energy innovation concept

Environmental-energy policy is tricky business. It involves two externalities: not only pollution and greenhouse gas emissions, but also innovation. That is, effective environmental-energy policy must not only price clean air in order to discourage overproduction of carbon intensive energies, but also promote the socially efficient level of research and development funding for innovation. This is compounded by the presence of environmental path-dependency and directed technical change (Acemoglu et al., 2012). Effective environmental-energy policy moving forward should not focus exclusively on emissions abatement, but rather on developing policy rules that support competition, a price on clean air, and selective R&D funding.

Before going further, it’s useful to consider a brief re-run of some basic economics to provide clarity to the overall discussion. Nobel Laureate Kenneth Arrow published a seminal paper in 1962 explaining that innovation is a market failure—markets systematically under-invest in R&D and other innovation-building activities. Investors cannot obtain the full return on their investments because new knowledge is non-rival and, at best, partially excludable through intellectual property rights and trade secrets. The task is, therefore, to create instruments that minimize perverse behavior and distortions while sufficiently funding public R&D efforts.

This is crucial in the context of environmental-energy policy. Rather than developing and implementing policy instruments that simply limit carbon intensive activities, much more can be achieved by also promoting innovation-building activities—accelerating economic growth and reductions in GHGs. Of course, there are no free lunches—all policies have a cost. Many proponents of environmental-energy policy action are guilty of espousing the strong double-dividend hypothesis, that there are joint environmental and economic benefits with no costs. Models suggesting the presence of a strong double-dividend make implausible assumptions, such as not accounting for pre-existing distortions in the economy or not accounting for declines in private-held scarcity rents (see Fullerton and Metcalf, 1997). While environmental-energy policy can promote economic growth, doing so is neither easy nor straightforward; specifically, normative decisions regarding tradeoffs between short & long term economic growth rates, equity, and distribution are required. With this in mind, surveying over a decade of economics literature reveals four guiding lessons.

First, commitment and credibility are crucial: absent credibility and follow-through over environmental-energy policy, agents (i.e. individuals, firms, countries) lack incentives to effectively coordinate actions. That is, fragmentation among countries, occurring in the form of carbon leakage and/or disjoint incentives, creates friction. Successful coordination enables greater knowledge spillovers between industries, aligns incentives, and prevents carbon leakage.

Second, specific policy incentives are suboptimal: rather than providing loans to specific energies, international environmental-energy agreements that foster mutual gains through trade and joint R&D development are most likely to succeed. For example,Johnston and Hascic (2010) show that inducing technical change is achieved best by supporting “local” general purposes technologies, in contrast to specific renewable energy technologies. In particular, supporting general purpose technologies, especially those that are highly substitutable, enables greater indirect spillovers. For example, wind and solar are considered relatively strong substitutes, given that they are both intermittent energy sources and energy is a homogeneous commodity. Targeting R&D expenditures towards storage technologies, rather than the generating technologies themselves, i.e. wind or solar, is found to yield greater gains in innovation. Intuitively, advances in storage—a general purpose technology—are accessible by wind, solar, among other technologies.

Independent of this concern regarding general purpose and specific technologies, there are issues of (1) time consistency and (2) dynamic optimization. Nobel Laureates Edward Prescott and Finn Kydland illustrate (1) in that policies yielding short term benefits are often negated by changes in expectation occurring in subsequent states. For example, consider the basic example of wind production tax credits (PTCs): companies enjoy receiving PTCs while in place, but intermittent provision limits PTC effectiveness. Likewise, Nobel Laureate Robert Lucas illustrates (2) in that many economic analyses treat individuals as static objects—making decisions for all time periods based only on an assessment of the current state. Unfortunately, many environmental-energy policies regarding specific incentives are designed in such a manner that they do not consider issues of re-equilibration and sorting post policy implementation.

Third, structural incentives are necessary, but not sufficient: although a carbon tax or tradable permit scheme is necessary to price clean air, neither would entirely address the positive externalities resulting from knowledge spillovers. Acemoglu et al. (2012), for example, provides the first comprehensive and systematic model incorporating environmental externalities in general equilibrium, concluding that environmental taxes alone would be insufficient to avert an “environmental disaster”.

Fourth, R&D subsidies must be used, but with caution: optimal R&D subsidies depend to a large degree on the elasticity of substitution between relevant energies. That is, allocating R&D subsidies to general purpose technologies generates spillovers based on the assumption that the generating technologies (that use the storage capabilities) are relatively substitutable. Despite direct gains and indirect spillovers, even R&D subsidies should be used sparingly. There are an array of possible problems that may ensue via inappropriate or excessive R&D provision, such as political lock-in and path dependency (Foxon, 2002) and displacements of private investment (Popp and Newell, 2009).

Hopefully policymakers can focus on developing effective time-invariant rules to price carbon and induce technical change via environmental-energy policy, rather than avoiding the issue or settling for sub-par outcomes.

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Acemoglu, D., Aghion, P., Bursztyn, L., and Hemous, D. (2012). The environment and directed technical change. American Economic Review. 102(1): 131-166.

Foxon, T. (2002). Technological and institutional ‘lock-in’ as a barrier to sustainable innovation. ICCEPT Working Paper.

Fullerton, D., and Metcalf, G. (1997). Environmental taxes and the double-dividend hypothesis: Did you really expect something for nothing? Chicago-Kent Law Review, presented the “Symposium on Second-best Theory.”

Johnstone, N., and Hascic,I.(2010). Directing technological change while reducing the risk of (not) picking winners: The case of renewable energy. OECD Environment Directorate.

Popp, D., and Newell, R. (2009). Where does energy R&D come from? Examining crowding out from environmentally friendly R&D. NBER Working Paper 15423.