Innovation Economics Can Fight Global Warming

The U.S. House of Representatives may be on the verge of passing the most significant environmental measure since 1990. The bill, named for its sponsors, representatives Howard A. Waxman (D-Calif.) and Edward J. Markey (D-Mass.), would for the first time impose caps on carbon dioxide emissions, which contribute to global warming. It also would allow companies to buy credits from each other, permitting them to exceed their greenhouse gas limits.

While the so-called cap-and-trademechanism (or some kind of carbon pricing) is needed, it isn't enough. To really avert climate change, the government needs to adopt an explicitly green innovation policy. Unfortunately, green innovation is getting short shrift in this bill and in Washington generally.

Four prevailing doctrines shape U.S. economic policy today: Keynesian economics; two versions of neoclassical economics (conservative supply-side economics and liberal "Rubinomics"); and the new kid on the block, "innovation economics," about which BusinessWeek Chief Economist Michael Mandel wrote a cover story last September.

Both conservative and liberal neoclassicists oppose any government allocation of scarce goods and services. They prefer a market tool such as emissions trading that would set a price for carbon pollution, believing—incorrectly—that companies seeing potential profits would then develop needed technologies. The two camps differ slightly in how to determine a carbon price. In line with their faith in markets, most supply siders who worry about global warming favor carbon taxes, while liberal neoclassicists favor cap and trade.

profit motive requires real choices

Latter-day Keynesians, true to the principals of Keynes himself, also back cap and trade, though they regard it as a form of necessary regulation—government sets limits and companies have no choice but to comply. They also don't give much thought to explicitly spurring green innovation because they believe that strict caps in and of themselves would fix things.

Innovation economists see efforts to reduce emissions of carbon dioxide and other greenhouse gases as fundamentally an innovation challenge. They are less sanguine than neoclassicists about the power of price signals alone to bring about a solution, believing that the profit motive works only when there are adequate alternatives to shift to. Without viable electric cars, for example, people will still drive gasoline-powered cars, no matter how much fuel costs, although they might switch to more fuel-efficient models.

Moreover, they believe that even if the price signal is "correct," the innovation that's needed is often delayed because of market failures such as externalities—situations where innovators can't get the full reward from their innovations. Consequently, adherents of innovation economics say that the government must spend more on research and development to develop cost-effective noncarbon or low-carbon energy alternatives.

So who is right? Putting a price on carbon emissions would certainly help. But it's wishful thinking to believe that raising the price by $20 to $40 a ton would make a big difference. A case in point is the Netherlands. Gasoline there costs approximately $8 a gallon today—$5 of which comes from various taxes, amounting to a de facto carbon tax. This is equivalent to $400 per ton for carbon, vastly higher than the price that the Waxman-Markey proposal would bring about.

Keynesians ignore political realities

Yet while the Dutch drive less than Americans and do so in smaller cars, they still drive conventional vehicles. In fact, there are virtually no electric cars in the Netherlands. If a price of $400 per ton doesn't inspire consumers to embrace electric cars, why would a modest U.S. cap-and- trade system produce the kinds of innovation we need? Pricing carbon is not sufficient to change behavior or investments.

There's a fundamental problem with the Keynesian take on carbon reduction, too. Without systemic and radical innovation, meeting emission caps might become extremely costly in later years as limits become tougher. If the cost of regulation jumps, politicians would undoubtedly be pressured to weaken the caps. Any compromise would send the wrong signal to developing nations, which also must lower their output of greenhouse gases to slow or halt climate change.

If we are to halve global carbon emissions by 2050—the minimum reduction needed, according to many scientists—we will need radically cleaner technologies such as fully electric cars, affordable solar cells, and large-scale electricity storage devices.

To make this happen, the federal government should develop a broader approach, including spending more money on clean energy R&D. The government can afford it. In 1980, about 10% of federal research went to energy—down to less than 2% today. Getting back to 1980 levels would lift energy R&D expenditures by $11.4 billion a year.

Needed: Clean energy research funding

To encourage private-sector investment, Congress should also significantly increase the tax credit for R&D related to carbon emissions. Recent energy legislation created a 20% credit for corporate research conducted in collaboration with such public entities as federal labs and universities. That tax break should be 40%, and Congress should raise other energy R&D credits to 30%.

In addition, the government should establish new clean energy research centers that could discover and test new technology. Congress took a step in this direction with the 2007 creation of the Advanced Research Project Agency in the Energy Dept. Now lawmakers need to fully fund it.

The Waxman-Markey bill would establish eight "Clean Energy Innovation Centers" around the country to do R&D and accelerate the commercialization of clean energy technologies. But according to the Breakthrough Institute, the bill would allocate less than $1 billion to clean energy R&D. Much more is needed if we are serious about solving global warming.

In the end, differences over climate change go to the heart of most economic policy debates in Washington. Neoclassicists give short shrift to innovation (and innovation policy), and believe innovation is best left to the invisible hand of the marketplace. Likewise, neo-Keynesians don't give innovation its due, arguing that government can simply mandate the results it needs. In contrast, innovation economists put innovation at the center and argue that advances require bold public-private partnerships. We can't afford to do less.

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