The Economics of Environmental Innovation, Regulation and Commitment

Abstract

The present thesis extends the economic literature by introducing green horizontal innovation. Green horizontal innovation is characterized by new technologies that solve an existing pollution problem but give rise to a new one at the same time. A prominent example are CFCs that once replaced poisonous refrigants but are now phased-out themselves. Even groundbreaking technological advances are often merely shifting instead of solving environmental problems. Another concept introduced in this thesis is technological uncertainty. Ex-ante the properties of the next technology developed are not known. New technologies can be of two types. Either they come as perfectly clean ‘backstop’ technologies or as green horizontal innovations and are labeled ‘boomerangs’. In an infinite horizon model the socially optimal pollution and R&D policies under green horizontal innovation and technological uncertainty are derived. The main results are that in the absence of a backstop all available polluting technologies should be engaged in production. Moreover, under technological uncertainty a finite sequence of innovations is optimal. This informs ongoing policy debates like the one on the future of electricity production where there are trade-offs between two polluting technologies – nuclear power and fossil fuels. Moreover, the present thesis evaluates implementation strategies under green horizontal innovation. In a two-period model the government grants patents and adjusts environmental policy in case innovation occurs. However, the government is assumed to be unable to pre-commit on future environmental policies. The key insight is that tradable permits can fail to implement static efficient allocations. Efficiency is limited by patent holder’s monopoly pricing. The owner of the new technology might choose a license fee that restricts output to levels below the social optimum. Quantity regulation via pollution permits is therefore not effective. In contrast to previous results in the literature this also holds under vertical environmental innovation. The interaction between patents and environmental regulation goes therefore both ways. The choice of the environmental instrument affects incentives to innovation and patents create distortions in output markets. More sophisticated instruments are shown to be able to reduce the distortions caused by patents. A government’s ability to commit is crucial for dynamic efficiency. A prominent concept to solve the time-inconsistency problem is to delegate specific policies to an independent agency, e.g. a central bank. McCallum (1995) criticized this approach by claiming that delegation does not solve the commitment problem but merely relocates it. McCallum’s critique is formalized and partially contradicted. If there is uncertainty over future states of the world, delegation can improve credibility. Commitment is achieved by the costs incurred to pass and later change a law or the constitution. The higher these costs, the more credible are the associated policies. However, if there is uncertainty over the optimal future policy, these costs reduce a government’s flexibility. Hence, there is a trade-off between credibility and flexibility. Delegation is able to relax this trade-off if the bureaucrat responds to shocks in a way that is at least somewhat in line with the government’s preferences. Under uncertainty the government has more incentives to invest into credibility if she delegates. This insight explains the observed commitment effect of delegation and helps to improve the institutional design of environmental regulation and other policy areas.