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Study suggests cap and trade programs do not provide sufficient incentives for energy technology innovation; implications for climate policy
19 March 2012
Policies incentivizing the private sector to push to develop innovative “clean” technologies are likely to play a key role in achieving climate stabilization. However, cap and trade programs (CTPs) to reduce emissions—currently the world’s most prominent climate policy instrument—do not inherently provide incentives to induce the private sector to develop innovative technologies, according to a new open access paper published in the journal Proceedings of the National Academy of Sciences.
Margaret Taylor, a researcher at Lawrence Berkeley National Laboratory, explored the relationship between innovation and CTPs using empirical data from two successful CTPs: the US national market for sulfur dioxide (SO2) control and the northeast and mid-Atlantic states’ market for nitrogen oxide (NOx) control. (Respectively, Title IV of the 1990 Clean Air Act and the Ozone Transport Commission/NOx Budget Program.)
She suggests that the success of some CTPs in achieving pre-determined pollution reduction targets at low cost seems to have reduced incentives for research and development that could help develop more appropriate pollution control targets.
Policymakers rarely see with perfect foresight what the appropriate emissions targets are to protect the public health and environment—the history is that these targets usually need to get stricter. Yet policymakers also seldom set targets they don’t have evidence that industry can meet. This is where R&D that can lead to the development of innovative technologies over the longer term is essential.—Margaret Taylor
Taylor’s study shows that before trading began for these CTPs, analysts overestimated how difficult it would be for emissions sources to achieve targets, in a pattern frequently observed in environmental health, safety, and energy efficiency regulation, including all of the world’s CTPs. This was seen in overestimates of the value of allowances, which are permits to release a certain volume of emissions under a CTP. If an entity can reduce emissions cheaply, they can either sell these allowances for whatever price they can get on the market or they can bank these allowances to meet later emissions restrictions.
The cap-and-trade programs Taylor studied exhibited lower-than-expected allowance prices, in part because program participants adopted an unexpected range of approaches for reducing emissions sources in the lead-up to trading. A large bank of allowances grew in response, particularly in the SO2 program, signaling that allowance prices would remain relaxed for many years.
But this low-price message did not cause the policy targets in the CTPs to change, despite evidence that it would not only be cheaper than expected to meet these targets, but it would also be more important to public health to tighten the targets, based on scientific advances. The lower-than-expected price signal did cause emissions sources to reassess their clean technology investments, however, and led to significant cancellations, Taylor reported.
Meanwhile, the low price also signaled to innovators working to develop clean technologies—which are often distinct from the emissions sources that hold allowances—that potential returns to their research and development programs, which generally have uncertain and longer-term payoffs, would be lower than expected.
This effect also helps explain the study’s finding that patenting activity, the dominant indicator of commercially-oriented research and development, peaked before these CTPs were passed and then dropped once allowance markets began operating, reaching low levels not seen since national SO2 and NOx regulation began in 1970.
Regardless of the exact mix of contributory factors, the tendency to overestimate CTP allowance prices before trading—which is reminiscent of recurrent a priori overestimation of the compliance costs of traditional environmental, health, safety, and energy efficiency regulation—implies that early investments in clean technology adoption and invention will often turn out to be overvalued once trading begins. When this becomes clear to emissions sources and innovators, one logical effect should be reassessment of investment commitments.
...The implication is that CTPs do not inherently provide sustained incentives for private sector R&D investments in clean technologies, but may add to the uncertainty inherent in inventive activity. This effect is worth noting, given the likely importance for long-term climate stabilization of capturing the potential of R&D to create and improve clean technologies, as well as develop scientiﬁc personnel and organizational innovative capacity.
Allowance price-stabilization options (e.g., fixing prices in a predetermined range...or modulating prices through an independent third-party market actor chartered to advance the public interest, and so forth) have been suggested as ways to limit the uncertainty of CTPs, including for innovators. These options are likely to pose trade-offs, however, particularly regarding the ﬁeld of search for innovation, other elements of CTP design (e.g., the treatment of offsets and intertemporal allowance transfer), and complementary policy efforts with their own attributes of technology demand-pull and/or supply-push (e.g., emissions standards and public R&D support, respectively).
The knowledge base necessary to characterize these trade-offs and inform climate policy efforts to incentivize the private sector to reach its innovative potential in clean technologies is still nascent, and is developing across a number of research traditions and methods. Synthesizing this knowledge and deepening its attention to strategic activities and behavioral issues within the “black box” of innovation will aid global efforts to achieve the technological change necessary to avoid the worst impacts of climate change.—Taylor 2012
Margaret R. Taylor (2012) Innovation under cap-and-trade programs, PNAS doi: 10.1073/pnas.1113462109
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