Climate Policy and Innovation in the Absence of Commitment

It is well-recognized that new technology is a crucial part of any solution to the problem of climate change. But since investments in research and development take time to mature, price and quantity instruments, i.e., carbon taxes and cap-and-trade, run into a commitment problem. We assume that the government cannot commit to the level of a policy instrument in advance, but sets the level to be optimal ex-post. Under these assumptions, we show that when the supply curve of dirty (emission-producing) energy is flat, then an emissions tax is ineffective in promoting R & D into green (emission-free) energy while an emissions quota (i.e., cap and trade) can be effective. A subsidy to R & D is welfare-reducing. More realistically, when the supply curve of dirty energy is upward-sloping, then both tax and quota regimes can be effective in promoting R & D into emission-free technology. In this case, a tax generally induces more R & D than a quota. When the supply curve is sufficiently steep compared to the demand curve, a subsidy to R & D can expand the range of parameter values under which R & D occurs and this can be welfare-improving. If there is sufficient uncertainty about whether a climate policy will be adopted ex-post, then subsidizing R & D is an even more attractive policy option since a welfare-improving subsidy to R & D exists under a wider range of circumstances.