Author: David Driesen

As the world begins to experiment increasingly with environmental markets and market-based mechanisms--some touting them as miracle cures for any and every environmental problem--some researchers are looking at the unintended consequences of markets. To begin looking at some of these side-effects, The Ecosystem Marketplace asked David Driesen to summarize some of his research into how emissions trading can limit innovation.

Advocates of "market-based mechanisms" have frequently claimed that emissions trading programs provide superior incentives for innovation. Yet, electric utilities have relied almost entirely upon the most conventional, well-understood options for complying with the acid rain trading program: namely scrubbers and low sulfur coal. We have not seen a dramatic move toward more innovative approaches, like solar energy or fuel cells, under that program. Even though the acid rain trading program has produced some innovation (e.g. some patented scrubber designs), a recent detailed comparison of the acid rain program to previous traditional regulation concludes that the earlier "command and control" regime produced more innovation than the trading program.

In fact, the idea that emissions trading effectively stimulates innovation flies in the face of sound economics. People innovate when prices of conventional approaches are high enough to make them willing to endure the uncertainty of trying something new. If necessity--which can take the form of higher prices--is the mother of invention, then trading, which lowers the cost of employing conventional approaches, may reduce incentives to innovate.

It should therefore not be so surprising to find that a performance standard (sometimes called command-and-control regulation) clearly stimulates relatively costly innovation more effectively than a comparable trading program. This is so because trading encourages polluters to use the least costly control options, which, in turn, means that many innovations cannot compete effectively in a trading program. Only innovations costing less than the least costly conventional approaches at the most easily controlled facilities have a chance in a trading market.

Unfortunately, many of our most beneficial innovations cost a lot, at least initially. Cheap desktop computers, for example, came about through the refinement of very expensive machines that filled an entire room. More to the point, solar energy and fuel cells currently cost more than conventional approaches to energy production, even though their costs have fallen over the last decade. More production would provide greater opportunities to learn how to make them even cheaper and more effective. And such technologies, while not perfect, offer a raft of environmental benefits. Their widespread deployment would not only ameliorate global warming, but also reduce urban smog and acid rain, limit coal mining (which damages water and land), and lessen the danger of oil spills. The cheapest short term measures, which trading encourages, do not coincide with the greatest environmental benefits, or the lowest long-term cost.

One reason for this is that trading encourages polluters with high control costs to forego reductions at their own facilities (i.e. purchase credits from other pollution sources) thereby decreasing their incentives to innovate. Meanwhile, those facing low control costs will tend to go beyond compliance, but only to the extent necessary to generate credits to sell to buyers. Proponents of trading tend to assume that trading encourages innovation because there are incentives for sellers to go beyond compliance, but this view neglects half of the equation; it ignores trading's tendency to remove the necessity for buyers to innovate by allowing them to escape relatively high control costs. In other words, the very mechanism that has made trading so popular (it's ability to lower compliance costs), is also the reason why trading may not be as effective at encouraging environmental innovation as the a more traditional performance standard. Its strength is also a weakness.

This does not mean that trading never encourages innovation. Any stringent program, whether a trading program or a performance standard, will encourage some innovation. But trading may not (and often does not) do a better job at encouraging initially expensive, but ultimately important, innovation than a comparably designed performance standard.

And this is only the case for well-designed trading programs. Badly-designed programs (of which there are several) are even more problematic. Take, for example, a well-designed trading program like the acid rain program: it does a perfectly fine job of realizing its stated goals cost effectively. But poorly designed programs, such as the bubble programs and wetlands mitigation programs, often save money by disguising failures to adequately protect the environment. For instance, they encourage programs aimed at activities that cannot be well monitored or that allow for gaming in various ways, and thereby often fail to achieve their goals. Unfortunately, such programs have been more common than many assume.

Design matters; both in terms of performance and to a program's ability to encourage innovation. If trading under the Kyoto Protocol, for example, focuses upon well-monitored pollution sources in countries with caps below current levels, it should provide real verifiable reductions. Unfortunately, the Kyoto Protocol's trading programs may allow credits for difficult to verify efforts to enhance "carbon sinks" or worse yet, "hot air" credits reflecting the decreasing carbon levels that accompanied the economic decline of the former Soviet Union. Design flaws such as these can destroy incentives to innovate or even to reduce pollution through conventional approaches. They lead, in short, to paper credits as a substitute for solid, real world improvements.

What does all this mean? First, we should consider more imaginative market-based approaches. For example, instead of just trading around government set emission limits (which is what cap-and-trade programs do), perhaps we should encourage competition to provide superior environmental performance. We could do this by setting up a system whereby companies that beat their competitors in reducing pollution get their cleanup costs (plus a modest premium) covered via payments taken from dirtier competitors. Second, we should look again at pollution taxes. Third, there may be cases in which traditional regulation remains a good idea. And finally, when we use trading, we should insist on rock-solid design. We need to remember that necessity--not trading--is the true mother of invention. And trading is no panacea. In some cases trading may actually eliminate necessity and, thereby, limit innovation.

We tend to think that markets are like magic. Unfortunately, the real world is a little more complicated than some of the advocates of "market-based" mechanisms suggest.

David Driesen is Professor at Syracuse University College of Law. He can be reached at ddriesen@law.syr.edu.

First posted: September 21, 2005