Question

Assume that the marginal abatement cost curves (MACs) are linear and that the firm currently faces a standard imposed at the optimal level of pollution. Suppose a new technology can be adopted at zero cost, which causes the MAC to swing downwards. Also, assume that if the firm adopts the technology, the regulator automatically adjusts the standard to its new optimal level. Under what conditions will the firm adopt the new technology?

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Economic researchers have long been interested in the relationship between environmental policy and technical change. This interest has taken on a renewed vigor in recent years in response to increasing concerns about climate change. The ability of pollution reduction policies to induce technical change influences their dynamic efficiency and, in the climate context, has potentially important ramifications for the appropriate stringency of near-term emissions reductions. Moreover, a broader suite of policies to foster technical change (e.g., publicly-funded R&D) are becoming increasingly accepted as integral to a comprehensive approach to climate change. Appropriate environmental policy depends not just on whether and how much technology responds to policy, it also depends on which technologies respond.

Improvements in solar cells, for example, may have different impacts on carbon dioxide emissions reduction possibilities than improvements in the efficiency of fossil fuel power plants. An incremental improvement in solar cells may have a small impact on climate change if the carbon price is low (since solar is not widely economically competitive under such a scenario), but a larger impact if carbon prices are high. On the other hand, an improvement in the efficiency of fossil fuel power plants will have a large impact on climate change if carbon prices are low, but less impact if carbon prices are high causing society to substitute away from fossil fuels altogether. While not explicitly acknowledging this fact, researchers using theoretical models as well as applied aggregate-level (or “top-down”) integrated assessment models have employed a variety of simplified representations of technical change. These different representations lead to different impacts on the marginal costs of emissions reductions and, in turn, to different policy implications. For example, Baker, Clarke, and Weyant [2] have shown that different representations of technical change have very different effects on the optimal societal investment in climate change technology R&D in the face of uncertainty.

They find that the socially optimal investment in technologies that pivot the cost curve down increases with some Mean-Preserving-Spreads (MPS); while the socially optimal investment in 3 technologies that pivot the cost curve to the right tend to decrease in MPS. Yet the empirical basis for this aspect of technical change–how it effects marginal abatement costs–has been largely ignored in the construction of these models. This paper addresses the treatment of technical change in theoretical and aggregate-level models. The paper has three distinct, but related purposes. The first is to demonstrate that theoretical and aggregate-level applied models have, indeed, used a number of different formulations for technical change and, furthermore, that these different formulations can lead to very different impacts on the marginal costs of pollution reductions. In Section 2, we review a variety of approaches from the literature, and show that these representations have quite different, and sometimes surprising, effects on the marginal costs of pollution reductions. In particular, we highlight the interesting case of formulations in which technical change increases marginal abatement costs at higher levels of abatement. The second purpose of this paper is to provide examples demonstrating that this particular phenomenon– technical change increasing marginal costs–is not an error or an anomalous special case.

In Section 3 we show that the MAC is likely to be increased for improvements in technologies that might be employed at low or intermediate levels of abatement, but that would be substituted away from at higher levels of abatement. Efficiency improvements in fossil fuel power plants serve as one example in the context of climate change. Efficiency improvements provide valuable benefits at lower levels of abatement, but society may substitute away from fossil fuel electricity at higher levels of abatement if carbon capture and storage technologies do not prove viable. Internal combustion engines are another example. Improvements to fuel economy are valuable at lower levels of abatement, and are in fact potentially a cornerstone of near-term U.S. climate policy, but electric vehicles or hydrogen fuel cell vehicles may be the most appropriate choice at higher levels of abatement. Examples can also be found in a number of other contexts, including SO2 and particulate matter reduction, water pollution, and fish preservation. We focus on this phenomena because it seems to be the most surprising. 4 The third purpose of this paper is to demonstrate that the differences in the representation of technical change matter; that is, that implied policy prescriptions can be different with different representations. In Section 4 we first review previous results in the literature; we then re-work the seminal paper on Firm Incentives to Promote Technical Change in Pollution Control by Milliman and Prince [29] and show, for example, that different policy instruments may provide incentives for different types of technical change. Section 5 concludes the paper. Taken together these three elements make a case for care in the representation of environmental technical change in theoretical and applied environmental models.

There is no single, general effect of environmental technical change on the costs of abatement; in fact, it is possible that technical change can increase the marginal costs of abatement; and this phenomenon may change our conceptions of the most appropriate policy actions to spur environmental technical change. Although the case of increasing marginal costs is only one of many possibilities, the plausibility of its occurrence and the striking implications for Pigouvian taxes and policy more generally, provide a reminder that the devil is indeed in the details. Researchers and consumers of research alike should maintain a healthy skepticism in ascribing generality to the results of analyses positing a single, general representation of technical change. 2 Representation of Technical Change in Models In this Section we discuss a number of approaches that have been used to model technical change in top-down and theoretical models.1

This section has two purposes. One purpose is general — to demonstrate that there are, indeed, a variety of different representations and that these lead to different impacts on marginal abatement costs. We are not commenting on which specific technologies these 1See Clarke, et al. [8], Clarke, et al. [9], Clarke & Weyant [10], Gillingham, Newell, and Pizer [20], Grubb, et al. [23], Loschel [27], and Sue Wing [44], for surveys focusing on how technical change is made endogenous in formal models of energy and the environment. 5 Baker & Shittu [4] Popp [38] Baker & Shittu [4] Reduces cost/ increase output of non-fossil energy Production function / Profit function Sue Wing [43] Reduces emissions–output ratio Increasing MAC Goulder & Schneider [22] Gerlagh & van der Zwaan [18] Nordhaus [33] Buonano et al. [7] Popp [37] [38] Baker & AduBonnah [1] Downing & White [12] Parry [34] Milliman & Prince [29] Goulder & Mathai [21] Jung et al. [25]

Decreasing MAC Goulder & Schneider [22] Montero [30] Goulder & Schneider [22] Baker, Clarke & Weyant [2] Fischer, Parry & Pizer [16] Substitutes knowledge for non-fossil or overall energy Pivots down Assumes lower MAC Emissions-output ratio Impacts to cost of abatement Impacts to MAC van der Zwaan et al. [48] Reduces carbon content/emissions -output ratio Substitutes knowledge for fossil energy Pivots right Farzin & Kort [13] Sue Wing [43] Gerlagh & van der Zwaan [17] [18] Baker & AduBonnah [1] Baker, Clarke & Weyant [2] Rosendahl [41] Bramoulle & Olson [6] Baker & Shittu [4] Popp [38] Baker & Shittu [4] Reduces cost/ increase output of non-fossil energy Production function / Profit function Sue Wing [43] Reduces emissions–output ratio Increasing MAC Goulder & Schneider [22] Gerlagh & van der Zwaan [18] Nordhaus [33] Buonano et al. [7] Popp [37] [38] Baker & AduBonnah [1] Downing & White [12] Parry [34] Milliman & Prince [29] Goulder & Mathai [21] Jung et al. [25] Decreasing MAC Goulder & Schneider [22] Montero [30] Goulder & Schneider [22] Baker, Clarke & Weyant [2] Fischer, Parry & Pizer [16] Substitutes knowledge for non-fossil or overall energy Pivots down Assumes lower MAC Emissions-output ratio Impacts to cost of abatement Impacts to MAC van der Zwaan et al. [48] Reduces carbon content/emissions -output ratio Substitutes knowledge for fossil energy Pivots right Farzin & Kort [13] Sue Wing [43] Gerlagh & van der Zwaan [17] [18] Baker & AduBonnah [1] Baker, Clarke & Weyant [2] Rosendahl [41] Bramoulle & Olson [6] Table 1: Categorization of representations of technical change in a selection of papers. Some papers have multiple representations of technical change. representations are likely to represent, only clarifying what has been used in the literature.

The second purpose is more specific — to demonstrate that a number of models represent technical change in a way that can lead to increasing marginal costs at higher levels of abatement. In Section 3 we argue that the formulations implying that technical change will lead to a higher marginal abatement cost curve (MAC) at high levels of abatement are reasonable, and give specific examples of technical change that can lead to this phenomena. Table 1 categorizes a non-exhaustive list of models that include assumptions about technical change. Some of the papers ([1][2][4][18][22][43]) have multiple representations of technical change, and therefore show up in multiple places in the table. 6 Throughout the paper we define abatement as follows. We assume that in the absence of technical change and in the absence of carbon policy there exists a profit-maximizing level of emissions, ε∗. Abatement is defined as the fractional reduction in emissions below this level. For example, if actual emissions are ¯ε, then abatement is ε∗−ε¯ ε∗ . Some kinds of technical change may lead to a new profit maximizing level of emissions, say ε∗ t < ε∗. In this case there will be abatement equal to ε∗−ε∗ t. ε∗ even in the absence of a carbon policy.2

We define the MAC to be zero (rather than negative) in these cases. 2.1 Decreasing marginal abatement cost All the papers in the top row of Table 1 use formulations in which technical change reduces marginal costs at all levels of abatement. There are, however, important differences among these formulations. 2.1.1 Assumes Lower MAC The papers in the box labeled Assumes Lower MAC make assumptions about how technical change will impact the MAC directly. All papers in this group assume that technical change will decrease the MAC. In fact, all the papers assume that technical change will pivot the MAC downward either in the computational or theoretical sections of the papers (e.g., Fischer et al. [16] in computational part; Goulder and Schneider [22] in theoretical part). In the first five papers in this group, the channel for technical change is R&D; in the bottom two papers, it is through learning by doing. Nevertheless, the assumptions about the type of technical change are very similar. Rosendahl [41] assumes that technical change will reduce the MAC in the analytical part of the paper, and that technical change will reduce the MAC proportionately in the computational part. Bramoulle and Larson [6] compare different technologies, but each of the different technologies 2That technical change made lead to a higher optimal level of abatement does not seem unrealistic.

For example, The Pacific Northwest Pollution Prevention Resource Center (http://pprc.org/solutions.cfm) reports numerous examples of firms that saved money while reducing pollution through reduced energy, water, or waste — implying that there was no positive cost of abatement. 7 impacts the MAC identically (reducing it proportionately); the difference between technologies is only in the rate of learning. 2.1.2 Pivots Down The group of papers in the box labeled Pivots Down assume that technical change will pivot the abatement cost curve down. If the cost of abatement μ is c (μ) before technical change, then it is φc (μ) after technical change, where φ < 1. This leads to a lower MAC, and in fact leads to a MAC that is pivoted downward if c0 (0) = 0. The darker thick line in the perfect substitution graph in Figure 1 illustrates the representations in the first two boxes.