Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

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For many years, there has been a great deal of discussion about carbon-pricing – whether carbon taxes or cap-and-trade – as an essential part of a meaningful national climate policy.  It has long been recognized that although carbon-pricing will be necessary, it will not be sufficient. Economists and other policy analysts have noted that policies intended to foster climate-friendly technology research and development (R&D) will also be necessary, but likewise will not be sufficient on their own.

Some recent studies and press accounts, which I reference below, have identified these two approaches to addressing CO2 emissions as substitutes, rather than complements.  That is fundamentally inconsistent with decades of research, and so my purpose in this essay is to set the record straight.

Carbon Pricing:  Necessary But Not Sufficient

First of all, why is there so much talk among policy analysts and policy makers – not simply among academics – about carbon‑pricing as the core of a meaningful strategy to reduce CO2 emissions?  Why, in fact, is this approach so overwhelmingly favored by the analytical community?  The answer is simple and surprisingly pragmatic.

First, there is no other feasible approach that can provide meaningful emissions reductions, such as the 80 percent reduction in national CO2 emissions by 2050 that was part of the legislation passed by the U.S. House of Representatives and proposed in the Senate and part of the Obama administration’s conditional pledge under the Copenhagen Accord.  Because of the ubiquity and diversity of energy use in a modern economy, conventional regulatory approaches –standards of various kinds – simply cannot do the job.  Only carbon pricing – either in the form of carbon taxes or cap-and-trade – can significantly tilt in a climate-friendly direction the millions of decentralized decisions that are made in our economy every day.

Second, carbon-pricing is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources.  Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.

Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.

For these reasons, carbon-pricing is a necessary component of a truly meaningful national climate policy.  [I’ve written about this in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”]  However, although it is a necessary policy component, carbon-pricing is not sufficient on its own. This is because there are other market failures that dilute the impacts of price signals on decision makers.

Technology R&D Policies:  Also Necessary, Also Not Sufficient

The most important of these “other market failures” is the public good nature of information.  Companies carrying out research and development (R&D) incur the full costs of their efforts, but they do not capture the full benefits.  This is because even with a perfectly-enforced system of intellectual property rights (such as patents), there are tremendous spillover benefits to other firms.  Decades of economic research – much of it by my former colleague and co-author, Professor Adam Jaffe, now Dean of Arts and Sciences at Brandeis University – has analyzed with empirical (econometric) analysis the remarkable degree to which inventions and innovations by one firm provide valuable information that leads to new inventions and innovations by other firms.

So, firms pay the costs of their R&D, but do not reap all the benefits.  The existence of this positive externality of firms’ R&D – or put differently, the public-good nature of the information generated by R&D – means that the private sector will carry out less than the “efficient” amount of R&D of new climate-friendly technologies in response to given carbon prices.  Hence, other public policies are needed to address this “R&D market failure.”

New path-breaking technologies will be needed to address climate change, and public support for private-sector or public-sector R&D will be crucial to meet this need.  But, at the same time, to address the climate-change market failure itself (that is, the externality associated with greenhouse gas emissions), carbon pricing will be necessary, for all of the reasons I gave above.  This is an application of an important and fundamental principle in economics:  two market failures require the use of two policy instruments.

Empirical analyses have repeatedly verified this crucial point – that combining carbon-pricing with R&D support is more cost-effective than adopting either approach alone.  Included in this set of studies are the following:  Carolyn Fischer (Resources for the Future) and Richard Newell (U.S. Energy Information Administration, on leave from Duke University), “Environmental and Technology Policies for Climate Mitigation”; Stephen Schneider (late of Stanford University) and Lawrence Goulder (Stanford University), “Achieving Low-Cost Emissions Targets”; and Daren Acemoglu (MIT), Philippe Aghion, Leonardo Bursztyn, and David Hemous (Harvard University), “The Environment and Directed Technical Change.”

Complements, Not Substitutes

An interesting, recent column, “Next Step on Policy for Climate,” by David Leonhardt in the New York Times (October 13, 2010, p. B1) might give some people the mistaken impression that technology policies are an adequate, even sensible substitute for carbon-pricing.  That was not the intended message of the column.  In fact, Leonhardt – perhaps the leading economic journalist writing today in the United States ­– indicates clearly in his column that he is skeptical of the notion of thinking of technology subsidies as an adequate substitute for carbon-pricing (in particular, cap-and-trade).  And in a follow-up post at the New York Times’ Economix, he makes clear that “these two policies are not mutually exclusive.”

Nevertheless, Leonhardt’s original column (which included a very nice profile of my colleague, Professor Michael Greenstone of MIT) focused attention on a recent report –  a report that could give the false impression that technology policies would be a sensible substitute for serious carbon-pricing.  The report in question – “Post-Partisan Power” – received significant coverage, primarily because of its sponsorship:  a combination of a prominent Republican-oriented Washington think tank, the American Enterprise Institute (AEI), and an equally prominent Democratic-oriented Washington think tank, the Brooking Institution (and a third partner, the Breakthrough Institute, a California-based environmental think tank).

The report may well garner some bi-partisan political support, because it promises a free lunch of painless, win-win solutions, a promise that will resonate with many elected officials.  Indeed, the report’s sub-title is “how a limited and direct approach to energy innovation can deliver clean, cheap energy, economic productivity, and national prosperity.”  What’s not to like? And the authors are presumably smart and politically shrewd.  I know that’s the case with the AEI author, Steven Hayward, who I debated last year in the pages of the Wall Street Journal.

To its credit, the report lays out a menu of policies intended to stimulate carbon-friendly technological change, ranging from $500 million of Federal government funding of K-12 curriculum development and teacher training to $25 billion annually of direct Federal funding of energy innovation.

For the reasons I explained above (the “R&D market failure” and the “carbon emissions externality”), both direct technology R&D policies and serious carbon-pricing are necessary, but neither is sufficient on its own.  Unfortunately, this new report ­­– and some of the press coverage surrounding it – makes the claim that such direct government funding of technology innovation is a sufficient and sensible substitute for meaningful carbon-pricing.  That claim is both unfortunate and wrong, as it is supported neither by sound reasoning nor empirical research, as I have described above.

Again, many of the individual technology policy recommendations offered by the AEI-Brookings-BI report are worthy of serious consideration (as a complement, not a substitute for an economy-wide carbon-pricing policy).  But the specifics – indeed, much of the meat – are missing.  “Reform the nation’s morass of energy subsidies” – yes, but exactly which subsidies (all of which have important political constituencies behind them) will be eliminated?  “Recognize the potential for nuclear power” – yes, and both the House and Senate carbon-pricing schemes would have provided tremendous incentives for nuclear power investment.

Overall, there should be concern about how all of this will be funded.  Where will the $25 billion per year come from?  The report appropriately states that this should not come from general revenues, and thus add to the Federal debt.  “Phasing out current subsidies for wind, solar, ethanol, and fossil fuels” could be meritorious on its own, but how much does this generate, and does it even pass a political laugh-test?  Interestingly, beyond this, despite considerable rhetoric about moving beyond debates about carbon-pricing, the report recommends that in order to avoid adding to the Federal debt, it would be necessary to impose new taxes, including increased royalties for oil and gas extraction, a tax on imported oil, a tax on electricity sales, and a “very small carbon price” (presumably from a modest carbon tax or unambitious cap-and-trade system).

The actual numbers would be helpful, and the political feasibility remains a serious question.  The political challenges that emerged in the effort to pass cap-and-trade climate legislation will not magically disappear if there’s an attempt to induce Congress to approve $25 billion in funding.  As Tom Friedman noted on October 12th in the New York Times, Congress has not come close to fully funding the outstanding requests for about $4 billion for ARPA-E (energy) research.

More broadly, despite the attraction of the AEI-Brookings-BI proposal as a potential complement to carbon-pricing (and I am serious that the proposal is of value in that context), one has to be very careful about comparing proposed new policies in idealized form (for example, precisely the right subsidies eliminated and precisely the right new subsidies introduced) with real policies with all their warts (for example, the cap-and-trade bill that was passed by the House last year).  Making such comparisons can lead to flawed analysis and misleading results.

This is not a new issue.  Robert Hahn and I wrote about this generic problem nearly 20 years ago in an article (“Economic Incentives for Environmental Protection:  Integrating Theory and Practice”) which appeared the American Economic Review Papers and Proceedings (May 1992).  At the time, our concern was that this mistake was being made not by the opponents but by the supporters of cap-and-trade and other (then essentially untested) market-based instruments.  We worried that “many analysts use highly stylized benchmarks for comparison that ignore likely political realities,” and suggested that an appropriate “comparison would be between actual command-and-control policies and either actual trading [cap-and-trade] programs … or a reasonably constrained theoretical … program.”

Likewise today, when carrying out comparisons of policy alternatives, it is fine to compare two theoretical, idealized alternatives, or to compare two real-world policies, but it is problematic and usually misleading to compare a theoretical, idealized policy of one type with a real-world example of another type of policy.

The Bottom Line

Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy.  Likewise, to address the “R&D market failure,” direct technology innovation policies will also be required.  Both are necessary.  Neither is sufficient.  These are complements, not substitutes.

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Postscript: Four years ago, the U.S. Congressional Budget Office (CBO) — widely recognized for its non-partisan, first-rate research — produced a study on the same topic as the AEI-Brookings-BI report, but did so with rigor and without ideology.  The CBO report — Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions (September 2006) — was prepared by Dr. Terry Dinan, a long-time, respected CBO economist, and was peer reviewed by an impressive set of academic and other experts.  Sadly, the CBO paper received little press coverage, despite its high quality and its relevance.  For anyone interested in the topic of this post, particularly those who disagree with my theme, I hope you will read the CBO report.

Also, a reader of this blog post sent me a paper by David Hart and Kadri Kallas (from MIT’s Energy Innovation working paper series) that examines “Alignment and Misalignment of Technology Push and Regulatory Pull.” It’s worth reading in the context of combining carbon pricing and technology R&D policies.

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12 Responses to Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

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  3. Dear Dr. Stavins,

    To begin, I am glad that we agree on the critical need for dramatic, even “breakthrough” innovations in energy technology to achieve deep emissions reductions, and that you acknowledge that such innovation is not likely to be spurred on solely by carbon pricing. Innovation policy is thus central to solving national climate and energy challenges, and deserving of an appropriately central focus in national policy discourse.

    That said, I’d like to point you to a response to your essay from Michael Shellenberger and Ted Nordhaus of the Breakthrough Institute, who have written you via David Leonhardt’s Economix blog at the New York Times here.

    “A technology-first strategy is not a technology-only strategy,” they write. “Cheaper and better clean energy technologies are not a substitute for pricing, regulatory, public procurement or other policies that will be necessary to make a full transition from fossil fuel based technologies to low carbon technologies.”

    Thus, on your central point that R&D alone is insufficient, we wholeheartedly agree. However, I think we still differ critically on key fronts.

    First, this discussion continues to conflate a greater emphasis on innovation (as we advocate) with a greater emphasis on “research.” You are not alone in this characterization of our recommendations, Dr. Stavins (Mr. Leonhardt uses similar language, as have other responders). However, those two terms — innovation and research — are not synonymous and distinction is important.

    Innovation is not solely the domain of the laboratory, as Breakthrough’s policy recommendations have always made clear. Carbon pricing, procurement, regulation, deployment incentives–all could and should play roles in a smart innovation-focused strategy to make clean energy cheap enough for widespread adoption throughout the world, both developed and developing. So while we certainly agree that a greater emphasis on R&D is far from sufficient, the question isn’t really about research vs. cap and trade, as your post above boils things down too.

    Our second point of divergence is on your assertion that cap and trade or carbon pricing is the only way to accelerate the deployment and adoption of clean and efficient technologies, which, as Michael and Ted point out in their reply, stands in clear contrast to plenty of historic precedent.

    In fact, the real-world history of carbon markets is not inspiring (e.g. the poor performance of the EU ETS), while direct public investment in new energy technologies (along with selected regulatory strategies) has been the primary driver of deployment of new low carbon technologies all over the world. In fact, two OECD nations stand apart from all others in accomplishing a rapid decarbonization of their energy supply systems in the 20th century — France and Sweden — both through direct, public-led development, procurement and deployment of large-scale zero-carbon energy sources (nuclear in the case of France and nuclear and hydropower in the case of Sweden). In neither case, has carbon pricing played a key role in accomplishing each nation’s low-carbon energy transition. Likewise, China today is probably the fastest adopter of clean energy technologies, from wind and solar to high-speed rail and electric vehicles. Again, such efforts are technology-policy and public investment driven (with a helping of regulatory support), without any carbon price to speak of. South Korea, Japan, Portugal, Spain, the evolution of Denmark’s wind industry and Germany’s solar industry–all belie the notion that carbon pricing is the only way to develop and deploy low-carbon energy technologies. The development and adoption of countless other non-energy technologies may also offer instructive precedent (where Pigovian taxation has certainly not been a common driver of the evolution or adoption of significant new technologies).

    I thus find your claim that “there is no other feasible approach that can provide meaningful emissions reductions” beyond cap and trade (or a carbon tax) unconvincing, and symptomatic of the need for new ideas in the realm of national and international energy policy.

    Third, what we find critically absent from most of the conventional discussion of carbon pricing and cap and trade, including your essay above, is a focus on what we believe should be the key question for climate policy design: how can policies in the developed world successfully make clean energy cheap enough for adoption throughout the developing world.

    According to the IEA, 97% of CO2 emissions growth between 2010-2030 will come from non-OECD (developing) nations under BAU scenarios. The IEA estimates that there will be enough emissions growth in non-OECD countries to completely outweigh the total elimination of emissions in the OECD countries.

    The hard fact to wrestle with is therefore this: no matter what we do in the US, or EU, efforts to stabilize the climate will live or die in the developing world. We all have to keep our eye on that ball.

    So what I still find lacking in your policy formulation is a clear explanation of how making fossil fuels very expensive in the US (e.g. through a significant carbon price) can help to make clean energy cheap enough for widespread adoption throughout the developing world in the coming decades?

    We at the Breakthrough Institute do envision a role for carbon pricing, but it’s a very different one than you describe in your essay: the aim being not to make fossil fuels expensive enough to make clean energy relatively affordable (but still expensive in real terms), but rather to raise the revenues necessary to invest in a comprehensive innovation-focused policy strategy to make clean energy cheaper in real terms. Recognizing that R&D is far from sufficient, that innovation-focused strategy extends well beyond this realm, to explore ways in which procurement, competitive deployment incentives, and certain regulatory measures can help propel innovation and price declines for a suite of clean energy technologies.

    In the end, we very much appreciate that you recognize the critical role for innovation policy, and appreciate your engagement with our recent report and this critical set of questions. We don’t claim to have all the answers, but we strongly believe that framing the questions and objectives in a new light, and exploring new options beyond those that have become orthodox in climate policy discourse may lead to much greater progress than what has amounted to a serial failure of cap and trade efforts domestically and emissions targets-and-timetables focused multilateral treaty efforts at the international level.

    We look forward to discussing this more. Sincerely,

    Jesse Jenkins
    Director of Energy and Climate Policy
    Breakthrough Institute

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  6. Sanford Gaines says:

    I’ve been doing a lot of research recently on climate policy, and I’m wondering if this posting isn’t too defensive of the carbon pricing idea and not receptive enough to the pressing need for large-scalé energy research. I was just reading the summary of the Acemoglu et al. piece (thanks for that link), where they say “optimal policy relies less on a carbon tax, and even more so on direct encouragement to the development of clean technologies.” You cite their paper approvingly, and I take your point that the carbon tax is complementary to other policies, but aren’t Acemoglu et al. closer to the “post-partisan consensus statement than to your own post? Would love to get your reply by email.

  7. Professor Gaines,

    Without going into detail regarding the various dimensions and issues about the paper to which you refer, I would note that their major conclusion in this domain is that “optimal policy involves both carbon taxes and research subsidies.” That doesn’t seem to be such a controversial point, and it is the only point I sought to make in my blog post. Both are necessary, neither is sufficient.

    Best wishes,

    RNS

  8. stickman says:

    Good post and some interesting comments by Jesse Jenkins above, as well. (Jesse, i’m somewhat surprised that you didn’t comment on Norway alongside France and Sweden… It might have been “decarbonised” from virtually the get-go, but Norway certainly achieved its remarkable hydropower capacity on the back of a strong public-backed platform as well.)

    Rob, you mention several studies discussing the complimentary roles of carbon prices and technology policy, so I suppose it wouldn’t hurt to add one more:
    “Near-term technology policies for long-term climate targets—economy wide versus technology specific approaches” by Sanden and Azar (Energy Policy, 2004).
    http://goo.gl/PgAG

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  12. Kim Wang says:

    I agree with Leonhardt’s assertion that technology subsidies and cap and trade don’t have to be mutually exclusive. At the skeletal level of this debate aren’t we really just talking about “carrots” versus “sticks” here and which one of these best matches the political,economic, and fiscal room temperature at any given point in time? I think the recent passage of the clean energy credit bill in my current state of Georgia recently has some interesting lessons on this issue. Some close friends took on the task of promoting this bill after some of the top, and highest paid lobbyists in the state weren’t able to move the bill forward one inch. Ironically, they collectively had zero hours logged as lobbyists enviromentalists. The leader of this small team studied economics at the University of Georgia. They are all extremely internet savvy and heady thinkers. Their plan exhibits the kind of genius one only sees in true outsiders who aren’t fettered by the constraints of educational or political dogma. I job needed doing. They created a social network site, solardd.info that integrated with a Facebook contest to win an Ipad. Here is the brilliant part-they new that any piece of legislation only has a handful of real opponents-once the three opponents of the solar bill (GA HB 146) were identified, the Facebook advertisement would be shown whenever anyone residing in these areas got on Facebook. To earn points towards the Ipad, contestants enter their zip code and a script allows them to send an email in support of the bill directly to their representatives. The rest is history. A bill that was literally dead was passed in what has to be the quickest turnaround in political history. What’s more, the targets of the campaign actually became the sponsors of the bill and were responsible for its passage! Now Georgia is slated to start a project that will be one of the largest solar installs in the country and this bill was passed maybe two months ago. Moral of the story-1.soft paternalism works 2.people really,REALLY want an IPAD! There’s a great video at the website of the guys who pulled the whole thing off describing the process in detail-I guess now they are “experts” which means they probably are doomed to mediocrity and group think but I hope not because they are my sweethearts and I wish them all the best in their endeavors. The website is http://www.GaprMedia.com and I believe the video plays automatically-its worth a look and their strategy should be adopted nationally in my opinion.

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