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

Robert Stavins's picture
Professor & Director John F. Kennedy School of Government, Harvard University

Robert N. Stavins is the A.J. Meyer Professor of Energy & Economic Development, Director of Graduate Studies for the Doctoral Programs in Public Policy and in Political Economy and...

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  • Oct 22, 2010
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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”; Lawrence Goulder (Stanford University) and Stephen Schneider (late of Stanford University), “Induced Technological Change and the Attractiveness of CO2 Emissions Abatement Policies”; 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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Jesse Jenkins's picture
Jesse Jenkins on Oct 22, 2010

Michael Shellenberger and Ted Nordhaus of the Breakthrough Institute have responded to Professor Stavins’ post 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.”

However, asserting that cap and trade or carbon pricing is the only way to accelerate the deployment and adoption of clean and efficient technologies stands in contrast to a plethora of historic precedent, as Michael and Ted point out in their response. In many ways, the claim that “there is no other feasible approach that can provide meaningful emissions reductions” is symptomatic of how impoverished the climate debate has become, and how in need of new ideas that debate is (many new ideas are under discussion daily via the many contributors to this blog).

Furthermore, what’s also absent from most of the conventional discussion of carbon pricing and cap and trade, including Dr. Stavins’ 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, there will be enough emissions growth in non-OECD countries under BAU between now and 2030 to outweigh a complete 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 have to keep our eye on that ball.

So what I still find lacking in Dr. Stavins’ policy formulation is a clear explanation of how making fossil fuels very expensive in the US 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 Dr. Stavins describes: 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.

On that note, I should add that this debate, both in Dr. Stavins’ post above and elsewhere, continues to conflate a greater emphasis on innovation with a greater emphasis on “research.” Those terms 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 the question isn’t really about research vs. cap and trade, as Dr. Stavins’ post boils things down too.

In the end, we very much appreciate that Dr. Stavins recognizes the critical role for innovation policy, and appreciate his engagement on this critical set of questions. I look forward to more. Cheers,

Jesse Jenkins
Director of Energy and Climate Policy
Breakthrough Institute

Jesse Jenkins's picture
Jesse Jenkins on Oct 22, 2010

The goal, if we aim to stabilize atmospheric CO2 and temperature rise, must be to drive global emissions towards zero as quickly as possible.  Beyond that, the CO2 target changes little of substance in policy strategy today.  We’re debating if the car should be going 60 miles per hour or 80 or 100mph, when we’re pretty much stuck in idle, rolling backwards down the hill…  let’s get the car in gear eh?!

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