Technological Innovation and Emission Right Trading

In December 1997 more than 160 nations met in Kyoto, Japan, to negoti- ate binding limitations on certain greenhouse gases (primarily carbon dioxide) for the developed nations, pursuant to the objectives of the United Nations Framework Convention on Climate Change of 1992. The conference finally concluded with an international settlement, the Kyoto Protocol, in which the world’s wealthier countries (defined in Annex I of the treaty) agreed on bind- ing commitments to limit their greenhouse gas emissions by 5.2 %, relative to the levels emitted in 1990. Each of the participating developed countries is obliged to decide how to meet its respective reduction goal during a five-year period from 2008 to 2012 according to specific basic rules. All parties of the protocol are urged to foster partnerships in research and observation of climate science, impacts and response strategies. Furthermore, the agreement requires the signing countries to consider ways to minimize adverse effects on developing countries of these actions transmitted through trade. Anyway, the restrictions will lower global demand for carbon-emitting fuels, reducing their interna- tional prices. But on the other hand emission controls depressing economic activity in countries subject to emission restrictions might also lower these countries’ demand for imports, some of which come from developing countries. In combination, these changes in trade volumes and prices can have complex consequences, harming some developing countries while benefiting others.

The high potential costs of controlling pollutants by quantitative means have led to growing interest in many economic segments. For a global pollu- tant, such as carbon dioxide, a system of auctionable permits works in many ways like a carbon tax, although it is the total volume, rather than the marginal abatement cost, which is fixed. However, a permit scheme has various advan- tages, particularly if it allows for international trading. Unlike a carbon tax, permits can be saved for future use and thus, given that carbon is a long-lasting global pollutant, users retain a greater choice over the intertemporal path of consumption including the possibilities of a futures and options market. Fur- thermore, a major argument for a permit scheme is that potential international trading could allow extra cutbacks in pollution to be made in those countries, which have the lowest marginal abatement costs and sold to countries with higher marginal abatement costs. Additionally, countries also receive credits through various shared ecology-friendly programs and other systems that re- move carbon dioxide from the atmosphere such as forests. Theoretically this should reduce the total abatement cost since the permit scheme rewards coun- tries that meet their targets, and provides financial incentives to others to do so as soon as possible. In fact, each Annex I country has agreed to limit emis- sions to the levels described in the protocol, but many countries have limits that are set above their current production. Russia, for instance, currently easily meets the requirements, and therefore can sell off its credits to countries that don’t yet meet their targets. However, the Kyoto protocol allows for such international trading to begin at the start of the commitment period in 2008.

Ecological innovation is crucial for tackling the thorny issues of timing in climate policy.“Technical change is key to finding low-cost solutions to the cli- mate problem.”¹ Unfortunately, there is a lack of empirical evidence on the links between environmental policy and innovation. As a result, most environ- mental policy models treat technological change as exogenous and therefore cannot examine the potentially important links between policy and technolog- ical change. Although innovation is a fundamentally uncertain process, it is commonly agreed that innovations generally draw on underlying scientific or other knowledge, and that some kind of search or experimentation process is involved. In addition, it is accepted that many innovations are the result of knowledge obtained through experience or learning by doing, and also that cumulative experience is generally a significant factor. It is also recognized that some of the most radical innovations are designed to respond to the most pressing perceived needs, and hence market forces can act as a strong stim- ulus for innovation by firms aiming to reduce costs or to gain market share.

The notion that prices or policies increasing the cost of energy lead to new in- novations follows from the induced innovation hypothesis, was first suggested by Hicks (1932). For example, Michaelis (1997) shows the strong relation- ship between fuel prices and the rate of energy efficiency improvement in the aviation industry. Furthermore, Popp (2001, 2002) looked more broadly at energy prices and energy related innovation. He attempted to decompose the overall reduction in energy use that is associated with changing energy prices between the substitution effect and the induced innovation effect. Secondly Popp used a log-log regression on US patent data from 1970 to 1994 for differ- ent technologies and was able to conclude that energy prices have a strongly significant positive effect on innovation. The result of his research was that approximately“two-thirds of the initial change in industrial energy consump- tion after a price change is due to simple price-induced substitution, while the remaining one-third is due to induced innovation”². This finding suggests that environmental taxes and regulations not only reduce pollution by shifting be- havior away from polluting activities, but also encourage the development of new technologies that make pollution control less costly in the long run.

In order to thrive on the challenges of global climate policy and in the light of the Kyoto Protocol, it is obvious that enterprises face strong incentives to replace their production facilities by state-of-the-art ecologically friendly pro- duction plants. However financing might not always be possible especially for small and midsize firms constantly being short on working capital and cash flow problems. But even with no sufficient assets the help of public funds might finance an investment of such new technologies and production facilities. Em- ploying the framework of Jean Tirole (2001) on corporate governance enables to sketch a framework to show under which circumstances subsidies establish a Pareto-efficient situation for both, the entrepreneur and the public author- ities. Departing from the Arrow-Debreu paradigm by introducing an agency

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¹ Michael Grubb: Technologies, energy systems and the timing of CO2 emissions abatement, an overview of economic issues, Energy Policy, Vol. 25, No. 2, 1997, p. 161.

² David C. Popp: The effect of new technology on energy consumption; Resource and Energy Economics, Vol. 23, 2001, p. 237.