Low Carbon Economy, 2010, 1, 80-85
doi:10.4236/lce.2010.12010 Published Online December 2010 (http://www.SciRP.org/journal/lce)
Copyright © 2010 SciRes. LCE
Technological Change and Carbon Markets*
Patrik Söderholm
Luleå University of Technology Economics, Luleå, Sweden.
Email: patrik.soderholm@ltu.se
Received August 26th, 2010; revised October 8th, 2010; accepted October 25th, 2010.
In this brief note we discuss the innovation impacts of different market-based policy instruments in the climate field, and
in particular the case of markets for carbon allowances. The note provides a brief review of the theoretical and empiri-
cal literature, and addresses important issues concerning policy instrument choice, the need for multiple policies as
well as the timing and commitment strategies of the regulating agency. The analysis suggests that technological pro-
gress depends critically on developing and maintaining efficient carbon markets. In the case emissions are un-
der-priced and/or adoption behaviour distorted by, for instance, inefficient plant entrants and closure provisions, any
new carbon-free innovation will not be sufficiently exploited. However, for both economic and political reasons other
policy instruments-most notably public R&D and technology support-will be needed to complement the price signals
provided by carbon markets.
Keywords: Carbon Markets, Innovation, Climate Policy, Environmental Economics
1. Introduction
It is frequently argued that the nature and the pace of
technological change and the associated innovation ac-
tivities will be keys to addressing climate change in the
future. Technological change is the process by which the
economy changes over time in terms of the character of
productive activity (e.g., processes used for production
etc.). Technological progress (advance) thus enables the
production of greater output from the same inputs (or the
same output with less input). The long-term and poten-
tially very negative effects of climate change on society
require policy effo rts to be heav ily focu sed on inno vation
and technological change in the energy sector. Still, at
the same time some analysts question the ability of the
most significant climate policy instruments, markets for
carbon allowances such as the European emissions trad-
ing system (EU ETS), to promote innovation and the
development of new carbon-free technology [1].
In this brief note we therefore discuss the extent to
which (mandatory) carbon markets may induce the de-
velopment of new-and less costly-abatement technolo-
gies. We first provide a brief review of the theoretical
and empirical literature on the potential innovation im-
pacts triggered by different types of climate policy in-
struments and with particular emphasis on emissions
trading schemes (see Section 2).1 For our purposes the
term innovation is primarily used for a new or improved
(e.g., less costly) product or the use of new or different
material. Innovations can however differ in the sense that
some are radical and fundamentally alter the energy sys-
tem and any associated supply chains (e.g., the electric car)
while some are largely incremental and path-dependent
(e.g., coal blending in electric power plants) [4]. More-
over, in Section 3 we discuss also some important policy
issues, such as the importance of complementing policy
instruments to promote innovation as well as the timing
and commitment strategies of the regulating agency. Fi-
nally, Section 4 pr o vi des some final remarks.
Before proceeding, though, it should be noted that the
literature on environmental innovation and policy is ex-
tensive, and it builds on several research paradigms
(evolutionary economics, institutio nalism etc.) (e.g., [5]).
In this note however, we rely heavily on the most impor-
tant lessons that can be drawn from the environmental
*Financial support from the Swedish Environmental Protection Agency
and the Swedish Energy Agency is gratefully acknowledged as are
valuable comments from Max Åhman, Thomas Sterner and one ano-
nymous reviewer. Any remaining errors, however, reside solely with
the authors.
1The discussion focuses mainly on research and development (R & D)
of new technology, and thus not on the adoption of existing technology.
Still, it should be acknowledged that this distinction is far fro
straight-forward. For instance, technology adoption may induce sig-
nificant learning-by-doing impacts (e.g., [2]), and therefore any policy
design that affects adoption, such as the treatment of new entrants and
closures [3], may also have an impact on technological progress.
Technological Change and Carbon Markets
Copyright © 2010 SciRes. LCE
economics literature, but on occasion we also highlight
some of the limitations of this approach.
2. The Innovation Effects of Carbon Pricing
The incentive for innovation refers to the benefit a firm
enjoys from developing a new techno-logy. In other
words, profit-maximizing firms will be willing to allo-
cate resources to, for instance, environmental R&D ac-
tivities if the result will be lower abatement costs. The
theoretical studies on policy instrument choice and inno-
vation incentives (see [6] for a comprehensive survey)
essentially show that there exist a number of different
outcomes contingent on particular assumptions about, for
instance, the degree of competition in the output market
and/or in the carbon market itself, the slope of the mar-
ginal damage function, uncertainty, which timing and
commitment strategies are available for the regulator etc.
Overall therefore it is virtually impossible to present a
unanimous ranking of policy instruments with respect to
their innovation-stimulating effects [7]. Still, market-
based instruments tend to perform better than command
and control policies (in particular technology standards
or performance standards). Th e reason is that in the latter
case the firm would have no incentive to perform beyond
the pre-determined standard, while market-based instru-
ments such as carbon taxes or markets for tradable al-
lowances induce firms to conduct low-cost compliance
beyond the current level (since this reduces tax or the
allowance payments).
The latter results are however mainly valid in the case
where innovation is a private good, and thus where the
incentives considered concern only the firm’s own gains
from lower abatement costs [8]. In practice, however,
innovation is typically a public good implying that some
of the new knowledge may benefit other firms, which
can adopt the new technology (at a price). These ‘know-
ledge spillovers’ (for which the innovator is not com-
pensated) imply that R&D activities will be underpro-
vided from a societal perspective. This in itself can be an
argument for using additional technology and R&D sup-
port. In this setting the conclusions on how different pol-
icy instruments affect innovation become more ambigu-
ous. Moreover, the specific design of the policy instru-
ment rather than the choice of the instrument itself may
be more influential for innovation outcomes (e.g., [9]).
Of particular interest is a comparison of the innovation
incentive effects of carbon markets that rely on freely
distributed allowances and auctioned allowances, respec-
tively. In the following we therefore pay attention to
some key differences across the various market-based
instruments: emission taxes, freely distributed allow-
ances and auctioned allowances.
The literature suggests (e.g., [6]) that overall emission
taxes provide a stronger incentive to invest in R&D as
compared to freely distributed allowances. The reason is
that the allowance price falls with the diffusion of new
technology, thus implying that the adopting firms will
not be willing to pay as much for the innovation under
the (now cheaper) allowances as under a (constant) emis-
sion tax. Fischer et al. [7] show that if the (single) inno-
vator is able to exercise market power, this can raise the
gains to innovation in that a lower allowan ce price means
that the innovator does not need to pay as much for the
rest of its emissions. However, this benefit only emerges
in the case of auctioned allowances. The choice between
auctioned allowances and an emission tax is however
ambiguous. The efficient policy will depend, in part, on
the slope of the marginal damage curve2, and on how
imperfectly the innovative technology can be imitated.
For instance, emission taxes provide more innovation
incentive if imitation is difficult, while auctioned allow-
ances perform better in the case with substantial knowl-
edge spillovers to the adop ting firms [8].
The above indicates some important implications for
the design of mandatory tradable allowan ce scheme such
as the EU ETS. For instance, within the EU ETS freely
distributed allowances have been th e dominant allocation
principle, while the innovation impacts of auctioned al-
lowances typically are greater (see also [10]). The an-
nouncement of full auctioning for the electric power sec-
tor starting in the year 2013 may thus induce more inno-
vation activities in this sector compared to the case where
allowances are freely distributed. Moreover, the price-
reducing impact of innovation may be limited in the EU
ETS due to the relatively wide sector-scope of the
scheme. Innovations in one sector may not be of interest
to the other sectors, and for this reason the impact on
allowance pr ice may be small (and even non- existen t) [8].
In a broad-based allowance market, the incentives to in-
novate in a given sector will thus resemble closely the
corresponding incentives under an emission tax.
Most of the empirical studies on the potential innova-
tion effects of emission allowance markets have focused
on the pioneering US systems such as the Acid Rain
Program and the Lead Phase-out Program [9]. For the
former case Popp [11] investigates innovations in the
so-called scrubber technology, one of many strategies to
abate sulphur dioxide emissions under the Acid Rain
program. He compares the outcomes under the allowance
program versus the command and control approach that
was in force before 1990. He uses patent data and data on
2For instance, the steeper the marginal damage curve the more do trad-
able allowances dominate the tax regi me [7 ]. A st eep marg ina l da mage
curve implies that pollution beyond a certain threshold causes very
negative effects on the environment, and for this reason it’sbetter to
regulate by means of quotas rather than prices.
Technological Change and Carbon Markets
Copyright © 2010 SciRes. LCE
the diffusion of this technology in a large number of
power plants during the time period 1972-1997. The re-
sults show that both policy instruments induced lower
scrubber costs, but the switch to allowance trading did
not induce more innovation overall. Nevertheless, the
introduction of an allowance market improved the sul-
phur removal efficiency of the scrubber technology, thus
implying a more targeted and environmentally benign
technological change. Another important-and largely
unexpected-innovation induced by the Acid Rain Pro-
gram was the improved ability to pursue coal blending,
thus mixing high-with low-sulphur coal in power plants
Many other studies confirm the positive impact of al-
lowance markets3 on the deployment of existing tech-
nologies and incremental innovations, but some also
question their effectiveness in inducing radical innova-
tions (e.g., [1]). The latter result can be attributed in part
to the lack of stringency (i.e., generous allocation and
thus lenient targets), and predictability of many existing
allowance markets (e.g., [10]). Still, in many instances
carbon pricing needs to be complemented by other po licy
instruments that explicitly address other significant bar-
riers to radical innovation. These include (again) R&D
support to address the issue of knowledge spillovers, but
also infrastructure investment in order to reap the bene-
fits of network externalities and economies of scale [14].
Clearly, in the case where there is a lack of policy sup-
port for, say, the introduction of strict emission quotas
and auctioned allowances, other instruments (such as
technology subsidies) may be needed to address the
long-term climate policy targets [15].
At the policy level the EU ETS is frequently expected
to induce significant innovation (e.g., [16]), but given the
novelty of this scheme empirical studies of its innovation
impacts are scarce. Schneider et al. [17] and the accom-
panying paper by Rogge and Hoffman [18] are excep-
tions, though. They perform a large a number of inter-
views to trace the impact of EU ETS on technological
change and adoption in the German electric power sector.
Their results show that EU ETS has affected both the
pace and the direction of technological change, although
the authors also acknowledge that it is difficult to em-
pirically separate the effects of EU ETS on the one hand
and the general development of EU climate policy on the
Power generators and technology suppliers have sig-
nificantly increased their R&D budgets during the last
ten years, and the pricing of carbon has been an impor-
tant motive behind this increase. Moreover, the main
innovation impacts of the allowance scheme are to be
found in coal-fired power generation. R&D efforts are
directed towards increasing the fuel efficiencies of both
new and existing plants; in the past such efforts were
only induced by fuel savings but with a price on carbon
there is an additional benefit of improving efficiency.
However, the EU ETS appears also to be a prime moti-
vator behind the strong R&D activities in the carbon
capture and storage (CCS) technology, and firms are, for
instance, teaming up with chemical process technology
providers to acquire the necessary chemical-engineering
know-how. These impacts of EU ETS on R&D and in-
novation can in part be understood by the fact that the
electric power sectors in most European countries had
not faced explicit climate policy instruments before the
advent of EU ETS.
In contrast, R & D activities in the competing tech-
nologies have been much less prevalent. For instance,
neither gas-fired generators nor wind power developers
in Germany claim to have increased their R&D efforts as
a result of EU ETS. In the wind power case, the feed-in
tariff system in Germany is instead the most important
driver of innovation activities (e.g., [19]). Overall these
experiences of EU ETS point towards a rather path-depe-
ndent process of technological change in which R&D
efforts largely build upon and reinforce existing compe-
tencies and know-how. This probably depends in part on
the power of lobby groups over policy making and these
issues are in need of more research.
3. The Interaction of Climate Policy and
So far in this brief note we have implicitly assumed the
presence of an essentially myopic regulator, who does
not anticipate a new technology and therefore commits
ex ante to, for instance, a certain emissions cap that is
efficient with respect to the existing technology. How-
ever, as pointed out by Fischer [8], just as “the amount of
innovation depends on […] price signals, getting the
right price signals depends on the amount of innovation,”
(p. 11). The environmental economics literature has paid
increased attention to the strategy space of both the
regulator and the regulated ag ent. This strand of research
shows, for instance, that under perfect foresight and
competitive conditions ex ante commitment and ex post
optimal policies generate very similar allocations (e.g.,
[20]). However, in imperfect markets the policy conclu-
sions are less clear. One relevant example is where there
exists a monopolistic innovator, who can determine the
price of his new technology. Here a policy commitment
to a certain emission tax level will minimize the distor-
tions from this monopoly situation, while an allowance
market would be more distorting given that the innovator
3As also shown in Sterner and Thurnheim [13], price based policies
such as the refunded emission payment can have significant effects on
technological innovation and diffusion.
Technological Change and Carbon Markets
Copyright © 2010 SciRes. LCE
will be able to influence the price of allowances.
Moreover, the regulator’s optimal response to innova-
tion is complicated by the presence of significant uncer-
tainty in abatement costs (due to the difficulty in pre-
dicting innovation outcomes). In the case of allowance
markets, which cap emissions, too little abatement will
take place in the presence of innovation. However, since
the environmental damages of carbon dioxide emissions
are relatively insensitive to the rate of emissions at any
particular point in time, the efficiency benefit of reducing
volume uncertainty would be limited. Thus, in the case of
uncertainty in abatement costs due to future innovation
activities, a constant tax on carbon emissions would be
favoured [21].
In a recent paper, though, Weber and Neuhoff [22]
examine the effect of firm-level innovation in carbon
abatement technology (i.e., the new knowledge is a pri-
vate good) on the optimal design of carbon allowance
markets, with or without a price cap and a price floor,
respectively. They show that in the presence of innova-
tion the optimal emission cap decreases, and this can lead
to a higher than expected carbon price so as to provide
sufficient incentives for private R & D. This tends to
speak in favour of carbon allowance markets versus car-
bon taxes. In allowance markets certainty about emission
outcomes are obtained at the cost of increased price un-
certainty (compared to an emission tax), but when prices
increase this serves as an additional innovation incentive.
Finally, while it is clear that allowance markets such as
the EU ETS can have significant innovation-promoting
impacts, other policies may be necessary to spur an effi-
cient level of innovation. As was noted above, R & D
activities generate knowledge with substantial public
good characteristics. This means that a single firm cannot
generally reap the benefits of its investment in new
knowledge, and it does therefore not have enough incen-
tives to undertake such activities. An important policy
lesson from this is that even if policies to correct for en-
vironmental externalities are in place, the level of envi-
ronmental R & D may be suboptimal (and too low). Two
types of market imperfections call for two types of policy
instruments [23], but while carbon pricing should be the
engine of climate policy it is less clear how technology
policies should be designed in practice.
Although the social benefits of R&D activities in new
abatement technology are higher than the private ones, it
must be acknowledged that this is the case for many R &
D activities throughout the entire economy (including
many environmental projects). This implies that the op-
portunity cost of specific R & D projects may also be
high, and the economics literature suggests that technol-
ogy policy should-as a starting point-primarily address a
broad set of knowledge spillovers through generic policy
instruments (such as patents and broad R & D subsidies)
rather than focus on R & D and innovation activities in
one specific activity or sector (e.g., [24]). As noted by
Fischer [25]:
“The role for publicly supported innovation is strong-
est when some spillover effects are present and at least a
moderate share of the social costs-including the marginal
damages of emissions is reflected in the price. [...] While
mitigation policy must be the engine for reaching envi-
ronmental policy goals; technology policy can help that
engine run faster and more efficiently, but it only help s if
the engine is runni ng.” (p. 500)
Thus, technology policy is no substitute for emissions
pricing [25]. Indeed Parry et al. [26] show that the wel-
fare gains from environmental innovation may not be
much greater than the corresponding social benefits of
cost-effectively abating carbon emissions by means of
existing technologies. This highlights the importance of
developing and maintaining efficient carbon markets; if
emissions are under-priced and/or adoption behaviour
distorted, any new carbon-free innovation will not be
sufficiently exploited. For instance, the introduction of
auctioned allowances and more efficient plant entrants
and closure provisions in the EU ETS (e.g., [3]) and
other similar carbon markets could therefore well be just
as important for innovation outcomes as public R&D and
technology supp ort.
4. Final Remarks
Previous research confirms the important role of carbon
pricing in spurring innovation activities in the energy
sector, but such policies need also to be complemented
by explicit technology policy to address the presence of
knowledge spillovers. Still, technology policy is no sub-
stitute for emissions pricing. Technological progress de-
pends critically on developing and maintaining efficient
carbon markets; in the case emissions are under-priced
and/or adoption behaviour distorted by, for instance, in-
efficient plant entrants and closure provisions, any new
carbon-free innovation will not be sufficiently exploited.
Given the importance of future technological progress for
combating climate change additional research that ad-
dresses the impact of different combinations of policy
instruments on technological change is needed, including
also a stronger emphasis on multi-disciplinary approa-
In addressing the policy challenges involved in devel-
oping new carbon-free technology it is also important to
recognize that policy acceptance may be just as impor-
tant as policy effectiveness, and future research will b en-
efit from addressing any trade-offs between acceptance
and effectiveness. The establishment of carbon markets
typically involves compromises (e.g., the use of free al-
Technological Change and Carbon Markets
Copyright © 2010 SciRes. LCE
location of permits in EU ETS). However, such com-
promises may interfere with an efficient market design
and they therefore come at a cost. If our understanding of
the magnitude of these costs are improved policy makers
could be helped in identifying the most important issues
for improvement. In a word, while the research so far has
highlighted a number of distortions in existing permit
markets, future research efforts could also investigate the
magnitude of t hese dist o rt i ons .4
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[24] V. Otto, A. Löschel and J. Reilly, “Directed Technical
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Science and Policy of Global Change Report No. 134,
4It is sometimes argued that carbon pricing represents an ineffective
olicy instrument since it may be difficult to implement high carbon
rices for political reasons. However, it is useful to distinguish between
olicy acceptance (the scope for getting the policy implemented) and
olicy effectiveness (once the policy has been implemented). A high
carbon price will be effective, but the scope for implementing such a
high price may differ depending on, for instance, allocation rules,
competitiveness concerns and revenue recycling schemes etc.).
Technological Change and Carbon Markets
Copyright © 2010 SciRes. LCE
Massachusetts Institute of Technology, Cambridge, USA,
[25] C. Fischer, “Emissions Pricing, Spillovers and Public
Investment in Environmentally Friendly Technologies,”
Energy Economics , Vol. 30, No. 2, 2008, pp. 487-502.
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are the Welfare Gains from Technological Innovation,”
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