The Environment and Directed Technical Change

NBER working papers / by Daron Acemoglu, Philippe Aghion Leonardo Bursztyn and David Hemous (RFFers may access this report onsite or by accessing RFF’s network first using VPN offsite]
http://www.nber.org/papers/w15451

[From Michael A. Levi’s CFR blog] Daron Acemoglu, Philippe Aghion, and two of their colleagues (MIT and Harvard) posted a fascinating working paper last October that hasn’t gotten the attention it deserves in the policy world…so I’ll try to explain a bit about what it says.

I take three big points away from it: First, under most plausible circumstances, optimal climate policy is a mix of carbon pricing and government innovation subsidies (that is, support for RD&D). Second, it’s probably much more expensive to achieve the same environmental outcomes through carbon pricing alone. Third, carbon leakage (the shifting of dirty industries to unregulated economies) can have bigger negative consequences than most have assumed.

The paper starts by pointing out something that most people probably don’t realize:

“The response of technological change to environmental policy has until very recently been all but ignored by leading economic analyses of environment policy, which have mostly focused on computable general equilibrium models with exogenous technology.”

In English, this means that most economic analyses of optimal climate policy (and of carbon pricing in particular) pretend that the pace of future innovation in clean energy technology has nothing to do with the strength of environmental regulation – it’s exogenous, or imposed on the model. Suppose a carbon price of $5, and the cost of clean energy technologies will steadily fall; impose a price of $500 instead, and that cost will drop at precisely the same rate.

This, of course, is nonsense. It sharply contradicts our intuition (which is borne out by empirical study) that environmental regulation tends to spur environmentally friendly innovation. Serious modeling of environmental policy needs to incorporate regulation-driven innovation – what economists call “endogenous innovation”.

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