Induced Innovation and Carbon Pricing

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In climate policy debates, it’s a matter of faith among some in the environmental and economics communities that “price is king.” No less an authority than Alan Blinder has referred to carbon prices as a “miracle cure,” key to inducing massive investment and, thus, radical innovation in the private sector.

But will it? No. As we argue in a new report, most analysts who see the carbon price as a be-all, end-all climate and energy solution are dramatically overstating the ability of market signals to draw forth major innovations. You can’t fully solve the climate problem without a clean energy portfolio approach that includes radical new technologies, yet you don’t get radical new technologies from a simple price on carbon (especially one that would be constrained by the political system).

At the heart of the matter is the old technology-push versus demand-pull debate. From the technology-push perspective, the way to drive innovation and technological change is through focused (or not-so-focused) development efforts. The policy toolbox from this perspective includes investment and incentives for basic, applied, and translational research, competitive institutional structures, and strategy, with the goal of generating an adequate and varied supply of new technology for market takeup. From the demand-pull perspective, the way to drive innovation is to set the market in such a way that price signals will induce innovators and entrepreneurs to accelerate their efforts to produce new technologies. The policy toolbox on this side includes carbon prices, as well as deployment-oriented programs like feed-in tariffs.

A smart energy innovation approach includes both supply- and demand-oriented policy – but it’s only until recently that the energy and climate community began to look in this direction, and even then only partially. Indeed, the debate in recent years has focused primarily on demand-pull and regulatory activities to “let the market decide.” The problem with this approach is that it only gets part of the equation right.

Why do we need both? Simply put, demand-pull policy with prices at its center can’t generate radical innovation. It can help to drive adoption of existing technology, and thus drive incremental improvements through learning curves. But the really radical technologies – such as those being developed by ARPA-E – are frequently too risky or uncertain for the private sector, and will thus receive less investment than necessary. Yet the radical stuff is critically important. For example, advanced battery storage is a fundamental necessity for large-scale wind power scaleup, and big leaps forward are needed in bioenergy, advanced nuclear, advanced materials, solar, and other areas. So policies that advance technological knowledge and performance without relying exclusively on price signals are necessary to drive down risk and uncertainty. It’s about looking at technology as existing on a continuum, and devising policy that supports clean technology along that continuum. From this perspective, a carbon price or other such demand-oriented approach is only a small part.

The problem with the price-only approach is that it misses this fundamental insight, and assumes that price signals alone can drive all necessary innovation. Indeed, as we trace in our paper, most of the big innovations that make our modern world what it is were developed not from market-driven activities in response to price signals, but from focused development efforts that sought to push technological boundaries for practical purposes, often with the public and private sectors working together. Some of these include:

The Airplane. Aviation technology received some of its most important boosts not from the market, but from public research investment and military procurement, especially during World Wars I and II. Military work in jet engine development in Germany, the United Kingdom, and the United States accelerated the commercial industry decades.

The Computer. The modern computing industry has its roots in public investment and military procurement. The military needs drove early advances in the first few generations of computers, and public dollars accounted for more than half of the funding for university computer science programs into the 1980s, as well as a major funding source for semiconductors.

The Automobile. More than 100 years elapsed between the invention of a steam-powered automobile and 20th century mass production. Throughout this time, innovators continually developed the technology until it was market ready, independent of the prices of horses, hot air balloons, or other forms of transportation. And even today, high prices of fuel in Europe haven’t lead to widespread use of electric cars, but simply more efficient internal combustion vehicles.

Gas Turbines for Power Generation. Modern gas turbines had their roots in the military’s mid-century jet engine development work, and steady improvements in gas power continued over the latter half of the 20th century even as the price of natural gas fluctuated wildly. And the current generation of gas turbines grew out of collaborative work between the private sector and the Department of Energy.

Carbon pricing or other demand policy is thus only part of a much bigger necessary solution to the clean energy challenge – and many climate and energy advocates have thus been beating the wrong bush. Rather than focusing on prices alone, advocates would be wise to focus their efforts on a much broader, more effective approach that includes technology strategy, sustained investment, and adequate support for clean new technologies along the entire development continuum, from the lab to the market.

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