Climate Policy and Induced R&D: How Great is the Effect?

Carbon taxes or tradable permit systems to address climate change may induce research and development in energy-related technologies. We construct a single-knowledge-stock model of R&D, growth and climate to assess the importance of this effect. The contribution of induced R&D is shown to be very sensitive to (i) the duplication externality, (ii) the feasibility of dedicated research subsidies to internalize inter-firm knowledge spillovers, (iii) the opportunity cost of R&D, (iv) the initial level of research expenditure, and (v) the elasticity of substitution between energy and other factors of production. In contrast, the direction and scale of the inter-temporal research spillover is of secondary importance. We find strong support for Rezai’s (2011) argument that, when the business-as-usual scenario (no policy) is modeled appropriately (all externalities treated as external), sacrifices for early generations associated with optimal climate policy are minor or non-existent. Employing our preferred selections for the parameters, we find that adding an induced R&D component to the model increases the welfare impact of the first-best policy (optimally chosen carbon tax and research subsidies) by an average value of more than 400 percent, and of the second-best policy (carbon tax alone) by approximately 22 percent.