Cap-and-Trade, Emissions Taxes, and Innovation

Emissions taxes and carbon caps can both lead to ecient production of energy, in the sense of controlling carbon emissions to the extent that is ecient with existing technologies. However, the regulatory policy has a second objective, which is to create incentives to develop lower-carbon technologies. With both objectives in mind, does one policy dominate the other? I show how tax regulation can do a better job of encouraging innovation and of ensuring that all energy producers use the cleaner technology. Under both tax regulation and carbon regulation, the royalty controls the price of energy. However, in the case of carbon regulation, the proprietor must expand energy supply in order to earn revenues. This may reduce gross prots in the energy sector and lead to lower rewards than under tax regulation. Making it worse, the proprietor might avoid price erosion by diusing the clean technology only partially, so that the dirty technology stays in use