This set of studies examines several critical issues related to climate policy and innovation. Innovation is an important facet of environmental policy, generally, as it generates new and improved technologies that bring down the cost of correcting negative externalities related to the environment. For addressing climate change, economists recognize that carbon pricing provides the dual advantage of being the most cost-effective policy option for the near term as well as the future: carbon pricing coordinates emissions reductions among firms so that those with the lowest cost of abatement take action, and it incentivizes firms to innovate to bring down the cost of abatement over the long-run.In the first chapter of this work, "US Carbon Pricing and Coal Power Plant Productivity", I find that coal power plants in the US Regional Greenhouse Gas Initiative (RGGI) have become significantly less efficient since the beginning of the cap-and-trade program, reflecting a deficit of innovative improvements to plants expected by academic and industry sources. Using econometric decomposition and harnessing the data on the US electricity sector in a new way to craft important operational variables, I find that RGGI coal plant owners accepted the efficiency penalty that mechanically comes with operating at low output rates. This is novel microeconomic evidence that firms may substitute non-innovative for innovative adjustments to an input price shock. I also provide evidence that RGGI coal plant owners have not made investments in efficiency-improving capital as expected; analytical results suggest this may be due to plant owners foreseeing a decline in production. These results are important for climate policy for the US electricity sector. I find a 4.56\% carbon emissions rebound effect among RGGI plants in the first four years of the program: though they reduced output and associated carbon emissions, their decline in efficiency constrained emissions reductions. This rebound effect is small but should be included in cost-benefit analyses of any carbon taxes proposed for the electricity sector. My results suggest that investment behavior will be unique among firms in a declining industry; as coal-fired power is phased out in the US, we can expect to see coal plant owners forego previously profitably efficiency upgrades. Finally, the current US climate policy specifically targets the efficiency of coal-fired power plants. These results show that this is a particularly costly way to address carbon emissions in the US.In my second chapter, “What do we lose by picking winners? The role of technology-specific clean energy incentives in induced innovation”, I examine a common policy combination, technology-specific renewable energy subsidies and carbon pricing. Do such subsidies, when added to a carbon price, incur dynamic social costs in the form of re-directing innovation away from the suite of “optimal”, cost-effective technology we would anticipate under just a carbon price? This chapter answers this question with an analytical model and a simulation calibrated to the EU electricity sector. I look at two important cases: the exogenous carbon price (carbon tax) case and the endogenous carbon price (cap-and-trade) case. Results from the analytical model indicate that innovation can follow production changes incentivized by clean energy subsidies. This points to subsidies having the potential to re-direct innovation away from unsubsidized and toward subsidized technologies. When the carbon price is endogenous, as in a cap-and-trade system, innovation directed toward reducing emissions of emissions-intensive inputs (such as coal and natural gas) falls unambiguously, due to the sensitivity of the carbon price to emissions abatement achieved by subsidized renewables. Simulation results point to subsidies reducing the incentive for innovation devoted to non-subsidized technology under high carbon taxes ($30-$40 per ton of CO2). Results are nonlinear in the size of the subsidy and carbon tax, highlighting the roles of both input price and input quantity changes in inducing innovation. When subsidies are used in combination with an emissions cap, the incentive for innovation for all technologies is depressed. Taken together, results point to subsidizing specific technologies as a poor way to guide innovation for clean technology when a carbon pricing scheme is present. Instead of overlapping specific subsidies for renewable technology on top of carbon pricing schemes, policymakers should use carbon pricing only, adding additional policies if evidence suggests specific market failures.In the third chapter of this work, “Induced innovation, market size, and total value to firms: The case of US electricity”, I highlight the importance of an emerging hypothesis in the induced innovation literature, the “market size” effect. This hypothesis holds that firms should innovate to reduce the cost of the input on which they rely most for production. Innovation incentives are often discussed in terms of relative input prices; input price and input quantity (or market size) effects should both play a role in incentivizing innovation but run in opposite directions. I discuss how a firm’s elasticity of substitution is a critical parameter that determines which effect dominates. Empirical estimation of induced innovation effects from input price and quantity changes should be guided by the econometrician’s knowledge of elasticities of substitution or variables that capture total value changes to firms in the face of input shocks. I propose that the US electricity sector provides a ripe empirical setting for testing the impact of market size on innovation, as the sudden availability of cheap natural gas starting in 2008 accelerated the sector’s switch in reliance on natural gas for production. Understanding the role of market size in tailoring innovation has special importance for climate policy. Stringent policy and a subsequent increase in the economy’s reliance on less emissions-intensive inputs will impact the direction of innovation, in addition to any policy-led input price changes.
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