Carbon markets stifle innovation – Traditional regulatory methods would be more effective

On its climate change information website, the New Zealand government explains how:

An emissions trading scheme (ETS) introduces a price on greenhouse gases to provide an incentive for people to reduce emissions and enhance forest sinks. Emissions trading provides flexibility in how participants comply with their obligations, enabling a least-cost response.

There are, of course, other ways to reduce emissions, such as traditional regulatory mechanisms. Pejorative phrases such as ‘command-and-control’ are usually used in the brief moment before regulation is dismissed from consideration. Indeed, the NZ Ministry for the Environment (MfE) asserts that imposing a price on greenhouse gas emissions is advantageous because:

It harnesses the market dynamic by providing automatic incentives for firms to invest in reducing emissions and to shift to lower-emissions products and services.

It provides flexibility for firms and fosters innovation and the seeking out of least-cost emission reduction strategies.

But something rather important is being glossed over here: An ETS doesn’t provide an automatic incentive for all firms to reduce emissions.

And, it turns out, this simple observation leads to some very awkward conclusions that have not been part of the carbon trading debate.

First, a quick reminder of how the carbon market is supposed to work. The basic principle of emissions trading is that those firms able to make greater reductions in emissions can sell their further reductions – in the form of emissions credits – to others who have been unable to make sufficient emissions reductions.

This is where the ‘least-cost’ idea comes in. The firms able to make the biggest reductions in emissions do so because it costs them less than everyone else. The firms for which emissions reductions would cost the most choose instead to buy credits on the carbon market. Overall, so the logic goes, the cost to the economy of total emissions reductions is minimised.

That may be so – in the short term. But if we are to make the 90% reductions in greenhouse gas emissions that are needed in the longer term, by which I mean maybe 20-40 years, we are going to need radically different systems of energy generation, transport, industrial and agricultural production, and service delivery. Achieving that goal undoubtedly requires radical innovation.

Unfortunately, despite the assertions of the MfE, an ETS won’t foster nearly enough innovation. In his 2003 conference paper “Design, Trading and Innovation” (pdf here), David Driesen, a law professor at Syracuse University, has shown that emissions trading “does a poor job in stimulating radical innovation.” In fact, he writes, “It probably stimulates less innovation than a comparably designed traditional regulation” (p.40).

How does Driesen come to this conclusion?

His argument is based on the fact that oft-repeated claims about ETSs stimulating innovation rely upon an error in the economic theory of emissions trading first pointed out in 1989 by David Malueg.

Driesen explains it as follows:

Polluters have an incentive to make extra emission reductions under emissions trading so that they can sell credits, therefore, emissions trading stimulates innovation. This model accurately explains the situation of sellers of credits. But it is also obviously incomplete. It leaves the buyers of credits out of the picture. (p.6)

As Driesen observes, this incomplete analysis actually forms the theoretical foundation for the standard argument that emissions trading encourages innovation and

Many economists, legal scholars, and practicing lawyers repeat this obviously incomplete argument over and over again as gospel. (p.6)

And so, it seems, does the NZ Ministry for the Environment.

To correct the incomplete understanding of carbon markets, let’s bring the buyers of emissions credits back into the picture. As I’ve already noted, firms for whom emissions reductions have the highest cost can buy emissions credits at a lower cost instead. Consequently, any incentives to innovate are completely removed from these firms.

What we must pay attention to here is the fact that it is the cost of existing approaches to emissions reduction that are highest for these firms. If these firms were actually faced with having to pay this high cost, they would experience a greater incentive to innovate in more radical ways than firms which find it easier (ie cheaper) to cut emissions using existing methods. And the firms facing higher costs would naturally seek new emissions reduction methods with lower costs than existing methods.

The conclusion is that firms which would otherwise have the greatest incentive to develop innovative solutions have the incentive removed by the ETS.

Because short-term economic benefit has been prioritised over more effective and innovative action on climate change, the development of radical long-term solutions which we urgently need is being suppressed by the ETS.

This may be counter-intuitive for those who always equate markets with freedom, creativity, and innovation – but we must finally conclude that, rather than carbon markets or any price-based instruments, regulatory mechanisms for greenhouse gas emission control are needed at the firm level. Regulation will most effectively encourage and maximize the innovation in emissions reduction methods that we so urgently need.

Sources

David Driesen (2003) Design, trading, and innovation. Available here (pdf).

David Malueg (1989) Emission credit trading and the incentive to adopt new pollution abatement technology. Journal of Environmental Economics and Management 16, 52-57.

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