Induced Technological Change and Climate Policy

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Induced Technological Change and Climate Policy

Prepared for the Pew Center on Global Climate Change
October 2004

By Lawrence H. Goulder, Stanford University

Press Release

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Eileen Claussen, President, Pew Center on Global Climate Change

Over the upcoming decades, large-scale reductions in emissions of carbon dioxide (CO2) and other greenhouse gases (GHGs) will be required to reduce the risks of global climate change.  In order to achieve this transformation, the development and diffusion of new technologies to reduce GHG emissions will be critical.  As the world’s largest and most inventive economy, the United States must play a decisive role in the discovery, innovation, and marketing of these new technologies, and climate policies can be influential drivers in this process.

Technological change occurs for a variety of reasons as firms compete in existing and new markets.  However, climate policies can spur additional or “induced” technological change (ITC).  This can be achieved through technology “push” policies that boost the invention and innovation processes (such as funding for R&D), and through direct emissions control policies that “pull” new technologies into the market (such as a GHG cap-and-trade program). 

In this report, Lawrence Goulder of Stanford University explores the role of induced technological change (ITC), and examines the implications of ITC for the effective design of climate policy.  These implications fall into four main categories: (1) how much ITC can lower the costs of climate policies, (2) what this means for the timing of policies, (3) the value of announcing policies well in advance of enactment, and (4) the most appropriate use of various policy instruments to boost technological change.  Until recently, economic models of climate change could not address these issues.  However, state-of-the-art modeling now treats ITC as an integral or “endogenous” component in calculations, thus providing new insights into this critical topic.
This report finds that all economic models that include ITC produce lower overall cost estimates for GHG reductions, especially when the climate policy is announced in advance.  Goulder also concludes that in order to reduce GHG emissions most cost-effectively, both technology-push and emissions reduction policies are required.  In addition, although studies show different implications of ITC on the overall timing of climate policy, all find that some abatement must begin now in order to jump-start the critical process of technological change.

The Pew Center and the author are grateful to Ian Parry, Richard Newell, Ev Ehrlich, Alan Manne, and Koshy Mathai for helpful comments on previous drafts of this report, and to Mark Jacobsen for his research assistance.  Previous Pew Center reports have addressed the role of technology in economics modeling (Edmonds et al.) and lessons for climate change from other U.S. programs in technology and innovation (Alic et al.). Insights from this report, together with companion papers in the Pew Center’s Economics series, are being utilized in the development of a state-of-the-art assessment of the costs to the United States of climate change mitigation.

Executive Summary

A central goal of climate policy is to avoid potential changes in climate and associated adverse biophysical impacts by slowing or avoiding the atmospheric build-up of greenhouse gases (GHGs).  Technological change will crucially influence the extent to which nations achieve this goal.  The direction and extent of technological change over the next century has profound implications for emissions and atmospheric concentrations of GHGs over time, the extent of future climate change, and associated impacts on human welfare. 
Climate policy can alter the future by influencing the rate and direction of technological change.  “Induced technological change” (ITC) here refers to the additional technological change that is brought about by policy.  This report explores how climate policy can induce technological change and examines the implications of ITC for the effective design of climate policy.

Some of the main findings are:

1.  The presence of ITC lowers the costs of achieving emissions reductions. By stimulating additional technological change, climate policy can reduce the costs of meeting a given target for reductions in GHG emissions or concentrations.  Until recently, most economy-wide climate change policy studies ignored ITC.  Models that disregard policy-induced technological advances will tend to overestimate policy costs. 

2.  The presence of ITC justifies more extensive reductions in GHGs than would otherwise be called for. Because ITC lowers the costs of achieving emissions reductions, the optimal extent of GHG reduction is greater than would be predicted by models that ignore ITC.  The net benefits from climate policy are larger as well.

3.  The presence of ITC alters the optimal timing of emissions abatement. Although considerable technological change occurs in the absence of policy intervention, climate policy can induce additional technological change by providing incentives for additional research and development (R&D) and by stimulating additional experience with alternative technologies or processes, thereby generating “learning-by-doing.”  Analysts offer contrasting views as to how ITC alters the optimal timing of emissions abatement compared to a case where climate policy does not affect the rate of technological change (that is, the case with no ITC).  Does ITC justify more extensive near-term emissions reductions, or does it justify postponing reductions?  Recent analyses indicate that insofar as technological change results from R&D, the presence of ITC justifies somewhat less abatement in the near-term, and more abatement in the future (when technological change has lowered the costs of abatement).  On the other hand, if ITC primarily results from learning-by-doing, greater emphasis on abatement in the short term may be called for, since early abatement efforts accelerate the learning process and can thereby lower costs.

4.  In the presence of ITC, announcing climate policies in advance can reduce policy costs. Announcing policies in advance can lower the cost of meeting given targets for cumulative abatement or reductions in GHG concentrations.  Illustrative results indicate that announcing a $25 per ton carbon tax 10 years in advance can reduce discounted economic costs (as measured by changes in gross domestic product or GDP) by about a third, compared to the same climate policy imposed with no prior notice.

5.  Economic analysis offers a justification for public policies to induce technological change, even when the returns are highly uncertain. Uncertainties surround many aspects of ITC.  Neither the returns to a given investment in R&D nor the extent of future learning-by-doing can be precisely predicted.  As a result, one cannot estimate with precision the cost savings from ITC or pinpoint the optimal timing of abatement.  Moreover, while prior announcements of climate policies will yield cost-savings, uncertainties about costs of adjustment make it impossible to accurately forecast these savings.  Despite these uncertainties, two key market failures provide a strong rationale for public policy to stimulate ITC.  These are: (1) the “spillover benefits” to society as a result of R&D investments by individual firms and (2) the presence of negative “externalities” – adverse impacts that are not accounted for in the market prices of carbon based fuels.

6.  To promote ITC and reduce GHG emissions most cost-effectively, two types of policies are required:  policies to reduce emissions and incentives for technological innovation. This study emphasizes that two types of policies are necessary to address the two market failures noted above and to achieve, at least-cost to society, a given target for cumulative reductions in emissions or GHG concentrations.  Technology incentives can deal with the market failure created by firms’ inabilities to capture all the returns on their R&D investments.  Direct emissions policies (such as carbon caps or carbon taxes) can deal with the market failure created by climate-related externalities.  Attempting to address the climate change problem with only one of these policy approaches cannot fully correct both market failures.  As a result, adopting one approach is likely to involve higher costs than utilizing the two approaches in tandem.  To date, direct GHG emissions policies have had little political success at the federal level.  But there is a strong need for these policies, along with technology incentives, to deal with the prospect of climate change in a cost-effective manner.