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Environmental policy reconsidered: The role of technological innovation
EUROPEAN ECONOMIC REVIEW European
ELSEVIER
Economic
Technical Innovation
Review
38 (1994) 545554
and Environmental
Environmental policy reconsidered: technological innovation Carlo
Carraro
a*b,c*, Domenico
Protection
The role of
Siniscalco
c2d
a Unioersity of Venice, Department of Economics, Ca’Foscari, 30123 Venice, Italy b CEPR, London, UK ’ Fondazione Mattei, Via S. Sofia 27, I-20122, Milan, Italy d University of Turin, Turin, Italy
Abstract This paper discusses recent environmental policy wisdom in the light of technological and organizational innovation. Starting from empirical evidence, it argues that the main econometric models which are used in environmental policy analysis do not consider properly the determinants and effects of innovation, and offer unreliable estimates of policy effects. Some solutions to the latter problem show that the integration between environmental policy and industrial policy can be more efficient than traditional environmental policies in the protection of the environment. Technological cooperation, moreover, can be an important instrument to stabilize international environmental agreements. Key words: Environmental JEL classification:
policy; Technological
innovation
LS
1. Introduction The environment can be used as a public consumption good; as a receptacle for emissions and waste; as a provider of natural resources. These competing functions give rise to a well-known problem of allocation, which also involves other assets which can substitute environmental resources. Other problems of allocation arise across generations, in the process of economic growth. In this context, each generation decides the amount to save and invest, and the amount of natural and environmental resources to *Corresponding author. 0014-2921/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0014-2921(93)E0079-Z
546
C. Carraro, D. Siniscalco / European Economic Review 38 (1994) 545-554
use for production and consumption. Sustainable growth is granted whenever the depleted resources are substituted with other forms of capital, so as to leave (at least) unchanged the welfare of future generations. The optimal allocation of environmental resources among uses and generations is not achieved through the market for several reasons: the public good nature of many environmental resources; the presence of local and transnational environmental externalities; the lack of intergenerational coordination; uncertainty. Hence the need for environmental policies which typically favour the substitution of environmental resources in production and consumption. The aim of this paper is to re-appraise environmental policy in the light of the role of technological and organizational innovation. The nature and scale of recent environmental phenomena requires innovation as a solution. Without innovation, as we shall see, the required substitutions may be impossible, or exceedingly costly. Hence, the design of environmental policies must account for their effects on innovation. The paper is divided into four sections. Section 2 provides some indications of the role of innovation in solving major environmental problems; Section 3 discusses the main econometric evidence on the substitution of natural resources in response to policy measures, with special reference to the modelling of innovation; Section 4, finally draws the main policy implications at the national and international level. A concluding section summarizes our results.
2. Some empirical indications protection
on the role of innovation for environmental
In order to solve the problems of allocation and over-exploitation of natural and environmental resources, and to foster the required substitutions, environmental economists mostly advocate the use of environmental taxation and other ‘economic instruments’. However, recent empirical evidence shows that a substantial reduction of important emissions, which are closely linked to economic activity, can hardly be achieved through the standard ‘textbook’ substitutabilities, in response to price changes. There are many instances in this area, and we select three. The first piece of evidence concerns the effects of the European carbon tax, which is aimed at stabilizing the emissions of CO, at the level of the year 1990 in order to combat global warming. According to the estimates presented by the European Commission, and carried out by several research institutions, even a ‘very high’ carbon tax ($lOboe on all energy sources excluding renewables) achieves only about one half of the required reduction target, which is only a preliminary step towards the solution of the greenhouse-effect problem. The
C. Carraro. D. Siniscalco 1 European Economic Review 38 (1994) 545-554
541
remaining half can be achieved only if a substantial proportion of the tax revenue (S60bn per year, at the EC level) is directly invested in energy saving and innovation programmes (cf. DRI, 1992; Carraro and Siniscalco, 1993a). The second piece of evidence concerns the income elasticity of many pollutants. Cross-country estimates carried out by Holtz-Eakin and Selden (1992), Grossman (1993) and Baldwin (1993) on World Bank data, show that the relation between per capita emissions and per capita income for most pollutants depicts a ‘bell shaped’ curve. Data from a great number of countries show that per capita pollution increases in the first phases of development and later decreases quite sharply, as development goes on. This kind of ‘environmental Kuznets curves’ are simple correlations, still in search of systematic explanation. The main determinants of the observed shape can be Engel’s law, structural change of the economies, and accumulation of capital; in any case, the reduction of per capita emissions seems to be scarcely related to prices, which are basically the same across countries. According to preliminary investigations, the diffusion of innovation related to investment seems to play a crucial role. In any case income effects appear to dominate price substitutions.’ The last piece of evidence comes from a business survey carried out on the first 200 corporations of Fortune 500 (Zanetti and Abate, 1993). According to the results of a questionnaire, big corporations in industrialized countries tend to respond to environmental policy measures primarily by technological and organizational innovations, secondarily by re-localizing of plants and production, and only in a small number of cases by switching inputs and reducing output, as predicted by standard environmental models. Summing up, substitutions between environmental and natural resources and other forms of capital exist, but do not seem to take place through the expected channels: rather, investment, innovation and technology diffusion seem to play a central role.
3. Econometric
evidence on natural resource substitutability
Over and above the indications recalled in the previous paragraph, is there any systematic econometric evidence on the elasticity of demand for natural resources to prices and income? And is there econometric work on the determinants and the effects of innovation on environmental variables? The answer is not very encouraging and confirms that there is much to be investigated. As far as environmental innovation in concerned, the body of
1 However, we should stress Chichilniski’s (1993) remark that across countries can explain differences in the use of environmental
differences resources.
in property
rights
548
C. Camaro. D. Siniscalco / European Economic Review 38 (1994) 545-554
evidence is practically non-existent. But the evidence on price and income elasticities is inadequate, too. A study by the OECD (1993) surveys the main international models on energy use and CO, emissions. These models can be divided into computable general equilibrium models, partial equilibrium econometric models, and general equilibrium econometric models. The low value of the elasticities of substitutions in all these models implies that the policy targets in terms of emission reduction are usually obtained at a rather high cost. In other words, the targets of environmental policies require very high tax rates which induce substantial output contractions. However, some very recent literature on the costs of stabilizing CO, emissions shows that the results obtained with the existing models are probably flawed because the elasticities of substitution between energy and other inputs are even lower than they appear, and because the models do not take into proper account innovation and income elasticities (cf. Dean and Hoeller, 1993; Boone et al., 1993; Botteon et al., 1993). In the main available models, technological innovation is usually modelled as an exogenous and linear process (cf. Boero et al., 1991). This might explain why in most simulations the carbon tax has a poor effect on global emissions unless very high tax rates are imposed. The few attempts’ to endogenise income elasticities and technological progress in environmental econometric models show that: _ the parameters linking fuel demand to relative prices are lower when technological progress is endogenous. This implies that the conventional assumption on exogenous technological progress introduces an upward bias in the estimated price elasticities; _ a change in energy relative prices has an impact on fuel demand which goes mainly through its effects on investment, R&D, and innovation; _ there exist policy measures which are likely to be much more effective than a change of energy relative prices in inducing energy saving and environmental innovation. The main idea behind the models which endogenise technological progress is to divide capital, and therefore investment, into two components: the energy-saving (or environment-friendly) capital is the one that embodies the new production technologies. The remaining capital is the accumulation of the old technology vintages. The ratio between these two components (i.e. the development of energy-saving vintages) depends on the amount of R&D. Following standard models of R&D, this depends on income, relative prices, ‘Some econometric Mattei Foundation program.
work to endogenise in Milan, at GRETA
technological progress in Venice, and inside
has been carried the EEC JOULE
out at the II research
C. Carraro, D. Siniscalco / European Economic Review 38 (1994) 545-554
549
and on policy measures such as innovation subsidies. Hence, an increase of energy prices (e.g. a carbon tax), increases firms’ R&D (see the next section on this point), which increases the amount of energy-saving capital. This has a negative effect on fuel demand which is larger than the direct effect of a change in relative energy prices. Moreover, emission ratios (i.e. the ratio between fuel consumption and polluting emissions such as SO,, NO,, CO) also depend on the accumulated vintages of the different types of capital. In this context, lower emissions can be achieved through three effects: the usual income and substitution effects (approximately re-assessed by accounting for the endogenous technical progress), and the innovation effect which directly reduces the emission ratios. If these results are shown to be robust by further econometric evidence, we can conclude, as in Section 2, that traditional econometric models ignore the main channels through which energy conservation and substitution take place. Hence, they cannot be considered reliable tools for policy evaluation. Moreover, endogenising income effects and technological progress and their effects on the environment opens the way to new policy tools that are specifically designed to favour environmental technological innovation. These policy issues will be discussed in the next section.
4. Theoretical
models of environmental
innovation and policy
Environmental policy plays a twofold role in the economic process that leads to lower emissions. On the one side, it can lead firms to adopt existing cleaner technologies which are not currently used because of their higher production costs vis-a-vis more polluting alternatives. On the other side, it stimulates firms’ R&D through which new environment-friendly technologies can be developed. Two questions should be addressed: (i) What are the effects of the usual environmental policy tools (taxation and other economic instruments) on the technological and R&D decisions of the firms? (ii) Is there a better set of policy tools that can induce a faster and/or cheaper improvement of production technologies? In answering the above questions we believe there is much to be gained by merging the environmental literature with the industrial organization literature on innovation. The two fields have so far communicated little; but once the importance of innovation is recognized, the theory of industrial organization is the obvious field to draw upon. The merger of the two fields is somewhat complex. The following papers by Laffont and Tirole and Motta and Thisse offer interesting examples. Here follow three other examples, which show that environmental taxation (and traditional environmental principles such as ‘the polluter pays’ principle) is not always a cost effective policy to solve environmental problems.
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Consider first diffusion, i.e. the case in which the firm can choose among alternative existing production technologies. Which policy instrument can foster the choice of the best available technology? Assume two technologies are available. Assume the more polluting one is less costly, possibly more efficient, than the other one. Hence, firms adopt the more polluting technology. Moreover, the less polluting one is characterised by higher set up and maintenance cost. Assume that pollution is positively related to output, and that the emission/output ratio increases with the rate of capacity utilization of the plants operated by the lirm.3 What are the effects of environmental policy on firms’ decisions? Consider an environmental tax. By raising the operating costs of the original technology, the tax can induce the firm to shift to the cleaner technology. However, the tax reduces output (and consumer surplus), increases the firms’ average costs, thus affecting its competitiveness, and does not affect the equilibrium rate of capacity utilization of plants characterised by the cleaner technology. However, it reduces the equilibrium rate of capacity utilization of more polluting plants (if still operated). The qualitative effects of emission permits are similar. The same target, i.e. the adoption of a cleaner technology, could be achieved through an innovation subsidy, which reduces the fixed costs of installing the cleaner technology. In this case, industry output and firms’ competitiveness are not modified, and the equilibrium rate of capacity utilization of the cleaner plants is lowered. Moreover, the subsidy does not affect the equilibrium rate of capacity utilization of the more polluting plants; however, it must be financed through costly (because distortionary) taxation. The conclusion about the optimal policy crucially depends upon two factors: the importance and/or the desirability of output reductions induced by emission taxes, and the availability of less polluting technologies. If output contraction is negligible and/or undesirable, and no constraint exists on the supply of less polluting technologies, then the appropriate policy instrument is likely to be the innovation subsidy. Otherwise, environmental taxes might be preferred because they reduce emissions through three channels: technological change, output contraction, and the reduced rate of capacity utilization of more polluting plants (which are still operated if the availability of less polluting plants is limited). The policy recommendation is therefore the following: the government should favour the widest availability of the cleaner technology, either by and/or by favouring innovation removing legal constraints or quotas, diffusion. Such a policy would create the conditions for the innovation subsidy to be the optimal policy instrument. As a consequence, the government would achieve lower polluting emissions without reducing output and 3The complete model can be found in Carraro
and Soubeyran
(1993).
C. Carraro. D. Siniscalco / European Economic Review 38 (1994) 545-554
551
consumer surplus, without raising firms’ operating costs, and excessively utilizing the less polluting plants. Notice that these policy recommendations shift the attention of policymakers from environmental policy (strictly defined as taxes, subsidies, permits, and the like) to a more general set of policy tools which belong to industrial and trade policies. Similar conclusions are obtained in the case of innovation, by relaxing the assumption that the new technology is instantaneously available to firms.4 Assume that firms can reduce emissions per unit of output only after having developed a new production technology, and that such development is costly and takes time. In such a context, how should environmental policy be designed? Assume that the timing of innovation is the outcome of firms’ R&D strategic behaviour. As a consequence, it is possible to model the innovative activity as a race towards invention, where the final prize consists of a patent that allows the winner to enjoy a strategic advantage over other competitors in terms of reduced production costs, product differentiation, or superior quality. This race is best represented as a dynamic game among firms in which each Iirm’s optimal R&D strategy is jointly determined with the other firms’ strategic variables. Consider again the effect on an environmental tax. If properly designed, it can induce the firm to invest in R&D in such an way that the new, cleaner, technology is adopted after t, periods of time. At the equilibrium, emissions are lower both with respect to the status-quo (no taxation), and with respect to a situation in which emissions are taxed, but firms stick to the old technology. Moreover, as expected, output levels are higher than in the preinnovation state. Therefore, emission taxes, by inducing emission-reducing innovation, loosen the traditional trade-off between growth and environmental quality. However, t,, the optimal private time of adoption, differs from the optimal social one (denoted by t,), which is defined on the basis of a measure of total welfare. More precisely, firms have an incentive to postpone innovation with respect to the social optimum, in order to minimize R&D costs (cP>t,). This conflict between government and industry can be regulated through the application of an appropriate subsidy scheme. Each government has an incentive to associate innovation subsidies to the emission tax, in order to implement the socially optimal dates of innovation.5 Even in this case, the policy conclusion does not recommend the introduction of a ‘simple’ environmental policy. It rather stresses the importance of combining several policy tools in order to stimulate environmental R&D
4 The following remarks are based on the results proposed in Carraro and Topa (1991). 5The features of the optimal subsidy in the presence of asymmetric information are analysed Carraro and Topa (1991).
in
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C. Carraro.
D. Siniscalco / European Economic Review 38 (1994) 545-554
and to maximize social welfare (which accounts both for consumers’ surplus and the disutility from polluting emissions). Consider, as a last example, the role of innovation policy in sustaining and expanding international agreements on the protection of transnational and global environmental resources. 6 Many environmental agreements tend to use other policy variables, such as development aid, as a tool for increasing the number of signatories (recent examples at the Climate Change Convention or the agreements on CFCs production control). We argue that a cooperative technological innovation policy can also be directed towards increasing the number of countries which agree to sign an international environmental agreement. As is well-known, the global externalities related to some forms of pollution jeopardize the unilateral attempts at reducing emissions; the appropriability of a cleaner global environment by all countries provides an incentive not to join global environmental agreements, thus undermining the attempts at cooperation by free-riding. The recent literature and practice on international agreements shows that, despite the incentives to free-ride, coalitions can exist, but involve a limited number of countries, and are too small for a satisfactory protection of the environment. Therefore, the objective of the cooperating countries is to expand these coalitions by appropriate transfers. The incentive to free-ride, however, quickly dominates any attempt at expansion, when the bargaining takes place on the basis of emissions only. Starting from this consideration, a recent intuition is that we must ‘add some elements’ to environmental negotiations, in order to sustain cothere exists one interesting mechanism of operation. Among others,’ creating and expanding environmental coalitions, i.e. of increasing the number of cooperating countries. This mechanism is based on the linkage of the environmental agreement, which is profitable but unstable, to another agreement which is profitable and stable, because it involves a positive excludable externality. Consider the following example. Suppose countries negotiate on R&D cooperation in the industrial field (or, more generally, outside the environmental sector). In this case, R&D cooperation introduces a positive externality (innovation and the sharing of R&D fixed costs), thus increasing the signatory countries’ welfare. If participation in the agreement on R&D cooperation is made conditional upon the signature of the environmental agreement, the incentive to free-ride on the benefit of a cleaner environment (which is a public good fully appropriable by all players) is offset by the 6The analysis of the link between R&D cooperation and international environmental is proposed in Carraro and Siniscalco (1936b). ‘Some proposals are contained in Carraro and Siniscalco (1992, 1993~).
protection
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C. Carraro. D. Siniscalco / European Economic Review 38 (1994) 545-554
incentive to belong to the joint coalition and to appropriate the benefit stemming from the positive technological externality. The latter incentive increases the welfare of the joint agreement vis-a-vis the two separate agreements and, if it leads to full cooperation in both fields, is also Pareto optimal.
5. Conclusion The main conclusions
of our analysis
can be summarized
as follows:
(i) Environmental innovation plays a key role in the solution of environmental problems; therefore, both economic models and policy measures need to be reconsidered. (ii) Econometric models for environmental policy analysis should account for the relationship between relative prices, policy decisions, firms’ R&D and technological innovation. (iii) Policy, in particular, should be specifically designed to promote technological innovation, and to favour its diffusion. As a consequence, the optimal policy to control pollution is a mix of complementary measures which does not necessarily correspond to the conventional environmental policy recommendations (for example, the role of taxation must be reconsidered, and industrial and trade policy measures must account for environmental targets). (iv) Finally, it is important not to neglect the international dimension of R&D policy in relation to the trans-national nature of environmental externalities. As previously suggested, R&D cooperation and spillovers from R&D activity, which can be regulated through appropriate industrial policies, can be used to expand and stabilize international agreements on the environment. We would like to stress that further research work is necessary to properly understand the interdependence between environmental and industrial policy measures, and their effects on emissions. In particular, the role of environmental R&D and innovation in growth models need to be explored.’ *A few attempts
into this direction
are the papers
by Verdier (1993) and Blackburn
et al. (1993).
References Baldwin, R., 1993, Does sustainability require growth?, in: I. Goldin and A. Winters, economics of sustainable development (Cambridge University Press, Cambridge).
eds., The
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Blackburn K., P. Chang and V. Hung, 1993, Endogenous growth, environment, and R&D, in: C. Carraro, eds., Trade, innovation, environment (Kluwer Academic Publishers, Dordrecht). Boero, G., R. Clarke and L.A. Winters, 1991, The macroeconomic consequences of controlling greenhouse gases: a survey, Mimeo. (University of Birmingham, Birmingham). Boone, L., S. Hall and D. Kernball-Cook, 1992, Endogenous technical progress in fossil fuel demand, Working paper (Centre for Economic Forecasting, London Business School, London). Botteon, M., C. Carraro and M. Gallo, 1993, Econmetric models for environmental policy, Paper prepared for the Bank of Italy Conference on Econometric Modelling: Recent Developments, Perugia, 28.7-1.10, 1993. Carraro, C. and D. Siniscalco, 1992, The international dimension of environmental policy, European Economic Review 36, 379-387. Carraro, C. and D. Siniscalco, eds., 1993a, The european carbon tax: An economic assessment (Kluwer Academic Publishers, Dordrecht). Carraro, C. and D. Siniscalco, 1993b. Policy coordination for sustainability: Commitments, transfers, and limited negotiations, in: I. Goldin and A.. Winters, eds., The economics of sustainable development (Cambridge University Press, Cambridge). Carraro, C. and D. Siniscalco, 1993c, Strategies for the international protection of environment, Journal of Public Economics 52, no. 3, 3099328. Carraro, C. and A. Soubeyran, 1993, Environmental policy and the choice of production technology, in: C. Carraro, Y. Katsoulacos and A. Xepapadeos, eds., Environmental policy and market structure (Kluwer, Dordrecht). Carraro, C. and G. Topa, 1991, Taxation and the environmental innovation, in: C. Carraro and J. Filar, eds., Control and game-theoretic models of the environment (Birkhauser, Basel). Chichilniski, G., 1993, Property rights and the dynamics of renewable resources in north-south trade, in: C. Carraro, ed., Trade, innovation, environment (Kluwer Academic Publishers, Dordrecht). Dean, A. and P. Hoeller, 1993, Costs of reducing CO, emissions: Evidence from six global models, OECD report (OECD, Paris). DRI, 1992, Impact of a package of EC measures to control CO, emissions on European industry, Report for the commission of the European communities, DGXI. Grossman, G., 1993, Pollution and growth: What do we know? in: I. Goldin and A. Winters, eds., The economics of sustainable development (Cambridge University Press, Cambridge). Holtz-Eakin, D. and T.M. Selden, 1992, Stoking the fires? CO2 emissions and economic growth, Working paper no. 4248 (NBER, Cambridge, MA). OECD, 1993, The economic costs of reducing CO, emissions (OECD, Paris). Verdier, T., 1993, Environmental pollution and endogenous growth, in: C. Carraro and J. Filar, eds., Control and game-theoretic models of the environment (Birkhluser, Base]). Zanetti, G. and A. Abate, 1993, Salvaguardia dell’ambiente press0 le maggiori imprese mondiali, in: D. Siniscalco, ed., Stato, grandi imprese e sviluppo sostenibile (11 Mulino, Bologna).
ELSEVIER
Economic
Technical Innovation
Review
38 (1994) 545554
and Environmental
Environmental policy reconsidered: technological innovation Carlo
Carraro
a*b,c*, Domenico
Protection
The role of
Siniscalco
c2d
a Unioersity of Venice, Department of Economics, Ca’Foscari, 30123 Venice, Italy b CEPR, London, UK ’ Fondazione Mattei, Via S. Sofia 27, I-20122, Milan, Italy d University of Turin, Turin, Italy
Abstract This paper discusses recent environmental policy wisdom in the light of technological and organizational innovation. Starting from empirical evidence, it argues that the main econometric models which are used in environmental policy analysis do not consider properly the determinants and effects of innovation, and offer unreliable estimates of policy effects. Some solutions to the latter problem show that the integration between environmental policy and industrial policy can be more efficient than traditional environmental policies in the protection of the environment. Technological cooperation, moreover, can be an important instrument to stabilize international environmental agreements. Key words: Environmental JEL classification:
policy; Technological
innovation
LS
1. Introduction The environment can be used as a public consumption good; as a receptacle for emissions and waste; as a provider of natural resources. These competing functions give rise to a well-known problem of allocation, which also involves other assets which can substitute environmental resources. Other problems of allocation arise across generations, in the process of economic growth. In this context, each generation decides the amount to save and invest, and the amount of natural and environmental resources to *Corresponding author. 0014-2921/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0014-2921(93)E0079-Z
546
C. Carraro, D. Siniscalco / European Economic Review 38 (1994) 545-554
use for production and consumption. Sustainable growth is granted whenever the depleted resources are substituted with other forms of capital, so as to leave (at least) unchanged the welfare of future generations. The optimal allocation of environmental resources among uses and generations is not achieved through the market for several reasons: the public good nature of many environmental resources; the presence of local and transnational environmental externalities; the lack of intergenerational coordination; uncertainty. Hence the need for environmental policies which typically favour the substitution of environmental resources in production and consumption. The aim of this paper is to re-appraise environmental policy in the light of the role of technological and organizational innovation. The nature and scale of recent environmental phenomena requires innovation as a solution. Without innovation, as we shall see, the required substitutions may be impossible, or exceedingly costly. Hence, the design of environmental policies must account for their effects on innovation. The paper is divided into four sections. Section 2 provides some indications of the role of innovation in solving major environmental problems; Section 3 discusses the main econometric evidence on the substitution of natural resources in response to policy measures, with special reference to the modelling of innovation; Section 4, finally draws the main policy implications at the national and international level. A concluding section summarizes our results.
2. Some empirical indications protection
on the role of innovation for environmental
In order to solve the problems of allocation and over-exploitation of natural and environmental resources, and to foster the required substitutions, environmental economists mostly advocate the use of environmental taxation and other ‘economic instruments’. However, recent empirical evidence shows that a substantial reduction of important emissions, which are closely linked to economic activity, can hardly be achieved through the standard ‘textbook’ substitutabilities, in response to price changes. There are many instances in this area, and we select three. The first piece of evidence concerns the effects of the European carbon tax, which is aimed at stabilizing the emissions of CO, at the level of the year 1990 in order to combat global warming. According to the estimates presented by the European Commission, and carried out by several research institutions, even a ‘very high’ carbon tax ($lOboe on all energy sources excluding renewables) achieves only about one half of the required reduction target, which is only a preliminary step towards the solution of the greenhouse-effect problem. The
C. Carraro. D. Siniscalco 1 European Economic Review 38 (1994) 545-554
541
remaining half can be achieved only if a substantial proportion of the tax revenue (S60bn per year, at the EC level) is directly invested in energy saving and innovation programmes (cf. DRI, 1992; Carraro and Siniscalco, 1993a). The second piece of evidence concerns the income elasticity of many pollutants. Cross-country estimates carried out by Holtz-Eakin and Selden (1992), Grossman (1993) and Baldwin (1993) on World Bank data, show that the relation between per capita emissions and per capita income for most pollutants depicts a ‘bell shaped’ curve. Data from a great number of countries show that per capita pollution increases in the first phases of development and later decreases quite sharply, as development goes on. This kind of ‘environmental Kuznets curves’ are simple correlations, still in search of systematic explanation. The main determinants of the observed shape can be Engel’s law, structural change of the economies, and accumulation of capital; in any case, the reduction of per capita emissions seems to be scarcely related to prices, which are basically the same across countries. According to preliminary investigations, the diffusion of innovation related to investment seems to play a crucial role. In any case income effects appear to dominate price substitutions.’ The last piece of evidence comes from a business survey carried out on the first 200 corporations of Fortune 500 (Zanetti and Abate, 1993). According to the results of a questionnaire, big corporations in industrialized countries tend to respond to environmental policy measures primarily by technological and organizational innovations, secondarily by re-localizing of plants and production, and only in a small number of cases by switching inputs and reducing output, as predicted by standard environmental models. Summing up, substitutions between environmental and natural resources and other forms of capital exist, but do not seem to take place through the expected channels: rather, investment, innovation and technology diffusion seem to play a central role.
3. Econometric
evidence on natural resource substitutability
Over and above the indications recalled in the previous paragraph, is there any systematic econometric evidence on the elasticity of demand for natural resources to prices and income? And is there econometric work on the determinants and the effects of innovation on environmental variables? The answer is not very encouraging and confirms that there is much to be investigated. As far as environmental innovation in concerned, the body of
1 However, we should stress Chichilniski’s (1993) remark that across countries can explain differences in the use of environmental
differences resources.
in property
rights
548
C. Camaro. D. Siniscalco / European Economic Review 38 (1994) 545-554
evidence is practically non-existent. But the evidence on price and income elasticities is inadequate, too. A study by the OECD (1993) surveys the main international models on energy use and CO, emissions. These models can be divided into computable general equilibrium models, partial equilibrium econometric models, and general equilibrium econometric models. The low value of the elasticities of substitutions in all these models implies that the policy targets in terms of emission reduction are usually obtained at a rather high cost. In other words, the targets of environmental policies require very high tax rates which induce substantial output contractions. However, some very recent literature on the costs of stabilizing CO, emissions shows that the results obtained with the existing models are probably flawed because the elasticities of substitution between energy and other inputs are even lower than they appear, and because the models do not take into proper account innovation and income elasticities (cf. Dean and Hoeller, 1993; Boone et al., 1993; Botteon et al., 1993). In the main available models, technological innovation is usually modelled as an exogenous and linear process (cf. Boero et al., 1991). This might explain why in most simulations the carbon tax has a poor effect on global emissions unless very high tax rates are imposed. The few attempts’ to endogenise income elasticities and technological progress in environmental econometric models show that: _ the parameters linking fuel demand to relative prices are lower when technological progress is endogenous. This implies that the conventional assumption on exogenous technological progress introduces an upward bias in the estimated price elasticities; _ a change in energy relative prices has an impact on fuel demand which goes mainly through its effects on investment, R&D, and innovation; _ there exist policy measures which are likely to be much more effective than a change of energy relative prices in inducing energy saving and environmental innovation. The main idea behind the models which endogenise technological progress is to divide capital, and therefore investment, into two components: the energy-saving (or environment-friendly) capital is the one that embodies the new production technologies. The remaining capital is the accumulation of the old technology vintages. The ratio between these two components (i.e. the development of energy-saving vintages) depends on the amount of R&D. Following standard models of R&D, this depends on income, relative prices, ‘Some econometric Mattei Foundation program.
work to endogenise in Milan, at GRETA
technological progress in Venice, and inside
has been carried the EEC JOULE
out at the II research
C. Carraro, D. Siniscalco / European Economic Review 38 (1994) 545-554
549
and on policy measures such as innovation subsidies. Hence, an increase of energy prices (e.g. a carbon tax), increases firms’ R&D (see the next section on this point), which increases the amount of energy-saving capital. This has a negative effect on fuel demand which is larger than the direct effect of a change in relative energy prices. Moreover, emission ratios (i.e. the ratio between fuel consumption and polluting emissions such as SO,, NO,, CO) also depend on the accumulated vintages of the different types of capital. In this context, lower emissions can be achieved through three effects: the usual income and substitution effects (approximately re-assessed by accounting for the endogenous technical progress), and the innovation effect which directly reduces the emission ratios. If these results are shown to be robust by further econometric evidence, we can conclude, as in Section 2, that traditional econometric models ignore the main channels through which energy conservation and substitution take place. Hence, they cannot be considered reliable tools for policy evaluation. Moreover, endogenising income effects and technological progress and their effects on the environment opens the way to new policy tools that are specifically designed to favour environmental technological innovation. These policy issues will be discussed in the next section.
4. Theoretical
models of environmental
innovation and policy
Environmental policy plays a twofold role in the economic process that leads to lower emissions. On the one side, it can lead firms to adopt existing cleaner technologies which are not currently used because of their higher production costs vis-a-vis more polluting alternatives. On the other side, it stimulates firms’ R&D through which new environment-friendly technologies can be developed. Two questions should be addressed: (i) What are the effects of the usual environmental policy tools (taxation and other economic instruments) on the technological and R&D decisions of the firms? (ii) Is there a better set of policy tools that can induce a faster and/or cheaper improvement of production technologies? In answering the above questions we believe there is much to be gained by merging the environmental literature with the industrial organization literature on innovation. The two fields have so far communicated little; but once the importance of innovation is recognized, the theory of industrial organization is the obvious field to draw upon. The merger of the two fields is somewhat complex. The following papers by Laffont and Tirole and Motta and Thisse offer interesting examples. Here follow three other examples, which show that environmental taxation (and traditional environmental principles such as ‘the polluter pays’ principle) is not always a cost effective policy to solve environmental problems.
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Consider first diffusion, i.e. the case in which the firm can choose among alternative existing production technologies. Which policy instrument can foster the choice of the best available technology? Assume two technologies are available. Assume the more polluting one is less costly, possibly more efficient, than the other one. Hence, firms adopt the more polluting technology. Moreover, the less polluting one is characterised by higher set up and maintenance cost. Assume that pollution is positively related to output, and that the emission/output ratio increases with the rate of capacity utilization of the plants operated by the lirm.3 What are the effects of environmental policy on firms’ decisions? Consider an environmental tax. By raising the operating costs of the original technology, the tax can induce the firm to shift to the cleaner technology. However, the tax reduces output (and consumer surplus), increases the firms’ average costs, thus affecting its competitiveness, and does not affect the equilibrium rate of capacity utilization of plants characterised by the cleaner technology. However, it reduces the equilibrium rate of capacity utilization of more polluting plants (if still operated). The qualitative effects of emission permits are similar. The same target, i.e. the adoption of a cleaner technology, could be achieved through an innovation subsidy, which reduces the fixed costs of installing the cleaner technology. In this case, industry output and firms’ competitiveness are not modified, and the equilibrium rate of capacity utilization of the cleaner plants is lowered. Moreover, the subsidy does not affect the equilibrium rate of capacity utilization of the more polluting plants; however, it must be financed through costly (because distortionary) taxation. The conclusion about the optimal policy crucially depends upon two factors: the importance and/or the desirability of output reductions induced by emission taxes, and the availability of less polluting technologies. If output contraction is negligible and/or undesirable, and no constraint exists on the supply of less polluting technologies, then the appropriate policy instrument is likely to be the innovation subsidy. Otherwise, environmental taxes might be preferred because they reduce emissions through three channels: technological change, output contraction, and the reduced rate of capacity utilization of more polluting plants (which are still operated if the availability of less polluting plants is limited). The policy recommendation is therefore the following: the government should favour the widest availability of the cleaner technology, either by and/or by favouring innovation removing legal constraints or quotas, diffusion. Such a policy would create the conditions for the innovation subsidy to be the optimal policy instrument. As a consequence, the government would achieve lower polluting emissions without reducing output and 3The complete model can be found in Carraro
and Soubeyran
(1993).
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consumer surplus, without raising firms’ operating costs, and excessively utilizing the less polluting plants. Notice that these policy recommendations shift the attention of policymakers from environmental policy (strictly defined as taxes, subsidies, permits, and the like) to a more general set of policy tools which belong to industrial and trade policies. Similar conclusions are obtained in the case of innovation, by relaxing the assumption that the new technology is instantaneously available to firms.4 Assume that firms can reduce emissions per unit of output only after having developed a new production technology, and that such development is costly and takes time. In such a context, how should environmental policy be designed? Assume that the timing of innovation is the outcome of firms’ R&D strategic behaviour. As a consequence, it is possible to model the innovative activity as a race towards invention, where the final prize consists of a patent that allows the winner to enjoy a strategic advantage over other competitors in terms of reduced production costs, product differentiation, or superior quality. This race is best represented as a dynamic game among firms in which each Iirm’s optimal R&D strategy is jointly determined with the other firms’ strategic variables. Consider again the effect on an environmental tax. If properly designed, it can induce the firm to invest in R&D in such an way that the new, cleaner, technology is adopted after t, periods of time. At the equilibrium, emissions are lower both with respect to the status-quo (no taxation), and with respect to a situation in which emissions are taxed, but firms stick to the old technology. Moreover, as expected, output levels are higher than in the preinnovation state. Therefore, emission taxes, by inducing emission-reducing innovation, loosen the traditional trade-off between growth and environmental quality. However, t,, the optimal private time of adoption, differs from the optimal social one (denoted by t,), which is defined on the basis of a measure of total welfare. More precisely, firms have an incentive to postpone innovation with respect to the social optimum, in order to minimize R&D costs (cP>t,). This conflict between government and industry can be regulated through the application of an appropriate subsidy scheme. Each government has an incentive to associate innovation subsidies to the emission tax, in order to implement the socially optimal dates of innovation.5 Even in this case, the policy conclusion does not recommend the introduction of a ‘simple’ environmental policy. It rather stresses the importance of combining several policy tools in order to stimulate environmental R&D
4 The following remarks are based on the results proposed in Carraro and Topa (1991). 5The features of the optimal subsidy in the presence of asymmetric information are analysed Carraro and Topa (1991).
in
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and to maximize social welfare (which accounts both for consumers’ surplus and the disutility from polluting emissions). Consider, as a last example, the role of innovation policy in sustaining and expanding international agreements on the protection of transnational and global environmental resources. 6 Many environmental agreements tend to use other policy variables, such as development aid, as a tool for increasing the number of signatories (recent examples at the Climate Change Convention or the agreements on CFCs production control). We argue that a cooperative technological innovation policy can also be directed towards increasing the number of countries which agree to sign an international environmental agreement. As is well-known, the global externalities related to some forms of pollution jeopardize the unilateral attempts at reducing emissions; the appropriability of a cleaner global environment by all countries provides an incentive not to join global environmental agreements, thus undermining the attempts at cooperation by free-riding. The recent literature and practice on international agreements shows that, despite the incentives to free-ride, coalitions can exist, but involve a limited number of countries, and are too small for a satisfactory protection of the environment. Therefore, the objective of the cooperating countries is to expand these coalitions by appropriate transfers. The incentive to free-ride, however, quickly dominates any attempt at expansion, when the bargaining takes place on the basis of emissions only. Starting from this consideration, a recent intuition is that we must ‘add some elements’ to environmental negotiations, in order to sustain cothere exists one interesting mechanism of operation. Among others,’ creating and expanding environmental coalitions, i.e. of increasing the number of cooperating countries. This mechanism is based on the linkage of the environmental agreement, which is profitable but unstable, to another agreement which is profitable and stable, because it involves a positive excludable externality. Consider the following example. Suppose countries negotiate on R&D cooperation in the industrial field (or, more generally, outside the environmental sector). In this case, R&D cooperation introduces a positive externality (innovation and the sharing of R&D fixed costs), thus increasing the signatory countries’ welfare. If participation in the agreement on R&D cooperation is made conditional upon the signature of the environmental agreement, the incentive to free-ride on the benefit of a cleaner environment (which is a public good fully appropriable by all players) is offset by the 6The analysis of the link between R&D cooperation and international environmental is proposed in Carraro and Siniscalco (1936b). ‘Some proposals are contained in Carraro and Siniscalco (1992, 1993~).
protection
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incentive to belong to the joint coalition and to appropriate the benefit stemming from the positive technological externality. The latter incentive increases the welfare of the joint agreement vis-a-vis the two separate agreements and, if it leads to full cooperation in both fields, is also Pareto optimal.
5. Conclusion The main conclusions
of our analysis
can be summarized
as follows:
(i) Environmental innovation plays a key role in the solution of environmental problems; therefore, both economic models and policy measures need to be reconsidered. (ii) Econometric models for environmental policy analysis should account for the relationship between relative prices, policy decisions, firms’ R&D and technological innovation. (iii) Policy, in particular, should be specifically designed to promote technological innovation, and to favour its diffusion. As a consequence, the optimal policy to control pollution is a mix of complementary measures which does not necessarily correspond to the conventional environmental policy recommendations (for example, the role of taxation must be reconsidered, and industrial and trade policy measures must account for environmental targets). (iv) Finally, it is important not to neglect the international dimension of R&D policy in relation to the trans-national nature of environmental externalities. As previously suggested, R&D cooperation and spillovers from R&D activity, which can be regulated through appropriate industrial policies, can be used to expand and stabilize international agreements on the environment. We would like to stress that further research work is necessary to properly understand the interdependence between environmental and industrial policy measures, and their effects on emissions. In particular, the role of environmental R&D and innovation in growth models need to be explored.’ *A few attempts
into this direction
are the papers
by Verdier (1993) and Blackburn
et al. (1993).
References Baldwin, R., 1993, Does sustainability require growth?, in: I. Goldin and A. Winters, economics of sustainable development (Cambridge University Press, Cambridge).
eds., The
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