New Publication: Does a carbon price incentivise the development of low emission technologies?

Higher carbon prices provide an effective incentive for firms to invest in developing new low emission technologies, according to our new research, which provides evidence of the link between carbon prices and low carbon innovation.

The development of new low emission technologies is a key element of the transition to a lower carbon economy. While various low emission technologies like photovoltaics, wind energy, and electric vehicle batteries have seen substantial improvements and falling costs in recent years, further technological innovation is required to curb rising global emissions.

One of the main mechanisms governments use to incentivise the development of new low emission technologies is carbon pricing, such as emissions trading schemes (ETS) and carbon taxes. By imposing a price on carbon emissions, carbon pricing increases firms’ demand for low emission technologies, which in theory stimulates increased research and development in these technologies.

Yet despite this theoretical prediction, our understanding of the empirical relationship between carbon pricing and low carbon innovation remains incomplete. While studies have shown that firms regulated under the European Union ETS and the Chinese pilot ETS increased their patenting in low emission technologies relative to unregulated firms, the effect of changes in the carbon price over time on firms’ level of innovation in low emission technologies is unclear.  

Our recent study explores the link between the EU ETS carbon price and the patenting rate in low emission technologies (the count of patents for low emission technologies as a proportion of all patents) in EU ETS countries. Changes in these variables over time are illustrated in the figure below, which shows the monthly patenting rate in low emission technologies from 1990 to 2019 and the mean monthly EU ETS carbon price from its inception in 2005 to 2019.

To explore the link between changes in the carbon price and the patenting rate in low emission technologies, we developed a model where firms iteratively update their carbon price expectations in response to recent price changes, use these price expectations in deciding whether to invest in developing new low emission technologies, and lodge patent applications for the new technologies two years later if the investment was successful.

In fitting this model to EU ETS carbon price and patenting data, we found that it explains much of the variation in the low emission technology patenting rate over time. The figure below illustrates the alignment between the expected low emission technology patenting rate based on our model and the observed rate.

The model indicates that a 1USD increase in firms’ carbon price expectations is associated with a 1.4% increase in the number of patents for low carbon technologies two years later in EU ETS countries. The model also indicates that changes in the carbon price gradually influence firms’ expectations of the future carbon price.

These findings suggest that higher carbon prices provide an effective incentive for low carbon innovation, and that moderate and sustained increases in the carbon price can substantially increase the level of low carbon innovation.

While this study illuminates the relationship between the carbon price and innovation in low emission technologies, it also highlights the need for further research to understand the types of low carbon innovation that firms undertake when the carbon price rises, which would improve our understanding of the degree to which carbon pricing can support the transition to a low carbon economy.

Authors: Bernardo Cantone, David Evans