New study suggests cap-and-trade results in decreased innovation

By John Timmer

Among those interested in addressing the problem of climate change, one of the primary debates is about the best way to induce the private sector to develop innovative technologies. Although some favor a simple carbon tax, the US' success with a cap-and-trade system has led to its use both in Europe and in regional systems within the US. A new analysis of past US programs, however, suggests that cap-and-trade hasn't quite been the success many think it is. Its rapid early gains have been followed by a period of stagnation.

The US implemented cap-and-trade systems in the 1990s as a response to the problem of acid rain. Chemicals produced by combustion of fossil fuels (primarily coal) had previously been regulated by standard environmental regulation. However, over the course of the 1990s, SO2 and NOx were both subject to a cap-and-trade system that gave industries the option of taking different approaches to the control of these emissions. All significant sources of these chemicals were given allowances targeted to keep the total emissions below levels deemed acceptable. Innovators that cut their emissions substantially could sell their allowances to sources that found it too difficult or expensive to do so.

On some levels, this was a significant success. Emissions dropped and the cost of reaching that goal turned out to be far less than many had predicted. But Berkeley's Margaret Taylor has now gone through the numbers and found data suggesting not all is as rosy as it appears.

There are some indications in the literature that suggest cap-and-trade doesn't quite spur the sort of widespread advances their proponents sometimes suggest. For example, some studies have found a subset of early movers rapidly adopt technology that is so successful that it drops emissions sufficiently that late movers don't actually have any incentive to act. In addition, early successes can limit the incentives for further technology developments. Taylor's study attempted to determine if there were any evidence of these issues in the existing cap-and-trade markets.

To begin with, Taylor compared the expected price range of emissions credits with those that actually prevailed once trading began. Except for a few brief periods, the credits traded for far less than expected. For SO2, typical prices were around half the expected values; for NOx, the values were 70-80 percent of predictions. As a result, many sources simply purchased excess credits and banked them for future use—in the case of SO2, 75 percent of the credits allocated over the first five years were banked.

The system did work in the sense it induced industries to switch to use the approaches that were easiest to adopt. For sulfur emissions, this largely involved a switch to low-sulfur coal, along with the targeted deployment of post-combustion scrubbers. However, the rapid plunge in the value of credits actually led to the cancellation of scrubber orders for sources that produce over 3.6Gw of power. For NOx emissions, a combination of demand reduction and the shift to less polluting power sources were the two key factors in meeting emissions goals.

One thing that should be obvious is the two largest approaches to meeting emissions targets—changing fuel sources and changing power sources—require almost no innovation. To get at the role of innovation in these markets, Taylor searched for patent applications going to technology that enabled either pre- or post-combustion emissions reductions of both of these chemicals.

All four categories showed a similar pattern. Patent applications were roughly constant across the period in which these chemicals were subjected to standard environmental regulations. But they were largely unchanged during the period in which industries were preparing for the advent of cap-and-trade, and plunged within a few years of its implementation. This data hints that the rapid success of the program actually ended up reducing the pressure for innovation.

As Taylor concludes, "The implication is that CTPs [cap-and-trade programs] do not inherently provide sustained incentives for private sector R&D investments in clean technologies." And, in contrast to their intended goal, they do not reduce the uncertainty about the future cost of compliance, which would otherwise help industries plan their investments. There have been ideas about how to better modify these systems so that they encourage sustained innovation, but Taylor notes that research in those areas is "still nascent." For now, however, her research suggests that, while cap-and-trade works for lowering emissions, it may not guarantee the sustained market innovation that some of its proponents promise.