Tübingen, Germany

September 23, 2010

The Economics of Climate Change and Energy Innovation

Gabriel A. Chan

Pre-Doctoral Candidate in Public Policy

John F. Kennedy School of Government

Harvard University

1

Thank you

2

Outline

• A few disciplining facts

• Environmental economics

• The shift to advanced energy technologies

• Innovation economics

• Energy innovation policy in the USA

3

A Few Disciplining Facts of CO2 Emissions

4

Who Is Responsible?

Relative contributions by developing and developed countries to

a) cumulative CO2 emissions, b) current annual CO2 emissions,

c) the growth in CO2 emissions, and d) population

(Raupach, et al., 2007)

5

Who Is Responsible?

Relative contributions by developing and developed countries to

a) cumulative CO2 emissions, b) current annual CO2 emissions,

c) the growth in CO2 emissions, and d) population

(Raupach, et al., 2007)

6

Consumption-Based Accounting

But where responsibility lies is still not clear. Consumption-

based accounting of CO2 emissions reveal that >20% of global

emissions are embodied in traded goods

(Davis, Caldeira, 2010)

Units are Mt CO2 yr-1

7

Environmental Economics

8

The Climate as a Public Good

The environment is a public good: it is both non-rival and non-

excludable.

Non-rival means that one person’s “use” of the environment

doesn’t prevent someone else’s “use.”

Non-excludable means that no one can stop another person

from “using” the environment.

Given these two properties, if everyone acts only in their self-

interest, what will the level of public good provision be?

9(Parkham Farms)

10

Pollution as a Negative Externality

The emission of greenhouse gases imposes a negative

externality on others.

A negative externality is a cost imposed on a third party as a

result of an (otherwise) mutually beneficial transaction.

When negative externalities are present in the production of a

good, market prices do not reflect the total social cost of

production.

Further, additional social costs induced by negative externalities

are nearly always distributed inequitably – this is especially true

with climate change

11

The Intergenerational Externality and Discounting

The long lifetime of greenhouse gases in the atmosphere

imposes an intergenerational externality.

An intergenerational externality is an (unpriced) cost imposed on

future generations by the action of a person presently alive.

How should we go about thinking about the unborn?

Is extrapolating how we think about our own future relevant for

how we should behave towards future generations?

12

Adaptation to the Rescue?

Humans do adapt to changing circumstances.

Large cities that are bombed during wars are often devastated,

but by compared to other cities that are not bombed, population

levels recover to what they might have been had they not been

bombed. (Davis and Weinstein, 2002)

In the long-run, there is little evidence that this type of shock

adversely affects poverty, consumption, infrastructure

development, literacy, or population. (Kahn, 2010)

Will climate change be like this too?

13

Adaptation to the Rescue?

The period of adaptation may be transient, but it will certainly be

“painful.”

Human ability to adapt to new types of shocks cannot be proven

by historical anecdote.

It is inequitable to force those least responsible and least

capable to adapt to climate change.

Climate change impacts may occur abruptly, without warning.

Even if human systems can adapt, natural ecosystems that we

rely on may not be as resilient.

14

Certain about Uncertainty

The physical processes influencing uncertainty of the response

of temperature to GHG forcing (as ranked by 14 experts)

• Cloud radiative feedback

• Land-ice and snow albedo feedback

• Water vapor feedback

• Vertical/diapycnal ocean mixing

• Vegetation albedo feedback

• Ocean circulation (wind-driven and thermohaline)

• Deep water formation

• Sea-ice albedo feedback

(Zickfeld, Morgan, Frame, Keith, 2010)

15

Certain about Uncertainty

There is structural scientific uncertainty of the relationship

between GHG concentrations and climate impacts but also deep

uncertainty regarding the cost of any given impact event.

Typically, “average surface temperature change” is used to

motivate policy (e.g. the 2-degree target).

Average temperature change ignores the variation in effects

across regions and time

More importantly, average temperature change (even in the

context of the scope of space and time) ignores low probability,

high consequence climate “catastrophes”

(Zickfeld, Morgan, Frame, Keith, 2010)

16

Certain about Uncertainty

Climate change mitigation serves as insurance against the

chance that we might be living in a world where the impacts of

climate change will be disastrous.

But how do we achieve mitigation?

(Zickfeld, Morgan, Frame, Keith, 2010)

17

The Shift to Advanced Energy Technologies

18

The Moving Parts of Climate Policy

In most climate policy discussions, there are three (sometimes

implicit) moving parts:

• levers to control economic growth,

• levers to control the level of GHG mitigation, and

• levers to control the role of advanced technologies.

In may analyses, the levers that control mitigation are fixed and

analysis optimizes economic growth via the role of advanced

technologies.

This has important implications for how we think about what is

feasible in practice and for where we interpret our own levers to

bring about change lie.

19

Energy Use in the USA Under Climate Policy

(Paltsev, et al, 2010)

Mitigation level is fixed and advanced technologies are deployed

to maximize economic growth.

20

When Does Environmental Policy Change?

More realistically, policymakers will be very unwilling to move

their hand from the lever that controls economic growth.

Therefore, policymakers de-facto optimize policy using the

levers to control climate change mitigation and the levers to

control the role of advanced technology.

This is a more cynical view of environmental policy, but there is

evidence that regulatory policy moves forward only when it is

sufficiently affordable for the regulated.

21

The Montreal Protocol

The Montreal Protocol is a more than twenty year old

international agreement that limits the emission of ozone-

depleting substances.

(US Climate Change Science Program, 2008)

22

The Montreal Protocol

The Montreal Protocol has been extremely effective in achieving

its environmental objective while maintaining consistent (or

increasing) stringency.

The intended benefits of the Montreal Protocol are diffuse

(because the ozone layer is a public good), but why has the

Montreal Protocol provided such a high level of ozone layer

“quality?”

One answer is that the Montreal Protocol created large

concentrated (i.e. private) benefits to DuPont via a global

monopoly for its substitute product (which it held patents on) as

a second order effect.

(Oye and Maxwell, 1995)

23

Lessons from the Montreal Protocol

If environmental regulation succeeds when it becomes

sufficiently beneficial to centralized interests and when economic

growth is not sacrificed, how should climate policy be designed

better?

Climate policy will more likely be successful in terms of long-

term viability and maintained stringency if:

• avoiding pollution is sufficiently affordable,

• there are profit opportunities in avoiding emissions, and

• there are sufficient (technical) mitigation opportunities available

From this perspective, developing new technologies through

Research, Development, and Demonstration (RD&D) will play a

crucial role in providing “climate insurance.”

24

Innovation Economics

25

Ideas are Indivisible

The production of an idea requires a fixed cost (i.e. education,

searching, testing, etc.), but subsequent production of the same

idea has a very low marginal cost and is often non-rival.

Economic theory suggests that if price > marginal cost, then

there will be too little diffusion of the good.

But economic theory also suggests that if price = marginal cost,

producers who incur the fixed cost will never recoup their

expenditures and will therefore be incentivized to reduce supply

of new goods.

Further, the cumulative nature of ideas production and the

complementarity of ideas enhances indivisibility

(Arrow, 1962), (Stern, 2010)

26

Ideas are Inappropriable

Without intellectual property law that is both deeply and strictly

enforced, inventors cannot fully appropriate the benefits of their

investment in ideas production (i.e. ideas are only partially

excludable).

For example, an inventor might not be able to exclude:

• unauthorized users

• unauthorized producers

• unauthorized use by other inventors

At its essence, the appropriability of innovation is a societal

choice, set largely by patent law.

(Arrow, 1962), (Stern, 2010)

27

Idea Creation Creates Spillovers

One innovation activity can spur innovation across time, space,

industry, technology, etc.

For example

• airplane turbine technology is being applied to wind power and

fossil power plants

• synthetic plastic technology is being applied to algal biofuels

• semiconductor technology is being applied to photovoltaic

28

Idea Creation is Uncertain

If idea creation was certain ex-ante, there is nothing to do

research on.

How should we make decisions about investing in RD&D if the

returns are fundamentally uncertain?

29

Fat-Tailed Uncertainty of RD&D

(Stern, 2010)

Conditional on being funded by venture capital (VC), a very

large proportion of the total returns to VC investment are

realized by a small number of ventures.

30

Innovation and Climate EconomicsPublic good characteristics:

non-rivalry:

• We share the same climate.

• We have access to similar innovations.

non-excludability:

• I cannot stop someone from feeling climate change.

• I cannot fully stop someone from using prior innovation for

private gain.

Externalities

• Greenhouse gas emissions are external to economic activity

• Technological spillovers are external to economic activity

Uncertainty:

• The impact of GHG emissions is uncertain and fat-tailed

• The impact of RD&D spending is uncertain and fat-tailed

31

How Does Innovation Occur?

• Learning by searching within a sector (R&D)

• Knowledge spillovers from other sectors

• Economies of scale

unit, plant, manufacturing, organizational, firm, industry, and

inter-industry level

• Economies of scope

sharing of knowledge, facilities, equipment, and other inputs

such as marketing and design services between products

• Learning-by-doing or by using

changes in the productivity of labor enabled by experience

of production

(Anadon, 2010)

32

How Has Innovation Occurred in Photovoltaics?

Learning by

doing

Economies of

scaleR&D

(Nemet, 2007) (Anadon, 2010)

33

Government and Innovation

34

The Role of Government in RD&D

What should the role of government be in setting RD&D policy?

It is easy to spend other people’s money – especially when there

is great uncertainty about outcomes and a large delay between

decisions and outcomes.

What should the metrics for RD&D success be and how can

interested parties be brought into the process without

corrupting?

In the United States, interested parties (coal, nuclear,

environmentalists, etc.) organize to lobby for increased federal

support for research.

(Lester, 2008)

35

The Role of Government

Stated simply, the government has an economic reason to

intervene when there are market failures.

Climate change and innovation have public good characteristics

and externalities, leading to under-provision of goods and over-

provision of bads. Further, fat-tailed uncertainty, if perceived

incorrectly, can lead to further market failure.

With two sources of market failure, the optimal policy is likely

two-pronged. To correct the climate market failure, pricing

carbon will go a long way. (Finding the “right” price is hard)

Correcting the innovation market failure is more complex in

many ways: the science of science is still weak and there are

many policy tools available

36

The Science of Science

Research

Development

Demonstration

Market formation

Diffusion

“valley of

death”

“valley of

death”

time

market

penetration

GEA, Anadon and Holdren (2009)

Innovation is complex with many actors with many functions

37

Many Energy Innovation Policy Tools

Energy-

Technology

Innovation

• Energy RD&D policy:

- Federal energy RD&D

funding

- Public-Private partnerships

for demonstration projects

- R&D Tax Credits

- International Cooperation

in energy RD&D

• Education policy to improve

and expand the ETI labor

force:

- Teacher compensation

- Curriculum

- Prizes, etc.

Market-Pull Policies

• Price or other deployment

incentives

- Direct spending (rebates)

- Government procurement

- Tax-related production

subsidies

- Loan guarantees

- Intellectual property

• Climate policy

- Carbon price

• Standard-based policy

- Performance standards

- Portfolio standards

Mowery and Rosenberg (1979); Anadon and Holdren (2009)

Increasing payoff to innovators:

Increasing the Demand for Innovation

Technology-Push Policies

Reducing cost of innovating:

Increasing the Supply of Knowledge

38

Energy Innovation Policy in the USA

39

U.S. energy innovation institutions are in flux

development

stage

level

of

risk Basic energy

research

commercialization

Applied R&D programs;

National LaboratoriesIndustry

grants &

partnerships

ARPA-E

Innovation

Hubs

Loan

guarantee

program

“Missing”

demonstration

institution

basic research

Standards

Procurement

Tax credits

Etc.

diffusiondevelopment

40

Volatility in R&D Deters Innovation

(Narayanamurti, Anadon, Sagar, 2009)

41

Uncertainty deters private investment

(AWEA, 2009)

PTC takes effect

Cu

mu

lati

ve c

ap

acit

y (

MW

)

Production tax

credit expiration

years

The production tax credits (PTC) reduces the taxes of wind

developers based on wind power generation, but it was allowed

to expire in Congress on three occasions.

An

nu

al

Cap

acit

y (

MW

)

42

U.S. support for energy RD&D

U.S. DOE Energy RD&D Spending

FY1978-FY2011 Request

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2009

ARRA

2010

2011

Req

uest

millio

n 2

00

5$

Fission Fusion EfficiencyRenewables Fossil including CCT demo Electricity T&DHydrogen EERE ARPA-E RE-ENERGYSE

(Gallagher and Anadon, 2010)

Post Arab-

OPEC Oil

Embargo

1973-1974

Clean Coal

Technology Program,

government/industry

joint venture

Energy

Policy Act

Energy Security

and Independence

Act

Stimulus

package

43

Government Energy-Related ExpendituresERD3 support for fossil, renewable and nuclear energy

0

500

1000

1500

2000

2500

3000

3500

4000 W

ind

S

ola

r

B

iom

ass

H

ydro

G

eoth

erm

al

O

ther

(landfill, etc

) and

pro

gra

m d

irection

C

oal

O

il &

Gas

N

ucle

ar

Million o

f Y

ear

2007$

Financial Support for

Deployment

Tax-Related Deployment

Subsidies

Direct Deployment

Expenditures

RD&D Other

RD&D DOE

Data from Federal Financial Interventions and Subsidies in Energy Markets 2007 (EIA) & Gallagher and Anadon; Anadon & Holdren (2009)

Total support for coal and gas larger than that for renewables

ERD3 support for fossil, renewable and nuclear energy

0

500

1000

1500

2000

2500

3000

3500

4000

W

ind

S

ola

r

B

iom

ass

H

ydro

G

eoth

erm

al

O

ther

(landfil

l, etc

) and

pro

gra

m d

irectio

n

C

oal

O

il &

Gas

N

ucle

ar

Mill

ion o

f Y

ear

2007$

Financial Support for

Deployment

Tax-Related Deployment

Subsidies

Direct Deployment

Expenditures

RD&D Other

RD&D DOE

Oth

er

44

Government Support for R&D in Renewables

0

50

100

150

200

250

300

350

400

450

Austr

alia

Cana

da

De

nm

ark

Fin

land

Fra

nce

Germ

any

Italy

Ja

pa

n

Kore

a

Neth

erlands

No

rwa

y

Spa

in

Turk

ey

U.K

.

U.S

.A.

Mil

lio

n U

SD

(2

008

pri

ces

an

d P

PP

)

Other Renewables

Hydropower

Geothermal

Bio-energy

Ocean

Wind

Solar

(IEA Member Surveys on energy RD&D, 2010)

Data for 2007

45

A Summary of US RD&D Policy

• Strategy and alignment of push and pull policies are lacking

Supporting coal and natural gas reduces the impact of policies

supporting renewables

Supporting R&D but not demonstration projects wastes resources

• Researchers and entrepreneurs have had little certainty

Volatility in government R&D

Uncertainty in industry R&D tax credits

Uncertainty in production tax credits

• High transaction costs caused by state/local vs. federal policies

Renewable portfolio standards

Local permitting and other issues

• Although things are starting to change

(Anadon, 2010)

46

Summary

47

Summary

Absent intervention, two types of market failure in climate change:

• GHG emissions are over-provided

• Innovation is underprovided

Decisions must be made under two types of large, fat-tailed

uncertainties:

• The impact of GHG emissions

• The impact of RD&D policy

Innovation policy is complex because it is difficult to tie inputs to

outcomes and there are many policy tools available.

The USA has experimented with many policy options, but its

overall approach is still largely fragmented

48

A special thanks to Laura Diaz Anadon and the sponsoring organizations:

49

Gabriel A. Chan

gabe_chan@hksphd.harvard.edu

scholar.harvard.edu/gabechan