations) and buyers of allowances (i.e., polluters who emit more pollution than their allowance allocations). The argument here is that the net incentives for innovation may be ambiguous under a CTP because, although the instrument may incentivize sellers to make more changes to their production processes than other instruments, it may also incentivize buyers to make fewer changes [17; 22].[6] Fourth, a few studies and one review of the literature focus on the situation in which non-polluting third-party firms – rather than polluting firms – invent and commercialize new technologies of relevance to the environmental focus of a CTP [11; 15; 18; 23]. In this situation, the rewards for innovation stem from technology sales to polluting firms rather than from abatement cost savings or revenues from allowance sales, and therefore turn the traditional accounting in models on its head.[7]
What does the empirical literature say about the validity of these concerns? Unfortunately, as reviews [e.g. 5; 24] have pointed out, there is a dearth of empirical studies on CTPs and innovation. The focus of the few studies that exist is on individual CTPs [e.g. 25; 26; 27; 28; 29], rather than on bringing our collective experience operating CTPs over the last two decades to bear on understanding the innovative conditions defined by these policy instruments more generally. As such, the empirical literature has not been as useful to the policy debate as the theoretical literature.
This paper aims to rectify this situation, to some extent. The first part of the paper focuses empirically on the question of whether the major innovation sources of new products and processes related to existing CTPs are typically the polluting firms that are allotted allowances, or non-polluting third parties. As predicted in [23], the evidence supports the idea that “innovations in pollution control are often (if not mostly) supplied by special outside suppliers.” This condition also appears to hold for five of the major technologies of relevance to GHG mitigation from the electric power sector.[8] The second part of the paper considers the implications of the distinction between the innovators and the adopters of environmental technologies in an empirical treatment of the innovation dynamics under the three most prominent CTPs in existence that have lengthy-enough operations for evaluation and strong similarities to climate CTPs. This part of the paper shows that in each CTP, lower-than-expected allowance prices emerged that led to smaller-than-expected markets for a wide range of emissions reduction technologies. Further, in two of the three CTPs, significant cancellations of technology orders already in process compounded the reduced market expectations for these technologies during CTP operations. In addition, dramatic declines occurred in patenting activity in all of the identified technologies when CTPs were operating, as compared to periods of time that were dominated by more traditional environmental regulation. The paper concludes by raising concerns about whether CTPs will be able to induce the levels of pre-commercial inventive activity necessary to achieve climate safety without careful policy design and possibly complementary policy efforts.
2 Technology Innovators and Adopters
This part of the paper focuses empirically on answering the question of whether the major innovation sources of new products and processes related to CTPs are typically the polluting firms that are allotted allowances, or non-polluting third parties. Although this question has received very little attention in the literature, so far, the answer to it is fundamental to any understanding of the competitive dynamics of innovation under CTPs.
If the innovators are distinct from the polluters, there will be additional uncertainties introduced into the innovation process under a CTP system than under either emissions taxes or traditional environmental regulation. Any innovator has to cope with R&D investment decisions that are long-term and have uncertain technical outcomes, of course. But because the innovator rewards to non-polluting third-party firms stem from technology sales to polluting firms, it is easier for a third-party firm to predict total rewards under conditions of fixed emissions prices or fixed emissions quantities than it is under the changing allowance price situation that occurs under a CTP. This is because the polluting firm “potential customers” of a new technology can choose a less predictable array of options under a CTP, including allowance purchases either alone or in combination with lower cost, less effective technologies that might not have been considered competitors to an innovator under a different policy regime. If the third-party is the innovator, its investments in R&D under a CTP will necessarily be based in large part on allowance price expectations, and the portfolio of technological pathways that these innovators choose to follow will probably need to be justified internally by potential payoffs that incorporate premiums for allowance price uncertainty.
As mentioned above, a few theoretical economic studies and one review of the literature focus on the situation in which non-polluting third-party firms – rather than polluting firms – invent and commercialize new technologies of relevance to the environmental focus of a CTP [11; 15; 18; 23]. The prevalence of this situation is not really touched upon, however, except in [23].
Meanwhile, [30] empirically investigates the composition of R&D expenditures in the electric utility industry, which has been a major target of the three CTPs in existence with long enough operations for evaluation and strong similarities to climate CTPs, as well as all proposed and operating climate CTPs. Using data from the Federal Energy Regulatory Commission (FERC) and Energy Information Administration (EIA), this study finds that “most of the environmental research in pollution abatement technologies was conducted by electric equipment manufacturers such as Babcock and Wilcox and not by utilities.”[30] Electric utilities, by contrast, “conducted very little pollution abatement research—rather the bulk of abatement expenditure was concentrated on compliance issues and is thus not considered R&D.” In other words, according to the R&D expenditure data considered in [30], non-polluting third-party firms are the primary sources of the innovations that are most relevant to resolving the pollution issues targeted by CTPs.
But many R&D programs do not result in commercialized innovations. To get a better sense of innovative activity at the intermediary step between invention and commercialization, it is helpful to turn to patent data. Patents are required by law to publicly reveal the details of a completed invention that meets thresholds of novelty, usefulness, and non-obviousness. Studies have shown that patenting activity parallels R&D expenditures, which are often difficult to find at a disaggregated enough level for research purposes, and can also be linked to events that occur outside the firm. Surveys [31; 32; 33] demonstrate that 40–60% of the innovations detailed in patent applications are eventually used by firms. This indicates that patents are probably best thought of as a well-accepted intermediary outcome of inventive activity, one that is tied both to the input of R&D expenditures and to hopes of commercialization. See [34] for a review of the use of patent statistics as economic indicators, including some of their strengths and weaknesses.