Climate Policies and Induced Technological Change: Which to Choose, the Carrot or the Stick?

Policies to reduce emissions of greenhousegases such as CO<Subscript>2</Subscript>, will affect the rate andpattern of technological change in alternativeenergy supply and other production processes.Imperfections in markets for non-pollutingtechnologies imply that a decentralised economydoes not deliver a socially optimal outcome,and this could justify policy interventionssuch as subsidies. This paper considers thewelfare effects of technology subsidies as partof a carbon abatement policy package. We arguethat the presence of spillovers in alternativeenergy technologies does not necessarily implythat subsidy policies are welfare improving. Weillustrate this point in the context of ageneral equilibrium model with two forms ofcarbon-free energy, an existing “alternative energy” which is a substitute for carbon-basedfuels, and “new vintage energy” which providesa carbon-free replacement for existing energyservices. Subsidisation of alternative energyon the grounds of spillover effects can bewelfare-worsening if it crowds-out new vintagetechnologies. Copyright Kluwer Academic Publishers 2004