Just as these issues are important in national and regional emissions trading schemes, the emergence of a liquid and efficient global carbon market has similar requirements. Indeed, to facilitate such a market, the EU and others wanting to develop global emissions trading will need to build on existing institutions to develop trading infrastructure. The World Bank emphasises that this includes ensuring strong legal bases to enforce compliance in the jurisdictions of participating firms and agreeing on minimum standards for monitoring, reporting and verification of emissions. Institutions that can deliver predictable and transparent information for emissions markets will also be vital, as will general oversight on the transparency of financial services that support trading such as securities, derivative products or hedge funds48.
Drawing out implications for the future of the EU emissions trading scheme The EU ETS will continue beyond 2012 with a third phase. The details of Phase III have yet to be determined, and will be considered in the European Commission"s review of the EU ETS in 2007. The review will propose developments in the scheme, drawing on the experience of the EU ETS to date. In particular, it will consider the expansion of the scheme to other sectors (including transport) and links to other trading schemes.
Decisions made now on the third phase of the scheme that will run post 2012, pose an opportunity for the EU ETS – the most important emissions trading market – to influence other emerging markets, as well as to be the nucleus of future global carbon markets. Based on the analysis in this section, there are certain key principles to consider in taking the EU ETS scheme forward. These are set out in Box 15.3.
Box 15.3 Principles for the future design of the EU ETS A credible signal • Setting out a credible long-term vision for the overall scheme over the next few decades could boost investor"s confidence that carbon pricing will exist in the EU going forward • The overall EU limit on emissions should be set at a level that ensures scarcity in the allowance market. Stringent criteria for allocation volumes across all EU sectors are necessary.
• To realise efficiency in the scheme, and minimise perverse incentives, there should be a move to greater use of auctioning in the longer term, although some free allocation may be important to manage short-term transitional issues49.
• Where free allocation is necessary, standardised benchmarking is a better alternative to grandfathering and updating.
A deep and liquid market • Clear and frequent information on emissions during the trading period would improve the efficient operation of the market, reducing the risks of unnecessary price spikes.
• Clear and predictable revision rules for future trading periods, with the possibility of banking between periods, would help smooth prices over time, and improve credibility • Broadening participation to other major industrial sectors, and to sectors such as aviation, would help deepen the market50.
• Enabling the EU ETS to link with other emerging trading schemes (including in the USA and Japan) could improve liquidity as well as establish the ETS scheme as the nucleus of a global carbon market.
• Allowing use of emission reductions from the developing world (such as the CDM or its successor) can continue to benefit both the efficiency of the EU scheme as well as the transfer of low carbon technology to the developing world 15.5 Carbon pricing across sectors of the economy Abatement costs are minimised when the carbon price is equalised across sectors As discussed in Chapter 9, sectors vary widely in terms of the current availability and average cost of abatement options. The cost of avoiding deforestation, for instance, appears to be relatively low compared with the cost of many low-carbon power generation options; by contrast, in aviation, although there are some opportunities for efficiency gains, options for technology switching are currently very limited.
As discussed in the previous chapter, to minimise the total cost of abatement, the carbon price (whether explicit via a tax or trading instrument, or implicit via regulation) should be equalised across sectors. When the carbon price is applied to sectors with cheap abatement options, initially, emissions will tend to decline more; when applied to sectors with more expensive abatement options, the degree of abatement will be less than in cheaper abatement sectors. At the same time, the price increase for the output of the latter sectors will be, and should be, greater.
This means that from an efficiency perspective, sectors with expensive abatement options should not be excluded from carbon pricing; but neither should they be subject to a different higher carbon price in that sector in order to achieve abatement.
As well as carbon pricing, governments should also look at the use of technology policies and efficiency policies across sectors – these are considered in the following two chapters. It is also important to consider climate change policy within the context of meeting other policy objectives within sectors, including its interaction with the treatment of externalities such as local air pollution and congestion.
The overall structure and scale of policy incentives will therefore reflect other market failures and complexities within the sectors concerned, as well as the climate change externality. As economies make the transition to full carbon pricing, they may in practice use a mix of instruments.
How the characteristics of different sectors affect choice and design of instrument The characteristics of sectors may influence the choice and design of the carbon pricing instrument. The underlying economic structures in which the emitters operate in sectors will differ, with implications for the attractiveness of using tax, trade or regulation instruments.
Some of the relevant features of different sectors include:
• Transaction costs: this may be affected by the number and dispersion of emitters, and the institutional arrangements for monitoring and pricing.
• Carbon leakage: this is the risk that emissions-intensive activity moves to an area not subject to a carbon constraint. The choice and design of an instrument may have implications for carbon leakage and competitiveness.
• Distributional impacts: depending on the market structure of the sector, the choice of policy instrument may have different implications for who bears the cost.
• Existing frameworks: policy choices will be influenced by existing national policy frameworks and regulatory structures.
It is also important to consider where in the value chain to price carbon. If "upstream" emissions are priced (for instance, at the power station or oil refinery), it is not necessary to price "downstream" emissions as well (for instance, in domestic buildings or individual vehicles). However, Chapter 17 focuses particularly on policies to enable investments in energy efficiency by the end-user, which are not discussed separately here.
The following sections analyse how these factors influence policy choice in power and heavy industry, road transport and aviation, and agriculture.
Power and heavy industry At a global level, power and heavy industry (such as iron and steel, cement, aluminium, paper industries and chemical and petrochemicals) are large emitters. Because of their high carbon intensity, these sectors are likely to be very sensitive to carbon pricing. They typically invest in very long-lived capital infrastructure such as power plant or heavy machinery, so a clear indication of the future direction of carbon pricing policy is particularly important to them.
Power markets in particular are characterised by imperfect market structures, including state monopolies, regulatory constraints, and often large-scale subsidies. The interaction of carbon pricing with these imperfections is complex. Other industries such as paper and chemicals are more decentralised and deregulated. But overall, sources of emissions are concentrated amongst a relatively few, large, stationary installations, where emissions can be effectively measured and monitored.
The concentrated nature of emissions from these sources make them, in principle, well suited to emissions trading. As already discussed, the first and second phases of the EU ETS cover emissions from these sectors. Other trading schemes have a similar focus – the Regional Greenhouse Gas Initiative in the north-east of the USA, for instance, will cover only the power sector.
However, trading is not the only option. Tax could also be an effective mechanism, and would have the advantage of providing greater price predictability. Examples of countries using taxation to meet climate change goals in these sectors include the UK, which has used the Climate Change Levy, a revenue-neutral mechanism which encourages emissions reductions across sectors including industry; and Norway, which introduced a carbon tax in the early 1990s, covering much of its heavy industry as well as the transport sector (Box 15.4).
Box 15.4 A carbon tax in practice: Norway51
Like other Scandinavian countries, Norway introduced a carbon tax in the early 1990s. The tax was to form part of substantial shift in fiscal policy as Norway aimed to use the revenue generated by environmental taxes to help reduce distorting labour taxes.
The Norwegian carbon tax initially covered 60 percent of all Norwegian energy related CO2 emissions. There are several sectors that were exempted from the tax, including cement, foreign shipping, and fisheries. Natural gas and electricity production are also exempt, although virtually all Norway"s electricity production is from carbon-free hydroelectric power. Partial exemptions apply to sectors including domestic aviation and shipping, and pulp and paper.
The tax generates substantial revenues; in 1993 the tax represented 0.7 percent of total revenue, which by 2001 had increased to 1.7 percent. The tax is estimated to have reduced CO2 emissions by approximately 2.3% between 1990 and 199952. Overall in Norway, between 1990-1999 GDP grew by approximately 23 percent, yet emissions only grew by roughly 4 percent over the same period, indicating a decoupling of emissions growth from economic growth.
There is also some evidence that the tax helped to provide incentives for technological innovation. The Sleipner gas field is one of the largest gas producers in the Norwegian sector of the North Sea. The gas it produces contains a higher CO2 content than is needed for the gas to burn properly. With the imposition of a carbon tax the implied annual tax bill to Statoil, the state oil company, was approximately $50m for releasing the excess CO2. This induced Statoil researchers to investigate the storing of excess carbon dioxide in a nearby geological formation. After several years of study, a commercial plant was installed on the Sleipner platform in time for the start of production in 1996. Experience with this plant has has made an important contribution to the understanding of carbon capture and storage technology.
However, there have been some difficulties in the implementation of the tax:
• The impact of the tax on industry was weakened because of numerous exemptions put in place because of competitiveness concerns. This created a complex scheme, and blunted the incentive for industry to modify or upgrade existing plants.
• The carbon tax did not reflect the actual level of carbon emitted from fuels. For instance, low and high-emission diesel fuels are taxed at the same level, despite causing different levels of environmental damage.
• Although Norway, Sweden, Finland and Denmark all put carbon taxes in place in the early 1990s, they have not been able to harmonise their approaches – demonstrating the difficulties of co-ordinating tax policy internationally, even amongst a relatively small group of countries.
Heavy industries compete in international markets, and as Chapter 11 illustrated, there are some risks to competitiveness and of carbon leakage from the use of carbon policy in such sectors. In terms of tax and trading instruments, there may be a difference in impact if taxes cannot be harmonised globally. This is because an international trading scheme imposes a uniform carbon price across countries, minimising competitiveness implications for countries within the scheme, whereas taxes may impose different costs in different countries.
Regulatory measures have not played a major role in these sectors, although these have been used for other pollutants in the power sector, the EU"s Large Combustion Plants Directive being one example. The concentrated number of companies and sources of emissions may make formal or informal sectoral agreements on best practice an effective complement to carbon pricing – this is discussed in Chapter 22.
Road transport Although the production of fuel for road transport is centralised at oil refineries, most of the emissions from road transport come from a very large number of individual cars and other vehicles. Demand for transport tends to rise with income. There is considerable scope to improve efficiency in the sector, although the responsiveness of demand to price is low, and breakthrough technologies such as hydrogen are still some years away.
Many countries currently levy a road transport fuel tax. Fuel taxes are a close proxy for a carbon tax because fuel consumption closely reflects emissions. They are frequently aimed at other externalities at the same time (discussed further below), and have the advantage of providing a steady revenue stream to the government. Another example is taxes on purchase or annual car taxes, which can be calibrated by the efficiency of the vehicle.
However, it is also possible to use emissions trading in the road transport sector (see Box 15.5). A possible risk of including road transport in an emissions trading scheme is that permit prices and oil prices might move in tandem, thus exacerbating the extent of oil price fluctuations facing the motorist (in contrast to taxes, which are levied as a fixed amount rather than a percentage of fuel price charged, meaning that the fuel price is prone to less variation).
Box 15.5 Ways to include road transport in an emissions trading scheme There are three main ways in which emissions from road transport could be included in an emissions trading scheme; they differ according to whom the permits are allocated to.
• Motorists. Individual motorists would have to surrender permits whenever they purchased fuel. Quantity instruments might be better than prices at encouraging motorists to reduce their consumption of fuel. However, there would probably be high transaction costs associated with this approach.
• Refineries. Refineries located in the region of the scheme, would have to buy permits to cover the emissions generated when the fuel that they produce is used in vehicles. It would probably be necessary to couple this approach with border adjustments to the price of imported fuel to avoid carbon leakage. Border adjustments are discussed in detail in Chapter 22.
• Manufacturers. Vehicle manufacturers would be faced with a target for fuel efficiency of the average vehicle sold and, to the extent that they exceeded this target, they would have to buy permits to cover the excess expected lifetime carbon emissions from fuel inefficient vehicles. However, future emissions from these vehicles would be uncertain, making this hard to reconcile with trading schemes based on actual emissions.
The European Commission is currently reviewing the operation of the EU ETS, including whether it should be extended to include other sectors such as road transport.
The inclusion of aviation, road, rail and maritime could increase the size of the EU ETS by up to 50% (such that the EU ETS would cover around 55% of total EU 25 greenhouse emissions, and a larger proportion of total CO2 emissions), with benefits for liquidity53.
Regulatory measures play an important role in the transport sectors in many countries. Vehicle standards – which may be mandatory or voluntary – can put an implicit value on carbon, by restricting the availability of less efficient vehicles. These measures are discussed in more detail in Chapter 17.
In practice, a combination of policies may be justified. Existing policy frameworks and institutional structures in countries will be an important determinant of policy choice. Countries with a history of high fuel taxes, for instance, would need to think very carefully about the public finance implications of switching to trading with free allocations; voluntary standards might be very effective in countries with a strong tradition of co-operation between government and business, but much less so in countries with a different culture.
As in other sectors, climate change is not the only market failure in the transport sector and there are important interactions with other policy goals. Congestion, for instance, imposes external costs on other motorists by increasing their journey time. Congestion pricing and carbon pricing are very similar approaches from an economic point of view – they both price for an externality. Congestion charging could have a positive or negative impact on carbon emissions from transport, depending on how the instrument is designed and level at which the charge is set.
Aviation Aviation faces some difficult challenges. Whilst there is potential for incremental improvements in efficiency to continue, more radical options for emissions cuts are very limited. The international nature of aviation also makes the choice of carbon pricing instrument complex. Internationally coordinated taxes are difficult to implement, since it is contrary to International Civil Aviation Organisation (ICAO) rules to levy fuel tax on fuel carried on international services54. The majority of the many bilateral air service agreements that regulate international air services also forbid taxation of fuel taken on board. Partly for this reason, levels of taxation in the aviation sector globally are currently low relative to road transport fuel taxes. This contributes to congestion and capacity limits at airports – a form of rationing, which is an inefficient way of regulating demand.
While either tax or trading would, in principle, be effective ways to price emissions from this sector, the choice of tax, trading or other instruments is likely to be driven as much by political viability as by the economics. Chapter 22 will discuss further the issues of international co- ordination of policy in this area (as well as in shipping, which faces similar issues). A lack of international co-ordination could lead to serious carbon leakage issues, as aircraft would have incentives to fuel up in countries without a carbon price in place.
The level of the carbon price faced by aviation should reflect the full contribution of emissions from aviation to climate change. As outlined in Box 15.6, the impact of aviation on the global warming (radiatiive forcing) effect is expected to be two to four times higher than the impact of the CO2 emissions alone by 2050. This should be taken into account, either through the design of a tax or trading scheme, through both in tandem, or by using additional complementary measures.
Box 15.6 The impact of aviation on climate change
Aviation CO2 emissions currently account for 0.7 Gt CO 55
(1.6% of global GHG emissions).
However the impact of aviation on climate change is greater than these figures suggest because of other gases released by aircraft and their effects at high altitude. For example, water vapour emitted at high altitude often triggers the formation of condensation trails, which tend to warm the earth"s surface. There is also a highly uncertain global warming effect from cirrus clouds (clouds of ice crystals) that can be created by aircraft.
In 2050 under "business as usual" projections, CO2 emissions from aviation would represent 2.5% of global GHG emissions56. However taking into account the non-CO2 effects of aviation would mean that it would account for around 5% of the total warming effect (radiative forcing) in 205057.
The uncertainties over the overall impact of aviation on climate change mean that there is currently no internationally recognised method of converting CO2 emissions into the full CO2 equivalent quantity.
Agriculture and land use Agricultural emissions come from a large number of small emitters (farms), over three quarters of which are in developing and transition economies. Emissions from agriculture depend on the specific farming practices employed and the local environment conditions. Since the sources tend to be distributed, there would be high transaction costs associated with actual measurement of GHG at the point of emission.
An alternative approach in this sector would be to focus on pricing GHG emission "proxies". For example, excessive use of fertiliser or high nutrient livestock feeds is associated with high emissions, but by appropriate pricing, emissions can be reduced. However in practice, in many developing countries fertiliser is actually subsidised, largely to support the incomes of farmers. In many countries it is a somewhat regressive subsidy, as it is the richer farmers or agribusinesses who gain most.
Difficulties associated with measuring emissions are also the reason why it is difficult to incorporate GHG emissions from agriculture into a trading scheme. However there are examples of projects that have overcome these problems and enabled farmers who adopt sustainable agriculture practices, to sell their emission savings on to others via voluntary schemes; this issue is discussed further in Chapter 25.
Inadequate water pricing can intensify the problems of weak fertiliser pricing, since water and fertiliser are complementary inputs – additional fertiliser works much better with stronger irrigation.
Many countries have adopted regulation of agricultural practices. For example, regulations for the use of water in growing rice, the quantity and type of fertiliser used in crop production, or the treatment of manure. Regulations are often location specific, because local conditions influence best practice. However, in developing countries, enforcement of regulations can be difficult because they may not have the institutional structures or resources to allocate to this task. Better pricing of inputs is generally a preferable route: income support to poor farmers or agricultural workers can be organised in much better ways than subsidised inputs.
There are complex challenges involved with the inclusion of deforestation, the major cause of land use emissions, in carbon trading schemes. These are discussed in detail in Chapter 25.
15.6 Conclusions Chapter 14 discussed how, at the global level, policymakers need both a shared understanding of a long-run stabilisation goal, and the flexibility to revise short-run policies over time.
At the national – or regional level – policy makers will want to achieve these goals in a way that builds on existing policies, and creates confidence in the future existence of a carbon price. In particular, they will want to assess how carbon pricing (through either taxation, tradable quotas or regulation) will interact with existing market structures, and existing policies (for instance, to encourage the development of renewable energy or petrol taxes).
Governments will want to tailor a package of measures that suits their specific circumstances. Some may choose to focus on regional trading initiatives, others on taxation and others may make greater use of regulation. The key goal of policy should be to establish common incentives across different sectors, using the most appropriate mechanism for a particular sector. With market failures elsewhere, other objectives, and the costs of adjustment associated with long-lived capital, it will be important to look at both the simple price or tax options as well as quotas and regulation to see what incentives in particular sectors really work.
Carbon pricing is only one element of a policy approach to climate change. The following two chapters discuss the role of technology policy, and policies to influence attitudes and behaviours, particularly in regard to energy efficiency. All three elements are important to achieve lowest cost emissions reductions.
References A number of useful background readings on issues covered in this chapter are worth noting. A general approach to uncertainty and investment is covered in "Investment under uncertainty", by Avinash K. Dixit, A and Robert S. Pindyck, Princeton University Press,1994. A broad discussion of the technical and economic issues of emissions trading and existing schemes is in "Act Locally, Trade Globally:Emissions Trading for Climate Policy", by Richard Baron and Cedric Philibert, IEA, 2005. Detailed analysis of the EU Emissions Trading Scheme is covered in a special issue on EU ETS in Climate Policy, Volume 6, No.1, 2006.
A useful summary of issues for decisions on including economic sectors in an emissions trading scheme is illustrated by presentations at a Stern Review seminar on "Taxes versus trade in the transport sector", June 2006 (publication forthcoming at www.sternreview.org.uk).
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1 See Helm et al (2005) which argues that credibility problems in recent UK energy and carbon policy have costs for meeting objectives on energy and climate change. The irreversibility of energy investments and the risk of governments reneging on commitments to carbon commitments imply a need for a more consistent policy framework.
2 Grubb et al (1995), Lecocq et al (1998).
3 See Blyth and Sullivan (2006)
4 See Blyth and Yang (2006)
5 See www.epa.gov/airmarkets/arp/index.html for more detail on the US Acid Rain Program.
6 The 2000 Green Paper estimated the cost of meeting Kyoto as €9 billion euros without trading, €7.2 billion with trading amongst energy producers only, €6.9 billion with trading among energy producers and energy intensive industry and €6 billion with trading among all sectors. See EC (2000).
7 The scheme covers emissions from heat and energy use from installations of a particular size in these sectors. See EC (2003) for more detail on the scope of the EU ETS 8 Articles 9 to 11 and Annex III of EU (2003) outline the criteria for allocation in the NAP 9 Based on emission estimates for EU25 countries in WRI (2005)
10 This assumes around 2 billion tonnes of allowances are allocated each year for three years, and that the average allowance price is $19 (€15)
11 Schleich and Betz (2005)
12 The Clean Development Mechanism is one of the flexible mechanisms under the Kyoto Protocol. Its operation is discussed in detail in Chapter 23.
13 Capoor and Ambrosi (2006) state that European and Japanese private entities dominated the buy-side of the CDM market in 2005 and 2006, taking up almost 90% of transacted project emissions credits.
14 See McKinsey et al (2005) for details of the survey of governments, companies and NGO views on issues for the Review of the EU ETS. For UK companies, see also UKBCSE and The Climate Group (2006)
15 Grubb et al (2006)
16 Grubb et al (2006)
17 EC (2005)
18 See Kruger and Egenhofer (2005). Also, some countries such as the UK went further asking firms to provide verification of data submitted by firms on historic emissions which werebaselines for initial allocations.
19 See EC (2004) for details of these guidelines.
20 See Egenhofer and Fujiwara (2005)
21 RGGI covers Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York and Vermont. See www.rggi.org for more details.
22 See announcements by the Governor of the State of Calitornia, www.climatechange.ca.gov 23 See Butzengeiger (2005) and Taiyab (2006) for more on markets for voluntary carbon offsets 24 See, for instance, Pizer (2002) and Pizer (2005)
25 See Jacoby and Ellerman (2004)
26 Helm and Hepburn (2005)
27 Blyth and Yang (2006) modelling shows that in principle, price caps and floors would reduce uncertainty on future prices, but as people need to believe that caps will stay the impact is limited.Stronger effects on reducing uncertainty come from lengthening the period of price stability from 5 to 10 years as discussed above.
28 These mechanisms are discussed fully in Chapter 23.
29 The CDM Executive Board approves methodologies for baseline setting in CDM projects. See Chapter 23.
30 See Grubb and Neuhoff (2006) for a discussion of the use of projections and price volatility in the EU ETS.
31 Helm and Hepburn (2006)
32 See Newell et al (2005) for an example of how such revision rules could work.
33 However, unrestricted banking can also allow emissions to be concentrated in time (Tietenberg,1998) – and such hoards of emissions could have high associated damage costs compared to dispersed emissions.
34 The discussion in this section assumes that the sale of permits to industry would happen through auctioning. Other methods are also possible, such as direct sales; these are not discussed fully here, but would be subject to some of the same arguments.
35 Neuhoff et al (2006) also find that in an international emissions trading scheme, if updating is used in one country but not others, it equates to free riding by the country that uses updating.
36 In an international trading scheme, if one country has free allowances for new plants, there are compeitiveness implications if other countries do not. This logic drove all 25 EU member states chose to set aside of allowances for new entrant plants that total around 5% of all EU allowances.
37Modelling of the UK electricity sector in Neuhoff et al (2006), demonstrates that free allowances for new plants using high carbon technologies could increase overall emissions. The existence of a "use it or lose it " closure rule for EU ETS allocations will reduce plant retirement rates and reduce investment in new plants, causing higher emission levels.
38 In the EU ETS, most member states had "use it or lose it" closure rules, mainly due to the rules for free allocation to new plants. In Germany, a "transfer rule" allowed allowances from old plants to be retained if a new plant was built.
This still risks new plants receiving higher allocation levels than needed.
39 Hepburn et al (2006a)
40 Neuhoff et al (2006) show that for generation plants in the EU ETS, benchmarks based on plant capcity as opposed to fuel and technology specific benchmarks are the least distorting.
41 The use of benchmarking on the basis of low carbon technology emission rates is an option and has been used in the EU ETS NAPs of some member states. See DTI (2005) for an example of the use of benchmarks for "new entrant" plants in the UK 42 Hepburn et al (2006a) considers auction design in the EU ETS 43 Hepburn et al (2006a)
44 Smale et al (2006) show that marginal cost increases from the EU ETS most affects the competitiveness of the aluminium sector as it competes in a very global market, and does not get free allowances to compensate-the aluminium sector is currently not directly covered by the scheme, but still faces higher electricity prices.
45 Sijm et al (2006) show that in the EU ETS, free allocation to electricity generation companies has created substantial windfall profits while consumers have faced increased electricity prices to reflect allowance costs.
46 To maintain profits, commentators state various levels of free allocation as necessary, they need not be 100%. See, for instance, work by Bovenberg and Goulder (2001), Smale et al (2006), Vollebergh et al (1997), Quirion (2003) on allocation and profitability. Also Hepburn et al (2006b) provide a generalised theoretical framework, including an analysis of asymmetric market structure and apply this to four EU ETS sectors.
47 Kruger and Egenhofer (2005)
48 Capoor and Ambrosi (2006)
49 See Neuhoff et al (2006) for more on free allocation and perverse incentives in the EU ETS 50 See Environment Agency (2006) for more detail on expansion options in the EU ETS.
51 This draws on Ekins and Barker (2001)
52 Bruvoll and Larsen (2002)
53 Estimates based on emission estimates for EU 25 in 2000 from WRI (2006).
54 Article 24 of Chicago Convention exempts fuel for international services from fuel duty. See ICAO (2006).
55 WRI (2005).
56 Aviation BAU CO2 emissions in 2050 estimated at 2.3 GtCO2, from WBCSD (2004). Total GHG emissions in 2050 estimated at 84 GtCO2e (for discussion of how calculated, see Chapter 7).
57 IPCC (1999). This assumes that the warming effect (radiative forcing) of aviation is 2 to 4 times greater than the effect of the CO2 emissions alone. This could be an overestimate because recent research by Sausen et al (2005) suggests the warming ratio is closer to 2. It could be an underestimate because both estimates exclude the highly uncertain possible warming effects of cirrus clouds.
16 Accelerating Technological Innovation
Key Messages Effective action on the scale required to tackle climate change requires a widespread shift to new or improved technology in key sectors such as power generation, transport and energy use. Technological progress can also help reduce emissions from agriculture and other sources and improve adaptation capacity.
The private sector plays the major role in R&D and technology diffusion. But closer collaboration between government and industry will further stimulate the development of a broad portfolio of low carbon technologies and reduce costs. Co-operation can also help overcome longer-term problems, such as the need for energy storage systems, for both stationary applications and transport, to enable the market shares of low-carbon supply technologies to be increased substantially.
Carbon pricing alone will not be sufficient to reduce emissions on the scale and pace required as:
• Future pricing policies of governments and international agreements should be made as credible as possible but cannot be 100% credible.
• The uncertainties and risks both of climate change, and the development and deployment of the technologies to address it, are of such scale and urgency that the economics of risk points to policies to support the development and use of a portfolio of low-carbon technology options.
• The positive externalities of efforts to develop them will be appreciable, and the time periods and uncertainties are such that there can be major difficulties in financing through capital markets.
Governments can help foster change in industry and the research community through a range of instruments:
• Carbon pricing, through carbon taxes, tradable carbon permits, carbon contracts and/or implicitly through regulation will itself directly support the research for new ways to reduce emissions; • Raising the level of support for R&D and demonstration projects, both in public research institutions and the private sector; • Support for early stage commercialisation investments in some sectors. Such policies should be complemented by tackling institutional and other non-market barriers to the deployment of new technologies. These issues will vary across sectors with some, such as electricity generation and transport, requiring more attention than others.
Governments are already using a combination of market-based incentives, regulations and standards to develop new technologies. These efforts should increase in the coming decades.
Our modelling suggests that, in addition to a carbon price, deployment incentives for low- emission technologies should increase two to five times globally from current levels of around $33billion.
Global public energy R&D funding should double, to around $20 billion, for the development of a diverse portfolio of technologies. 16.1 Introduction Stabilisation of greenhouse gases in the atmosphere will require the deployment of low- carbon and high-efficiency technologies on a large scale. A range of technologies is already available, but most have higher costs than existing fossil-fuel-based options. Others are yet to be developed. Bringing forward a range of technologies that are competitive enough, with a carbon price, for firms to adopt is an urgent priority.
In the absence of any other market failures, introducing a fully credible carbon price path for applying over the whole time horizon relevant for investment would theoretically be enough to encourage suitable technologies to develop. Profit-maximising firms would respond to the creation of the path of carbon prices by adjusting their research and development efforts in order to reap returns in the future. This chapter sets out why this is unlikely to be sufficient in practice, why other supporting measures will be required, and what form they could take.
This chapter starts by examining the process of innovation and how it relates to the challenge of climate change mitigation, exploring how market failures may lead to innovation being under-delivered in the economy as a whole. Section 16.3 looks more closely at the drivers for technology development in key sectors related to climate change. It finds that clean energy technologies face particularly strong barriers – which, combined with the urgency of the challenge, supports the case for governments to set a strong technology policy framework that drives action by the private sector.
Section 16.4 outlines the policy framework required to encourage climate related technologies. Section 16.5 discusses one element of this framework – policies to encourage research, development and demonstration. Such policies are often funded directly by government, but it is critical that they leverage in private sector expertise and funding.
Investment in Research and Development (R&D) should be complemented by policies to create markets and drive deployment, which is discussed in Section 16.6. A wide range of policies already exist in this area; this section draws together evidence on what works best in delivering a response from business.
A range of complementary policies, including patenting, regulatory measures and network issues are also important; these issues are examined in Section 16.7. Regulation is discussed in the context of mitigation more generally, and in particular in relation to energy efficiency in Chapter 17.
Overall, an ambitious and sustained increase in the global scale of effort on technology development is required if technologies are to be delivered within the timescales required. The decline in global public and private sector R&D spending should be reversed. And deployment incentives will have to increase two to five-fold worldwide in order to support the scale of uptake required to drive cost reductions in technologies and, with the carbon price, make them competitive with existing fossil fuel options. In Chapter 24, we return to the issue of technological development, considering what forms of international co-operation can help to reduce the costs and accelerate the process of innovation.
16.2 The innovation process Innovation is crucial in reducing costs of technologies. A better understanding of this complex process is required to work out what policies may be required to encourage firms to deliver the low-emission technologies of the future.
Defining innovation Innovation is the successful exploitation of new ideas1 . Freeman identified four types of innovation in relation to technological change2 :
• Incremental innovations represent the continuous improvements of existing products through improved quality, design and performance, as has occurred with car engines; • Radical innovations are new inventions that lead to a significant departure from previous production methods, such as hybrid cars; • Changes in the technological systems occur at the system level when a cluster of radical innovations impact on several branches of the economy, as would take place in a shift to a low-emission economy; • Changes of techno-economic paradigm occur when technology change impacts on every other branch of the economy, the internet is an example.
Many of the incentives and barriers to progress for these different types of technological change are very different from each other.
Innovation is about much more than invention: it is a process over time Joseph Schumpeter identified three stages of the innovation process: invention as the first practical demonstration of an idea; innovation as the first commercial application; and diffusion as the spreading of the technology or process throughout the market. The traditional representation of the diffusion process is by an S-shaped curve, in which the take-up of the new technology begins slowly, then "takes off" and achieves a period of rapid diffusion, before gradually slowing down as saturation levels are reached. He proposed the idea of "creative destruction" to describe the process of replacement of old firms and old products by innovative new firms and products.
There is an opportunity for significant profits for firms as the new product takes off and this drives investment in the earlier stages. High profits, coupled with the risk of being left behind, can drive several other firms to invest through a competitive process of keeping up. As incumbent firms have an incentive to innovate in order to gain a competitive advantage, and recognising that innovation is typically a cumulative process that builds on existing progress, market competition can stimulate innovation3 . As competition increases, and more firms move closer to the existing technological frontier of incumbents, the expected future profits of the incumbents are diminished unless they innovate further. Such models imply a hump-shaped relationship between the degree of product market competition and innovation, as originally suggested by Schumpeter.
An expanded version of this "stages" model of innovation that broadens the invention stage into basic R&D, applied R&D and demonstration is shown in the subsequent figure. In this chapter the term R&D will be used but this will also cover the demonstration stage4 . The commercialisation and market accumulation phases represent early deployment in the market place, where high initial cost or other factors may mean quite low levels of uptake.
Figure 16.1 The main steps in the innovation chain5
This model is useful for characterising stages of development, but it fails to capture many complexities of the innovation process, so it should be recognised as a useful simplification. A more detailed characterisation of innovation in each market can be applied to particular markets using a systems approach6 . The transition between the stages is not automatic; many products fail at each stage of development. There are also further linkages between stages, with further progress in basic and applied R&D affecting products already in the market and learning also having an impact on R&D.
Experience curves can lead to lock-in to existing technologies As outlined in Section 9.7 dynamic increasing returns, such as economies of scale and learning effects, can arise during production and lead to costs falling as production increases. These vary by sector with some, such as pharmaceuticals, experiencing minimal cost reductions while others fall by several orders of magnitude. These benefits lead to experience curves as shown in Box 9.4.
Experience curves illustrate that new technologies may not become cost effective until significant investment has been made and experience developed. Significant learning effects may reduce the incentive to invest in innovation, if companies wait until the innovator has already proven a market for a new cost effective technology. This is an industry version of a collective action problem with its associated free-rider issues.
Figure 16.2 Illustrative experience curve for a new technology
Dynamic increasing returns can also lead to path dependency and "lock-in" of established technologies. In this diagram, the market dominant technology (turquoise line) has already been through a process of learning. The red line represents a new technology, which has the potential to compete. As production increases the cost of the new technology falls because of dynamic increasing returns, shown by the red line above. In this case, the price of the new technology does ultimately fall below the level of the dominant technology. Some technological progress can also be expected for incumbent dominant technologies but existing deployment will have realised much of the learning7 .
The learning cost of the new technology is how much more the new technology costs than the existing technology; shown by the dotted area where the red line is above the blue. During this period, the incumbent technology remains cheaper, and the company either has to sell at a loss, or find consumers willing to pay a premium price for its new product. So, for products such as new consumer electronics, niche markets of "early adopters" exist. These consumers are willing to pay the higher price as they place a high value on the function or image of the product.
The learning cost must be borne upfront; the benefits are uncertain, because of uncertainty about future product prices and technological development, and come only after point A when, in this case, the technology becomes cheaper than the old alternative. If, as is the case in some sectors, the time before the technology becomes competitive might span decades and the learning costs are high, private sector firms and capital markets may be unwilling to take the risk and the technology will not be developed, especially if there is a potential free- rider problem.
Innovation produces benefits above and beyond those enjoyed by the individual firm ("knowledge spillovers"); this means that it will be undersupplied Information is a public good. Once new information has been created, it is virtually costless to pass on. This means that an individual company may be unable to capture the full economic benefit of its investment in innovation. These knowledge externalities (or spillovers) from technological development will tend to limit innovation.
There are two types of policy response to spillovers. The first is the enforcement of private property rights through patenting and other forms of protection for the innovator. This is likely to be more useful for individual products than for breakthroughs in processes or know-how, or in basic science. The disadvantage of rigid patent protection is that it may slow the process of innovation, by preventing competing firms from building on each others" progress. Designing intellectual property systems becomes especially difficult in fields where the research process is cumulative, as in information technology8 . Innovation often builds on a number of existing ideas. Strong protection for the innovators of first generation products can easily be counterproductive if it limits access to necessary knowledge or research tools for follow-on innovators, or allows patenting to be used as a strategic barrier to potential competitors.
Transaction costs, the equity implications of giving firms monopoly rights (and profits) and further barriers such as regulation may prevent the use of property rights as the sole incentive to innovate. Also much of value may be in tacit knowledge ("know-how" and "gardeners" craft") rather than patentable ideas and techniques.
Another broad category of support is direct government funding of innovation, particularly at the level of basic science. This can take many forms, such as funding university research, tax breaks and ensuring a supply of trained scientists.
Significant cross-border spillovers and a globalised market for most technologies offer an incentive for countries to free-ride on others who incur the learning cost and then simply import the technology at a later date9 . The basic scientific and technical knowledge created by a public R&D programme in one country can spillover to other countries with the capacity to utilise this progress. While some of the leaning by doing will be captured in local skills and within local firms, this may not be enough to justify the learning costs incurred nationally.
International patent arrangements, such as the Trade Related International Property Rights agreement (TRIPs10 ), provides some protection, but intellectual property rights can be hard to enforce internationally. Knowledge is cheap to copy if not embodied in human capital, physical capital or networks, so R&D spillovers are potentially large. A country that introduces a deployment support mechanism and successfully reduces the cost of that technology also delivers benefits to other countries. Intellectual property right issues are discussed in more detail in Section 23.4.
International co-operation can also help to address this by supporting formal or informal reciprocity between RD&D programmes. This is explored in Chapter 24.
Where there are long-term social returns from innovation, it may also be undersupplied Government intervention is justified when there is a departure between social and private cost, for example, when private firms do not consider an environmental externality in their investment decisions, or when the benefits are very long-term (as with climate change mitigation) and outside the planning horizons of private investments. Private firms focus on private costs and benefits and private discount rates to satisfy their shareholders. But this can lead to a greater emphasis on short-term profit and reduce the emphasis on innovations and other low-carbon investments that would lead to long-term environmental improvements.
16.3 Innovation for low-emission technologies The factors described above are common to innovation in any sector of the economy. The key question is whether there are reasons to expect the barriers to innovation in low-emission technologies to be higher than other sectors, justifying more active policies. This section discusses factors specific to environmental innovation and in particular two key climate change sectors – power generation and transport.
Lack of certainty over the future pricing of the carbon externality will reduce the incentive to innovate Environmental innovation can be defined11 as innovation that occurs in environmental technologies or processes that either control pollutant emissions or alter the production processes to reduce or prevent emissions. These technologies are distinguished by their vital role in maintaining the "public good" of a clean environment. Failure to take account of an environmental externality ensures that there will be under-provision or slower innovation12 .
In the case of climate change, a robust expectation of a carbon price in the long term is required to encourage investments in developing low-carbon technologies. As the preceding two chapters have discussed, carbon pricing is only in its infancy, and even where implemented, uncertainties remain over the durability of the signal over the long term. The next chapter outlines instances in which regulation may be an appropriate response to lack of certainty. This means there will tend to be under-investment in low-carbon technologies. The urgency of the problem (as outlined in Chapter 13) means that technology development may not be able to wait for robust global carbon pricing. Without appropriate incentives private firms and capital markets are less likely to invest in developing low-emission technologies.
There are additional market failures and barriers to innovation in the power generation sector Innovation in the power generation sector is key to decarbonising the global economy. As shown in Chapter 10, the power sector will need to be at least 60% decarbonised by 205013 to keep on track for greenhouse gas stabilisation trajectories at or below 550ppm CO2e.
For reasons that this section will explore the sector is characterised by low levels of research and development expenditure by firms. In the USA, the R&D intensity (R&D as a share of total turnover) of the power sector was 0.5% compared to 3.3% in the car industry, 8% in the electronics industry and 15% in the pharmaceutical sector14 . OECD figures for 2002 found an R&D intensity of 0.33% compared to 2.65% for the overall manufacturing sector15 . Unlike in many other sectors, public R&D represents a significant proportion, around two thirds of the total R&D investment16 .
The available data17 on energy R&D expenditure show a downward trend in both the public and private sector, despite the increased prominence of energy security and climate change. Public support for energy R&D has declined despite a rising trend in total public R&D. In the early 1980s, energy R&D budgets were, in real terms, twice as high as now, largely in response to the oil crises of the 1970s.
Figure 16.3 Public energy R&D investments as a share of GDP18
Figure 16.4 Public R&D and public energy R&D investments19
Private energy R&D has followed a similar trend and remains below the level of public R&D. The declines in public and private R&D have been attributed to three factors. First, energy R&D budgets had been expanded greatly in the 1970s in response to the oil price shocks in the period , and there was a search for alternatives to imported oil. With the oil price collapse in the 1980s and the generally low energy prices in the 1990s, concerns about energy security diminished, and were mirrored in a relaxation of the R&D effort. Recent rises in oil prices have not, yet, led to a significant increase in energy R&D. Second, following the liberalisation of energy markets in the 1990s, competitive forces shifted the focus from long- term investments such as R&D towards the utilisation of existing plant and deploying well- developed technologies and resources – particularly of natural gas for power and heat, themselves the product of R&D and investment over the previous three decades. Third, there were huge declines in R&D expenditures on nuclear power following the experiences of many countries with cost over-runs, construction delays, and the growth of public concerns about reactor safety, nuclear proliferation and nuclear waste disposal. In 1974, electricity from nuclear fission and fusion accounted for 79% of the public energy R&D budget; it still accounts for 40%. Apart from nuclear technologies, energy R&D budgets decreased across the board (Figure 16.8).
Figure 16.5 Trends in private sector energy R&D20
The sector"s characteristics explain the low levels of R&D There are a number of ways to interpret these statistics, but they suggest that private returns to R&D are relatively low in the sector. There are four distinct factors which help explain this.
The first factor is the nature of the learning process. Evidence from historical development of energy-related technologies shows that the learning process is particularly important for new power generation technologies, and that it typically takes several decades before they become commercially viable. Box 9.4 shows historical learning curves for energy technologies.
If early-stage technologies could be sold at a high price, companies could recover this learning cost. In some markets, such as IT, there are a significant number of "early adopters" willing to pay a high price for a new product. These "niche markets" allow innovating companies to sell new and higher-cost products at an early profit. Later, when economies of scale and learning bring down the cost, the product can be sold to the mass market. Mobile phones are a classic example. The earliest phones cost significantly more but there were people willing to pay this price.
In the absence of niche markets the innovating firm is forced to pay the learning cost, as a new product can be sold only at a price that is competitive with the incumbent. This may mean that firms would initially have to sell their new product at a loss, in the hope that as they scale up, costs will reduce and they can make a profit. If this loss-making period lasts too long, the firm will not survive.
In the power sector, niche markets are very limited in the absence of government policy, because of the homogeneous nature of the end-product (electricity). Only a very small number of consumers have proved willing to pay extra for carbon-free electricity. As cost reductions typically take several decades this leaves a significant financing gap which capital markets are unable to fill. Compounding this, the power generation sector also operates in a highly regulated environment and tends to be risk averse and wary of taking on technologies that may prove costlier or less reliable. Together, these factors mean that energy generation technologies can fall into a "valley of death", where despite a concept being shown to work and have long-term profit potential they fail to find a market.
For energy technologies, R&D is only the beginning of the story. There is continual feedback between learning from experience in the market, and further R&D activity. There is a dependence on tacit knowledge and a series of incremental innovations in which spillovers play an important role and reduce the potential benefits of intellectual property rights. This is in strong contrast with the pharmaceutical sector. For a new drug, the major expense is R&D. Once a drug has been invented and proven, comparatively little further research is required and limited economies of scale and learning effects can be expected.
The second factor is infrastructure. National grids are usually tailored towards the operation of centralised power plants and thus favour their performance. Technologies that do not easily fit into these networks may struggle to enter the market, even if the technology itself is commercially viable. This applies to distributed generation as most grids are not suited to receive electricity from many small sources. Large-scale renewables may also encounter problems if they are sited in areas far from existing grids. Carbon capture and storage also faces a network issue, though a different one; the transport of large quantities of CO2, which will require major new pipeline infrastructures, with significant costs.
The third factor is the presence of significant existing market distortions. In a liberalised energy market, investors, operators and consumers should face the full cost of their decisions. But this is not the case in many economies or energy sectors. Many policies distort the market in favour of existing fossil fuel technologies21 , despite the greenhouse gas and other externalities. Direct and indirect subsidies are the most obvious. As discussed in Section 12.5 the estimated subsidy for fossil fuels is between $20-30 billion for OECD countries in 2002 and $150-250 billion per year globally22 . The IEA estimate that world energy subsidies were $250 billion in 2005 of which subsidies to oil products amounted to $90 billion23 . Such subsidies compound any failure to internalise the environmental externality of greenhouse gases, and affect the incentive to innovate by reducing the expectations of innovators that their products will be able to compete with existing choices.
Finally, the nature of competition within the market may not be conducive to innovation. A limited number of firms, sometimes only one, generally dominate electricity markets, while electricity distribution is a "natural" monopoly. Both factors will generally lead to low levels of competition, which, as outlined in Section 16.1, will generally lead to less innovation as there is less pressure to stay ahead of competitors. The market is also usually regulated by the government, which reduces the incentive to invest in innovation if there is a risk that the regulator may prevent firms from reaping the full benefits of successful innovative investments.
These barriers will also affect the deployment of existing technologies The nature of competition, existing infrastructure and existing distortions affect not only the process of developing new technologies; these sector-specific factors can also reduce the effectiveness of policies to internalise the carbon externality. They inhibit the power of the market to encourage a shift to low-carbon technologies, even when they are already cost- effective and especially if they are not. The generation sector usually favours more traditional (high-carbon) energy systems because of human, technical and institutional capacity. Historically driven by economies of scale, the electricity system becomes easily locked into a technological trajectory that demonstrates momentum and is thereby resistant to the technical change that will be necessary in a shift to a low-carbon economy24 .
Despite advances in the transport sector, radical change may not be delivered by the markets Transport currently represents 14% of global emissions, and has been the fastest growing source of emissions because of continued growth of car transport and rapid expansion of air transport. Innovation has been dominated by incremental improvements to existing technologies, which depend on oil. These, however, have been more than offset by the growth in demand and shift towards more powerful and heavier vehicles. The increase in weight is partly due to increased size and partly to additional safety measures. The improvements in the internal combustion engine from a century of learning by doing, the efficiency of fossil fuel as an energy source and the existence of a petrol distribution network lead to some "lock-in" to existing technologies. Behavioural inertia compounds this "lock-in" as consumers are also accustomed to existing technologies.
Certain features of road transport suggest further innovative activity could be delivered through market forces. Although there is no explicit carbon price for road fuel, high and stable fuel taxes25 in most developed countries provide an incentive for the development of more efficient vehicles. Niche markets also exist which help innovative products in transport markets to attract a premium. These factors together help to explain how hybrid vehicles have been developed and are now starting to penetrate markets, with only very limited government support: some consumers are content to pay a premium for what can be a cleaner and more fuel-efficient product. There is also a small number of large global firms in this sector, each of which have the resources to make significant innovation investments and progress. They can also be less concerned about international spillovers as they operate in several markets.
Incremental energy efficiency improvements are expected to continue in the transport sector. These will be stimulated both by fuel savings and, as they have been in the past, by government regulation. Both the hybrid car, and later, the fuel cell vehicle, are capable of doubling the fuel efficiency of road vehicles, whilst behavioural changes – perhaps encouraged, for example, by congestion pricing or intelligent infrastructure26 – could lead to further improvements.
Markets alone, however, may struggle to deliver more radical changes to transport technologies such as plug-in hybrids or other electrical vehicles. Alternative fuels (such as biofuel blends beyond 5-10%, electricity or hydrogen) may require new networks, the cost of which is unlikely to be met without incentives provided by public policy. The environmental benefit of alternative transport fuels will depend on how they are produced. For example, the benefit of electric and hydrogen cars is limited if the electricity and hydrogen is produced from high emission sources. Obstacles to the commercial deployment of hydrogen cell vehicles, such as the cost of hydrogen vehicles and low-carbon hydrogen production, and the requirement to develop hydrogen storage further, ensure it is unlikely that such vehicles will be widely available commercially for at least another 15 to 20 years.
In Brazil policies to encourage biofuels over the past 30 years through regulation, duty incentives and production subsidies have led to biofuels now accounting for 13% of total road fuel consumption, compared with a 3% worldwide average in 2004. Other countries are now introducing policies to increase the level of biofuels in their fuel mix. Box 16.1 shows how some governments are already acting to create conditions for hydrogen technologies to be used. Making hydrogen fuel cell cars commercial is likely to require further breakthroughs in fundamental science, which may be too large to be delivered by a single company, and are likely to be subject to knowledge spillovers.
The development of alternative technologies in the road transport sector will be important for reducing emissions from other transport sectors such as the aviation, rail and maritime sectors. The local nature of bus usage allows the use of a centralised fuel source and this has led to early demonstration use of hydrogen in buses (see Box 16.1). In other sectors, such as aviation where weight and safety are prominent concerns, early commercial development is unlikely to take place and will be dependent on development in other areas first. The capital stock in the aviation, maritime and rail sectors (ships, planes and trains) lasts several times longer than road vehicles so this may result in a slower rate of take-up of alternative technologies. The emissions associated with rail transport can be reduced through decarbonising the fuel mix through biofuels or low carbon electricity generation. In the aviation sector improved air traffic management and reduced weight, through the use of alternative and advanced materials, can add to continued improvements in the efficiency of existing technologies.
Box 16.1 Hydrogen for transport Hydrogen could potentially offer complete diversification away from oil and provide very low carbon transport. Hydrogen would be best suited to road vehicles. The main ways of producing hydrogen are by electrolysis of water, or by reforming hydrocarbons. Once produced, hydrogen can be stored as a liquid, a compressed gas, or chemically (bonded within the chemical structure of advanced materials). Hydrogen could release its energy content for use in powering road vehicles by combustion in a hydrogen internal combustion engine or a fuel cell. Fuel cells convert hydrogen and oxygen into water in a process that generates electricity. They are almost silent in operation, highly efficient, and produce only water as a by-product. Hydrogen can produce as little as 5% of the emissions of conventional fuel if produced by low-emission technologies.27
There are several hydrogen projects around the world including:
• Norway: plans for a 580km hydrogen corridor between Oslo and Stavanger in a joint project between the private sector, local government and non-government organisations. The first hydrogen station opened in August 2006 • Denmark and Sweden: interested in extending the Norwegian hydrogen corridor • Iceland: home to the first hydrogen fuelling station in April 2003 and it is proposed that Iceland could be a hydrogen economy by 2030 • EU: trial of hydrogen buses • China: hydrogen buses to be used at the Beijing Olympics in 2008 • California: plans to introduce hydrogen in 21 interstate highway filling stations Innovation will also play a role by addressing emissions in other sectors, reducing demand and enabling adaptation to climate change. Innovation has enabled energy efficiency savings, for example, through compact fluorescent and diode based lights and automated control systems. Furthermore, innovation is likely to continue to increase the potential for energy efficiency savings. Energy efficiency innovation has often been in the form of incremental improvements but there is also a role for more radical progress that may require support. Some markets (such as the cement industry in some developing countries including China and building refurbishment in most countries) are made up of small local firms not large multinationals, which are less likely to undertake research since their resources and potential rewards are smaller. In addition, R&D, for example, in building technologies and urban planning could have a profound impact on the emissions attributed to buildings and increase climate resilience. Chapter 17 discusses energy efficiency in more detail.
Box 16.2 The scope for innovation to reduce emissions from agriculture Research into fertilisers and crop varieties associated with lower GHG emissions could help fight climate change28 . In some instances it may be possible to develop crops that both reduce emissions and have higher yields in a world with more climate change (see Box 26.3).
Another important research area in agriculture will be how to enhance carbon storage in soils, complementing the need to understand emissions from soils (see Section 25.4). The economic potential for enhanced storage is estimated at 1 GtCO2e in 2020, but the technical potential is much greater (see Section 9.6).
Research into sustainable farming practices (such as agroforestry) suitable to local conditions could lead to a reduction in GHG emissions and may also improve crop yields. It could reduce GHG emissions directly by reducing the need to use fertilisers, and indirectly by reducing the emissions from industry and transport sectors to produce the fertiliser29 .
Research into livestock feeds, breeds and feeding practices could also help reduce methane emissions from livestock.
In addition to using biomass energy (see Box 9.5), agriculture, and associated manufacturing industries, have the potential to displace fossil-based inputs for sectors such as chemicals, pharmaceuticals, manufacturing and buildings using a wide range of products made from renewable sources.
Direct emissions from industrial sectors such as cement, chemical and iron and steel can also benefit from further innovation, whether it is in these sectors or in other lower-carbon products that can be substitutes. Innovation in the agricultural sector, discussed in a mitigation context in Box 16.2 above, can also help improve the capacity to adapt to the impacts of climate change. New crop varieties can improve yield resilience to climate change30 . The Consultative Group on International Agricultural Research (CGIAR) will have a role to play in responding to the climate challenge through innovation in the agricultural sector (see Box 24.4). The development and dissemination of other adaptation technologies is examined in Chapter 19.
16.4 Policy implications for climate change technologies Policy should be aimed at bringing a portfolio of low-emission technology options to commercial viability Innovation is, by its nature, unpredictable. Some technologies will succeed and others will fail. The uncertainty and risks inherent in developing low-emission technologies are ideally suited to a portfolio approach. Experience from other areas of investment decisions under uncertainty31 clearly suggests that the most effective response to the uncertainty of returns is to develop a portfolio. While markets will tend to deliver the least-cost short-term option, it is possible they may ignore technologies that could ultimately deliver huge cost savings in the long term.
As Part III set out, a portfolio of technologies will also be needed to reduce emissions in key sectors, because of the constraints acting on individual technologies. These constraints and energy security issues mean that a portfolio will be required to achieve reductions at the scale required. There is an option value to developing alternatives as it enables greater and potentially less costly abatement in the future. The introduction of new options makes the marginal abatement cost curve (see Section 9.3) more elastic. Early development of economically viable alternatives also avoids the problem of "locking in" high-carbon capital stock for decades, which would also increase future marginal abatement costs. Policies to encourage low-emission technologies can be seen as a hedge against the risk of high abatement costs.
There are costs associated with developing a portfolio. Developing options involves paying the learning cost for more technologies. But policymakers should also bear in mind links to other policy objectives. A greater diversity in sources of energy, for instance, will tend to provide benefits to security of supply, as well as climate change. There is thus a type of externality from creating a new option in terms of risk reduction as well as potential cost reduction. Firms by themselves do not have the same perspective and weight on these criteria as broader society. The next section looks at how the development of a suitable portfolio can be encouraged Developing a portfolio requires a combination of government interventions including carbon pricing, R&D support and, in some sectors, technology-specific early stage deployment support. These should be complemented by policies to address non- market barriers. Alongside carbon pricing and the further factors identified in Chapter 17, supporting the development of low-emission technologies can be seen as an important element of climate policy. The further from market the product, given some reasonable probability of success, the greater the prima facie case for policy intervention. In the area of pure research, spillovers can be very significant and direct funding by government support is often warranted. Closer to the market, the required financing flows are larger, and the private returns to individual companies are potentially greater. The government"s role here is to provide a credible and clear policy framework to drive private-sector investment.
The area in the innovation process between pure research and technologies ready for commercialisation is more complex. Different sectors may justify different types of intervention. In the electricity market, in particular, deployment policies are likely to be required to bring technologies up to scale. How this support is delivered is important and raises issues about how technology neutral policy should be, which will be discussed later in this chapter in Section 16.6.
Figure 16.6 Interaction between carbon pricing and deployment support32
This diagram summarises the links between two of the elements of climate policy. The introduction of the carbon price reduces the learning cost since the new technology, for example a renewable, in this illustrative figure becomes cost effective at point B rather than point A, reducing the size of the learning cost represented by the dotted area. Earlier in the learning curve, deployment support is required to reduce the costs of the technology to the point where the market will adopt the technology. It is the earlier stages of innovation, research, development and demonstration which develop the technology to the point that deployment can begin.
Across the whole process, non-market barriers need to be identified and, where appropriate, overcome. Without policy incentives when required, support will be unbalanced, and bottlenecks are likely to appear in the innovation process33 . This would reduce the cost effectiveness at each other stage of support, by increasing the cost of the technology and delaying or preventing its adoption.
Uncertainties, both with respect to climate change and technology development, argue for investment in technology development. Uncertainties in irreversible investments argue for postponing policies until the uncertainties are reduced. However, uncertainties, especially with respect to technology development, will not be reduced exogenously with the "passage of time" but endogenously through investment and the feedback and experience it provides.
Most of the development and deployment of new technologies will be undertaken by the private sector; the role of governments is to provide a stable framework of incentives Deployment support is generally funded through passing on increased prices to the consumers. But it should still be viewed, alongside public R&D support, as a subsidy and should thus be subject to close scrutiny and, if possible, time limited. The private sector will be the main driver for these new technologies. Deployment support provides a market to encourage firms to invest and relies on market competition to provide the stimulus for cost reductions. Both public R&D and deployment support are expected to have a positive impact on private R&D.
In some sectors the benefits from innovation can be captured by firms without direct support for deployment, other than bringing down institutional barriers and via setting standards. This is particularly so in sectors that rely on incremental innovations to improve efficiency rather than a step change in technology, since the cost gap is unlikely to be so large. In these sectors firms may be comfortable to invest in the learning cost of developing low-emission technologies.
Firms with products that are associated with greenhouse gas emissions are increasingly seeking to diversify in order to ensure their long-run profitability. Oil firms are increasingly investing in low-emission energy sources. General Electric"s Ecomagination initiative has seen the sale of energy efficient and environmentally advanced products and services rise to $10.1 billion in 2005, up from $6.2 billion in 2004 – with orders nearly doubling to $17 billion. GE"s R&D in cleaner technologies was $700m in 2005 and expected to rise to $1.5 billion per annum by 2010.34 Indeed in a number of countries the private sector is running ahead of government policy and taking a view on where such policy is likely to go in the future which is in advance of what the current government is doing.
R&D and deployment support have been effective in encouraging the development of generation technologies in the past Determining the benefits of both R&D and deployment is not easy. Studies have often successfully identified a benefit from R&D but without sufficient accuracy to determine what the appropriate level of R&D should be. Estimating the appropriate level is made more difficult by the broad range of activities that can be classed as R&D. Ultimately the benefits of developing technologies will depend on the amount of abatement that is achieved (and thus the avoided impacts) and the long-term marginal costs of abating across all the other sectors within the economy (linked to the carbon price), both of which are uncertain.
However, some evidence provides indications of the effectiveness of policy in promoting the development of technologies:
• Estimates of R&D benefits. Private returns from economy-wide R&D have been estimated at 20-30% whilst the estimated social rate of return was around 50%35 .
While it is private-sector not public-sector R&D that has been positively linked with growth, the public-sector R&D can play a vital role in stimulating private spending up to the potential point of crowding out36 . It also plays an important role in preserving the "public good" nature of major scientific advances. Examples of valuable breakthroughs stimulated by public R&D must be weighed up alongside examples of wasteful projects.
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