Cap-and-Trade, Emissions Taxes, and Innovation

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Emissions taxes and carbon caps can both lead to efficient production of energy, in the sense of controlling carbon emissions to the extent that is efficient with existing technologies. However, the regulatory policy has a second objective, which is to create incentives to develop lower-carbon technologies. With both objectives in mind, does one policy dominate the other? The answer depends partly on whether the regulated price of energy is in the elastic or inelastic part of the demand curve. It also depends on the size of the improvement. Under tax regulation, an innovator can always profit from diffusing the clean technology to all producers. This is not true under a carbon cap because diffusion expands energy supply, reducing the price of energy and of allowances and eroding the producers’ willingness to pay for licenses. Under cap-and-trade regulation, the regulator has less ability to control the price of energy while ensuring productive efficiency (full diffusion). Because there is little incentive to invest in a larger improvement than will be fully diffused, cap-and-trade regulation limits innovation in a way that is avoided by a tax.