Does Emissions Trading Encourage Innovation?

Abstract

This article questions the conventional theory purporting to establish that emissions trading encourages innovation better than comparable traditional regulation. conventional theory relies upon the incentive emissions trading creates for polluters to make additional reductions in order to sell credits. But emissions trading also creates incentives for half of the pollution sources (the credit buyers) to make less reductions than they would under a traditional regulation. By focusing analysis only upon the sellers of credits, the traditional theory systematically biases results. induced innovation hypothesis - that innovation occurs in response to high costs - would suggest that emissions trading would tend to discourage innovation by lowering the cost of compliance through conventional techniques. Even innovation that costs a lot now can prove economically and environmentally superior over the long run, because innovation can make costs of new techniques fall over time and some innovations provide very wide ranging environmental benefits. But emissions trading encourages selection of the techniques with the cheapest current cost, not the cheapest long-term cost or the greatest long-term value. This article forms part of a larger project arguing for an economic dynamic approach to environmental law and law and economics. author's forthcoming book, The Economic Dynamics of Environmental Law (MIT Press 2003) sets out the full theory.