Taxes and cap-and-trade systems
Pigouvian taxes and cap-and-trade systems are not specifically designed to foster technical change but they
do have innovation effects: both systems modify the price of using the commodity that creates the
externality. As noted by Hicks (1932, 1963), “A change in the relative prices of the factors of production is
itself a spur to invention and to inventions of a particular kind – directed at economising the use of a factor
which has become relatively expensive.”
Taxes and cap-and-trade systems are not necessarily equivalent in fostering innovation, as attested to by a
growing body of economic literature. A recent review by Jaffe et al. (2002) suggests that both auctioned
and freely-allocated permits are inferior in their diffusion incentives to emission tax systems, but superior
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to command-and-control instruments. Under tradable permits, technology diffusion lowers the equilibrium
permit price, thereby reducing the incentive for participating firms to adapt.
Milliman and Prince (1989)
estimated that incentives for innovation were greater under an emission tax than under free emission
permits, and higher still under auctioned emission permits. However, an unambiguous exhaustive ranking
of instruments may not be possible on the basis of theory alone.
Other studies (e.g., Parry et al., 2002; Requate & Unold, 2003) suggest that the welfare-based ranking of
various instruments is only partially dependent on their effects in fostering technical change. In the
presence of cost-diminishing innovation, firms and regulators may have the same interest in reducing tax
levels, while they have opposite interests in modifying the amount of permits.
Generally speaking, cap-and-trade systems and Pigouvian taxes offer important advantages over more
focussed policy tools. They are economically efficient by equalising marginal cost of reduction all over the
board. They tend to foster technical improvements by “pulling the demand”, influencing a priori all
behavioural elements in the technical change chain. Of course, taxes and cap-and-trade systems do not
distinguish between the value of technical change versus behavioural change.
The efficacy of all market-based instruments, however, can be questioned from the viewpoint of “market
failures”. Although they themselves are intended to correct an important market failure, that of
“externality” issues such as pollution, they are efficient if markets are efficient – and there are many other
market barriers that may need to be overcome. Insufficient or incorrect information (for example,
consumers do not perceive how costly it is to own a power-guzzling air conditioner) represent a vast
category of market barriers that can be dealt with through standards or labels, as discussed above.
However, from a technology development perspective, perhaps the most important “market failure
” is that
created by the short-term vision of most economic agents. Even if agents and firms might anticipate future
allowances to be further restricted under cap-and-trade systems, or future tax levels to increase, they might
not engage in the extent of near-term technology development that would be required to allow deep
reductions when they will be needed. This problem is one of timing – and inherently leads the market to
invest in technologies that meet near-term goals rather than discounted, longer-term objectives.
Thus, for example, actions in some sectors characterised by very long lifetime of infrastructures – such as
buildings, or transport – might be too costly to implement; most of the benefits are only likely to
materialise after agreed near-term caps are in place – say, after 2012. Similarly, the research, development
and demonstration efforts needed to make some renewable energy technologies or other greenhouse gas
mitigating options competitive in the long term may be too costly given their likely limited payback in the
short term. This provides a compelling argument for policies and measures to complement those that
exclusively seek to modify market prices.
4.5 Voluntary agreements
Almost every AIXG country has adopted a voluntary approach of one sort or another. Approaches vary
from voluntary non-binding agreements on reporting emissions and progress to self-defined targets to
negotiated agreements that are legally binding, have benchmarking and performance assessment and
contain sanctions in the case of non-compliance (Bygrave & Ellis, 2002).
There is limited evidence as to the environmental effectiveness of voluntary agreements, which seem to
provide little incentive to innovate and can be weakened by a lack of credibility, especially vis-à-vis
public opinion. Yet voluntary agreements are likely to generate significant “soft effects” in
terms of dissemination of information and awareness raising. On the other hand, their
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ability to reduce administrative costs remains an open question; transaction costs should
also be evaluated. Finally, free-riding and regulatory capture can seriously affect the
effectiveness of voluntary agreements. Available evidence on the performance of voluntary
agreements suggests two main ways of using negotiated agreements and voluntary
programmes efficiently: using them in a policy mix; and using them to explore new policy
areas (OECD, 1999).
Voluntary approaches are seldom used as “stand-alone” instruments. Instead, they are often used in policy
packages with one or several other instruments such as command-and-control regulations, tradable permit
schemes, taxes or others. On-going OECD analysis based on several case studies (OECD, 2002a) notes
that the great diversity of approaches makes it difficult to draw general conclusions. However, the use of
voluntary approaches in combination with command-and-control policies seems to enhance technology
diffusion by comparison with command-and-control regulations used in isolation, thanks to various
information campaigns and forums of participants.
Combination of voluntary agreements with taxes usually means that companies accepting agreements and
undertaking emission reductions are partially or totally exempted from the tax. While adding the voluntary
option to the tax gives the affected companies more financial resources to undertake research and
development, it may also reduce the incentive to actually achieve technology improvements (OECD,
2002a): “
When the ‘shadow price’ on marginal emissions approaches zero, the firm has little incentive to
find ways to reduce them. Over the longer term, this could have important environmental repercussions”.
4.6 Policy mixes
What is true for voluntary agreements may be true as well for other instruments: none is likely to be fully
effective in isolation. Price mechanisms only work to the extent that markets are efficient, they do not
resolve market failures. Conversely, regulatory measures are better at dealing with market failures than in
directly addressing emission reductions. All IEA member countries use a broad range of policies and
measures to deal with their GHG emissions, in a variety of country-dependant policy mixes (IEA, 2002g).
The success of these combined approaches can only be judged in context, and there is probably no single,
one-fits-all silver bullet.
