This article was conducted by Victoria Watts and Solenn Le Goff and originally published in the Department magazine .inspired No. 16 in German.

Reducing global carbon emissions can seem like an uphill battle. Countries struggle to implement policies that do not lead to unintended consequences defying their original aims and economic interests. A change in our understanding of the effects of policies on technological innovation can help overcome this hurdle. The authors propose a green industrial policy that combines emission taxes, trade policy and subsidies.

Economists agree that technological innovation is endogenous and responds to policies and regulation. However, when it comes to climate change, the literature focuses on models in which technological change is exogenous and policies have no effect on the pace and path of innovation. Conclusions drawn from this exogeneity assumption have serious consequences. These are amplified as technological innovation is path dependent: decisions for a specific approach become self-perpetuating as it becomes harder to switch technology further down the line even if the chosen approach has obvious flaws.

Compared to local economic issues, global challenges have added layers of complexity. Mutual consent on appropriate global action in tackling climate change is hard to achieve and unilateral regulations, such as carbon taxes are often criticized for triggering a relocation of energy intensive production into unregulated markets.

Incorporating effects of climate policy into innovation growth models

David Hémous and co-authors create a new framework incorporating path dependency and the effect of public policies on innovation efforts. Assume an economy that produces one good. It can do this with fossil fuel or a clean energy. If fossil fuel energy is cheaper than clean energy, the economy will rely more on fossil fuels than on clean energy. Since the two inputs are substitutes, the fossil fuel sector will also earn higher revenues. This leads to innovation further improving the fossil fuel technology, e.g. better turbines for natural gas power plants. It also leads to less or nor innovation into clean energy, e.g. better blades for windmills.

Returning to the carbon tax example above: path dependency and the current high share of fossil-fuel energy production in China increases fossil-fuel-based innovations there, while the reduced demand for energy in regulated European countries will reduce green energy innovation here. In extreme cases, unilateral carbon taxes may even backfire and increase total emissions.

An effective unilateral green industrial policy

The paper argues that there it is possible to reduce emissions in both regulated and the unregulated countries in the long run. The unilateral green industrial policy combines clean research subsidies, trade policy and carbon taxes with the goal of supporting clean energy innovation in the regulated country. If research subsidies are maintained sufficiently long so that clean technologies become better than dirty ones, then the same forces which were pushing toward dirty innovation beforehand will favor clean innovation, making future subsidies obsolete.