Climate Policy and Innovation in the Absence of Commitment

We compare the effects of price and quantity instruments (an emissions tax and a quota with tradable permits) on the incentive to innovate to reduce the cost of an emission-free technology. We assume that the government cannot commit to the level of a policy instrument before R&D occurs but sets the level to be socially optimal after the results of R&D are realized. The equivalence of price and quantity instruments in inducing innovation that is seen in end-of-pipe abatement models does not hold. When the marginal cost of the dirty technology is constant, then a quota can induce R&D, but a tax is completely ineffective. However, if the marginal cost function of the dirty technology is steep enough, then both a tax and a quota with tradable permits can induce R&D, and the tax will do so in a wider range of circumstances. Furthermore, in this case, an R&D subsidy may induce R&D and raise welfare whether a tax or a quota regime is in place.