Cap-and-Trade Programs and Innovation for Climate Safety

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. Despite the claim that CTPs are better than other policy instruments in providing an incentive for innovation, the recent economics literature does not reflect such a consensus. For the most part, recent studies raise concerns about the validity of the assumptions underlying the dominant comparative modeling approach that compares policy instruments regarding their effects on innovation. This paper tries to shed some empirical light on the influential theoretical economics literature regarding CTPs and innovation, in the context of the climate safety challenge. It focuses first on whether the major innovation sources related to existing CTPs, as well as five major technology options for GHG abatement, are typically the polluting firms that are allotted allowances, or non-polluting third parties. Patent analysis here supports other evidence that non-polluting third-parties appear to be the primary sources of innovation. This implies that the innovation process under a CTP will include uncertainties that are not otherwise present under either emissions taxes or traditional environmental regulation. The second part of the paper assesses the innovation effects of the three most prominent CTPs in existence that have lengthyenough operations for evaluation and strong similarities to climate CTPs. 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 – the most widely used indicator of the levels of inventive effort involved in developing technologies for commercialization – in a wide range of technologies when CTPs were operating, as compared to periods of time dominated by more traditional environmental regulation. The paper concludes by raising concerns about whether CTPs will be able to induce the levels of innovation necessary to achieve climate safety without careful policy design and possibly complementary policy efforts. Classification Codes and