Environmental Policy Design Characteristics and Technological Innovation

Sustainable Life Media - Researchers at the OECD have issued a new report concluding that the most effective ways for governments to encourage sustainable innovation are to clearly outline their policies and to support market-based instruments such as environment –related taxes and carbon trading permits over direct regulation of business.

According to the research, there is empirical evidence that market-based instruments such as environmentally-related taxes and tradable permits are more likely to induce innovation than direct regulations such as technology-based standards. However just comparing incentives associated with market-based instruments with direct regulations in broad terms may be misleading. For instance, different environment-related taxes may have very different attributes. A tax on CO2 is flexible, targeted, deep, and often stable. However, a differentiated value-added tax for environmentally friendly products is not very flexible, targeted or deep.

Depending upon how the tax rate is determined, such a measure may actually have more similarity with technology-based standards than with an emissions tax in terms of impacts on innovation. The key point is that it is important to assess incentives for innovation in terms of their specific characteristics rather than by broad instrument type.

Drawing upon a worldwide database of patent applications, the effects of three of the most important characteristics (stringency, predictability, and flexibility) reveals that policy stringency plays a significant role in inducing innovation. More specifically, based on evidence from a broad cross-section of countries over the period 2000-2007 it is found that policy stringency has a positive impact on the likelihood of developing innovative means of air and water pollution abatement and solid waste management.

All environmental policies - whether they be taxes, subsidies, regulations, information attach a price to polluting. By increasing the price of polluting, it is hardly surprising to find that the more stringent the policy the greater the effect on innovations which have the effect of reducing emissions.

If there is uncertainty associated with a country's environmental policy, this will result in less innovation in environmental technologies. Conversely, the more stable and predictable a policy regime, the more innovation is likely to take place. This implies that governments should behave in a predictable manner if they wish to induce innovations that achieve environmental objectives at lower cost.

Why does this arise? Uncertain signals give investors strong incentives to postpone investments, including the risky investments which lead to innovation. There is an advantage to waiting until the policy dust settles. As such, by adding to the risk which investors face in the market, policy uncertainty can serve as a brake on innovation, both in terms of technology invention and adoption.

Empirical evidence over the period 2001-2006 supports the hypothesis that policy predictability has a distinct impact on innovation. This implies that governments have an interest to behave in a predictable manner if they wish to induce innovations that achieve environmental objectives at lower cost.

The third aspect of policy design that is examined empirically in this report is policy flexibility, which can be characterized as technology-neutrality. The results presented for panel data over the period 2001-2003 indicate that, for a given level of policy stringency, the more inflexible a policy regime, the less innovation takes place. In other words, the more flexible policy regime will induce more innovation than a regime which is prescriptive in nature.

This implies that rather than prescribing certain abatement strategies (such as technology-based standards), wherever possible governments should give firms stronger incentives to look for the optimal technological means to meet a given environmental objective.

The study's author conclude that since both governments and firms cannot foresee future trajectories of technological change, it is important to give innovators the incentive to search across a wider space to identify potential means of complying with regulations.

Therefore, by encouraging potential innovators to devote resources to identify the best way of achieving a given environmental objective, policy flexibility provides incentives for innovation above and beyond those provided by policy stringency.

The full study is available from the OECD website: Citation: Johnstone, N., I. Hašcic and M. Kalamova (2010), "Environmental Policy Design Characteristics and Technological Innovation: Evidence from Patent Data", OECD Environment Working Papers , No. 16, OECD