Design, Trading, and Innovation

This book chapter questions the conventional theory purporting to establish that environmental benefit trading encourages innovation better than comparable traditional regulation. It argues that the induced innovation hypothesis, that high costs encourage innovation, suggests that trading would lessen incentives for innovation by lowering the cost of complying with conventional approaches. The conventional theory relies upon the incentive emissions trading creates for polluters to make additional reductions in order to sell credits. But emissions trading also creates incentives for half of the pollution sources (the credit buyers) to make less reductions than they would under a traditional regulation. By focusing analysis only upon the sellers of credits, the traditional theory systematically biases results. Proper analysis must compare a trading program to a non-trading program with identical underlying limits. This analysis shows clearly that trading does not encourage high-cost innovation as well as a comparably designed performance standard. Even innovation that costs a lot now can prove economically and environmentally superior over the long run, because innovation can make costs of new techniques fall over time and some innovations provide very wide ranging environmental benefits. But trading encourages selection of the techniques with the cheapest current cost, not the cheapest long-term cost or the greatest long-term value. Design variables, such as the stringency of regulation and the quality of monitoring play an important role in encouraging (or failing to encourage) innovation. Neither traditional regulation nor environmental benefit trading stimulate innovation especially well, because government often regulates weakly. This chapter suggests an alternative economic incentive program that would maximize incentives for innovation and progress on environmental problems. This chapter forms part of a larger project arguing for an economic dynamic approach to environmental law and law and economics. The author's book, The Economic Dynamics of Environmental Law (MIT Press 2003), sets out the full theory