Market-Based Instruments and Technology Choices: A Synthesis

Abstract

Market-based instruments are widely used to encourage innovation and investment in cleaner technologies. Using a simple analytical framework and graphical representations, this paper provides a theoretical synthesis of the relationship between emissions prices/taxes and the firm’s optimal technology choice. This unified treatment incorporates the insights of a wide theoretical literature, as well as providing several new findings. Most surprisingly, perhaps, we identify circumstances in which a higher price of emissions actually reduces the incentive for investment in abatement technologies. We discuss the implications for environmental policy. The main conclusion is that a price on emissions invariably affects the type of abatement technologies firms invest in, so that the technological side of emissions abatement must always be considered in tandem with the design of the market-based instrument itself.