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Cap-and-Trade and Innovation

Pricing carbon will help drive R&D, but the market will still be bumpy.

Virtually all economists agree that one of the biggest selling points for pricing greenhouse gases (GHGs) – whether a carbon tax or cap-and-trade — is that it will boost innovation in low-carbon technologies.

But will innovation return the favor in California’s cap-and-trade market by making it function more smoothly, saving it from the potential Achilles’ heel of extremely low or high prices?

CaTInnovationFig1I’ve argued previously that extreme low or high prices are the most likely outcome of cap-and-trade for GHGs, unless there are administrative price bounds. The most important insight from the research Jim Bushnell, Frank Wolak, Matt Zaragoza-Watkins and I have done is that the level of uncertainty in the state’s “business as usual” (BAU) emissions — due to macroeconomic growth, technological change, and other factors that are mostly beyond our control — is much greater than the reductions that can be relied upon as a GHG price rises, at least within a politically-acceptable range. As a result, a cap-and-trade market for GHGs, driven by unpredictable BAU emissions, will likely end up at an administratively-determined price floor or price ceiling, with the associated emissions substantially below the cap or above it.

That doesn’t mean that cap-and-trade is a bad idea. But it does demonstrate the importance of a credible price floor that creates significant incentives to abate emissions and invest in R&D, and of a credible price ceiling that will prevent a political backlash if GHG emissions end up higher than hoped for.

CaTInnovationFig2Our conclusion has been closely scrutinized, poked, and prodded, as it should be. One of the most common issues raised has been the way in which we incorporate innovation, particularly technological breakthroughs in low-carbon energy.

In a nutshell, here’s the concern: Our conclusion of extreme low or high price outcomes is partially driven by our calculations suggesting that there is relatively little identifiable GHG abatement likely to occur in response to a GHG price between, say, $10 and $60 per ton, roughly the range that politicians in Sacramento indicate they might be able to live with. But — one critique goes — a higher GHG price will increase the value of low-carbon technologies and drive innovation. That means there is more price-responsive abatement than we accounted for – a more elastic abatement supply curve, in econospeak — so more chance that the market will reach equilibrium at a moderate price.

That would be true if R&D expenditures exhibited a smooth, predictable and timely effect on the cost of an alternative technology. Then, as the price of GHG allowances rose, R&D effort would climb, and the cost of abating GHG in some sector would incrementally, reliably fall. In that case, innovation would help provide an automatic brake on emissions as the emissions price rises, just as we can get from higher gasoline prices changing driving and vehicle purchase choices, fuel switching in electricity generation, or investment in improved energy efficiency.

But that is not how innovation works. Yes, a higher allowance price will drive up R&D on low-carbon technologies, but the effect on GHGs will not be smooth, predictable, or quick.

CaTInnovationFig3It won’t be smooth, because innovation isn’t a well-functioning spigot that can be turned up or down with a twist of the R&D funding handle. Some technologies don’t advance much no matter how hard you turn (think wave power, cellulosic biofuels, or fusion) and others have bursts of progress after years of modest improvements (as with batteries). A carbon price will help twist the handle, but it’s unlikely that it will deliver just the level of innovation that makes a technology cost-competitive if, and only if, the price of carbon is in the $10-$60 range (which, just to remind you, raises gasoline prices roughly 8 to 50 cents per gallon).

<WARNING: Even more geeky paragraph, which can be skipped if you aren’t in the mood right now (or ever)> Yes, we could still get a smooth response if there were hundreds of independent research bets in different sectors, each affecting a small share of emissions. Then the law of large numbers would deliver a smooth innovation response. But the vast majority of anthropogenic GHGs are from burning fossil fuels. The R&D bets on how to replace them are highly correlated across sectors of the economy. When major breakthroughs happen in alternative energy, thankfully, they impact a broad swath of emissions. Unfortunately, the same is true of major improvements in technologies that produce high-GHG energy – most recently fracking, but in the mid-20th century it was surface mining of coal.

Nor is the effect of a GHG price on innovation predictable. Cap-and-trade enthusiasts point to tremendous improvements over the last decade in solar PV, wind power, batteries, and electric vehicles, all of which have come down in cost to the point they are nearing competitiveness in some settings. That’s great, but that has happened with a zero or miniscule GHG price in the industrialized world. It’s no evidence of the degree to which innovation will respond to a market price on carbon.

CaTInnovationFig4And the innovation response to a carbon price won’t be quick. Those examples of exciting alternative technologies that are now nearing competitiveness were the soon-to-be technologies during the energy crises of the 1970s. Economic incentives since then have waxed and waned due to subsidies and fossil fuel price fluctuations, with associated cycles of R&D investment, but only 40 years later are we now starting to see technologies become a major force.

Even if the response of innovation to the state’s carbon price is uneven, unpredictable, and lagging, couldn’t the cap-and-trade price accelerate adoption of low-carbon sources as they get close to cost competitive? Yes it could, but only to the extent it is economic to exceed adoption levels that are already required by other California laws. Those mandated levels of renewable electricity, low-carbon transportation fuels or electric vehicles will occur even if the cap-and-trade price is zero (and thereby increase the probability that it will be). In California, those mandates are very aggressive.

Still, we need to stay focused on the real goal, which is global reductions in GHGs. A significant emissions price in California can help incent the innovations we need to get there, even if that price is an administratively-determined floor or ceiling. It just looks a lot more like a carbon tax.  Nuthin’ wrong with that.

Severin Borenstein View All

Severin Borenstein is Professor of the Graduate School in the Economic Analysis and Policy Group at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He received his A.B. from U.C. Berkeley and Ph.D. in Economics from M.I.T. His research focuses on the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. Borenstein is also a research associate of the National Bureau of Economic Research in Cambridge, MA. He served on the Board of Governors of the California Power Exchange from 1997 to 2003. During 1999-2000, he was a member of the California Attorney General's Gasoline Price Task Force. In 2012-13, he served on the Emissions Market Assessment Committee, which advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. In 2014, he was appointed to the California Energy Commission’s Petroleum Market Advisory Committee, which he chaired from 2015 until the Committee was dissolved in 2017. From 2015-2020, he served on the Advisory Council of the Bay Area Air Quality Management District. Since 2019, he has been a member of the Governing Board of the California Independent System Operator.

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