Second-Best Climate Agreements and Technology Policy

We study second-best climate agreements in the presence of technology spillovers within and across countries, where the technology externalities within each country are corrected through a domestic subsidy of R&D investments. We compare the properties of two types of international climate agreements when the inter-country externalities from R&D are not regulated through the climate agreement. With an international agreement on emission quotas, the equilibrium R&D subsidy is lower than the socially optimal subsidy. The equilibrium subsidy is even lower if the climate agreement instead dictates that a common carbon tax should be imposed in all countries. Under a quota agreement, total quotas should be set low enough for the price of carbon to exceed the Pigovian level, whereas the opposite may be true under a tax agreement. We also show that social costs are higher under a second-best tax agreement than under a second-best quota agreement.