Challenges of Technology Adoption under Cap-and-Trade Regulation

1. Cap and Trade: The Technology Adoption ProblemMay 4, 2009Economic Games and Mechanisms to Address Climate Change Suzanne Scotchmer University of California Economics and Law

2. The innovation problem • A conundrum: Under cap and trade regulation, a cleaner technology will not reduce carbon. Carbon emissions are set by the cap. • Instead, a cleaner technology will increase the production of electricity. The social benefit of a cleaner technology arrives as a larger supply of electricity. How does the innovator get compensated? Can we depend on private incentives to innovate?

3. The objective of cap-and-trade • The short run objective is to maximize electricity production subject to the carbon cap (by allocating production to the lower-emissions production plants). Observation: If there were no capacity constraints, this could result in monopoly. Monopoly reduces output, hence carbon, but is this the point? • The long run objective is to maximize electricity production by introducing cleaner technologies, that apply when production capacities are replaced or retrofitted. What creates the incentives to innovate and diffuse the innovations? (Here I consider the long run.)

4. In the long run:A conflict between full diffusion and profit.Suppose C/c0 exceeds the monopoly supply. Higher supply C/c resulting from the innovation depresses total profit. How can the innovator profit from the innovation?

5. Simple Model • To start, assume there are two firms, equal capacity, each owns half the allowances. • Firms 1 and 2 have the same emissions rate c0 • Firm 2 innovates to c< c0 . • Full diffusion is efficient: Both firms use the lower-emissions technology; each produces C/2c kilowatt hours. • Will the market achieve the efficient solution? (1) Cap and trade solution: Innovator buys the allowances from firm 1. Oops, monopoly. (2) The usual IP solution: Firm 2 licenses to firm 1. Does this achieve efficiency?

6. Licensing with royalties and fixed fees • Usual story: The royalty keeps the price high, and the fixed fee divides the profit. • But the price can only be high if the royalty has the effect of restricting supply. If the license terms are unrestricted (licensor can pay the licensee a fixed fee in return for getting royalties back), licensing will again lead to monopoly. • If fixed fees can be be “backwards” (from licensee to licensor), the firms cannot support the monopoly, but might not license at all. • Which leads again…. To the conflict between profit and full diffusion of the carbon-reducing technology.

7. Now consider competitive markets • Three markets: for electricity (competitive, with price p) for allowances (competitive, with price q) for licenses (royalty g chosen by innovator) • Profit per kilowatt hour = p- g–cq • Old emissions rate c0 , new emissions rate c • Carbon constraint: Aggregate supply E depends on licenses, e

8. Licensing leads to limited diffusion The price q of allowances and price Pof electricity rise with the royalty rate g. • Implicit is a demand for licenses • Proposition in paper: If c is much smaller than c0 , then diffusion is incomplete:

9. Intuition for incomplete diffusion • If the new emissions rate c is much smaller than the old emissions rate c0, the profit-maximizing number of licenses is not the maximum, C/c. • This is because the elasticity of demand for licenses is very high, due to the endogeneity of the allowance price. When the royalty is raised, the allowance price also rises, which enhances the attractiveness of the new technology relative to the old technology. Demand drops less than if the allowance price stayed fixed.

10. On the other hand, the innovator collects close to the social value when diffusion is complete: • In each period, the innovator collects • Even with full diffusion, the profit is less than the social value, for two reasons: • It leaves out the consumers’ surplus triangle between the old and new supplies of electricity. • Profit is only collected for a limited time.

11. Sequential innovators • The lesson so far is that increments to progress might be small. Large improvements that are not fully diffused will not be very profitable, and may not be undertaken. • This suggests that progress in reducing emissions will occur in modest steps. • At any date, order the emissions rates to be decreasing, c0 > c1 > c2 … • Suppose the royalties are 0=g0 <g1 <g2 • The relationship between the allowance price and royalties becomes more complicated.

12. Solve the game backwards • With emissions rates and royalties in place, solve for the “pricing equilibrium” (electricity price and allowance price) • Solve the royalty-setting game, assuming that firms predict the pricing equilibrium • Solve the innovation game (when and how much to innovate), assuming that firms predict the royalty-setting game and pricing equilibrium.

13. The pricing equilibrium

14. Second, Nash equilibrium in royalties (g1,g2), assuming g0=0.(Need to state the conditions when the public-domain technology is not used.)

15. Interpretations of the royalty-setting equilibrium • As royalty g2increases, the price of allowances and price of electricity increase. • If g1=0, profit approximates social value as before • Otherwise,

16. Still need to solve the innovation game • First characterize the efficient path of innovations in emissions reductions • Compare with…. The outcome in the market. This is tricky because it depends on the nature of the innovative process. (evolution) (production functions for knowledge) (randomly arriving investment possibilities)