Am. Econ. J. Econ. Policy http://doi.org/jqc (2012)

Costly carbon emissions should stimulate innovation in environmentally friendly technologies. Yet, little research is available about the effects of carbon policy on privately funded technical innovation.

With a general equilibrium model, Joshua Gans of the University of Toronto, Canada, looks at three different types of innovation: fossil-fuel-efficient technologies (for example, a fuel-efficient car), alternative-energy technologies (for example, solar panels) and carbon-offset technologies (such as carbon capture and storage). He finds that, under strict emission caps, fossil-fuel use will decrease and so will the incentive to invest in fossil-fuel-efficient innovation. In this scenario, alternative-energy technologies could attract investors; however, the incentive to innovate will largely depend on the profits, which are tied to the size of the economy, and stricter emission caps are likely to shrink the economy. If instead policy rewards carbon offsetting, reduced emissions will increase the price of carbon and make offset technologies unambiguously more lucrative.