Mandates and the Incentive for Environmental Innovation

Matthew S. Clancy, GianCarlo Moschini
June 2015  [15-WP 557]

Mandates are policy tools that are becoming increasingly popular to promote renewable energy use. In addition to mitigating the pollution externality of conventional energy, mandates have the potential to promote R&D investments in renewable energy technology. But how well do mandates perform as innovation incentives? To address this question, we develop a partial equilibrium model with endogenous innovation to examine the R&D incentives induced by a mandate, and compare this policy to two benchmark situations: laissez-faire and a carbon tax. Innovation is stochastic and the model permits an endogenous number of multiple innovators. We find that mandates can improve upon laissez faire, and that the prospect of innovation is essential for their desirability. However, mandates suffer from several limitations. A mandate creates relatively strong incentives for investment in R&D in low-quality innovations, but relatively weak incentives to invest in high-quality innovations, so that the dispersion of realized innovation quality is comparatively low. Moreover, a mandate achieves lower welfare than a carbon tax, and its optimal level is more sensitive to the structure of the innovation process.

Key Words: Carbon tax, Incentive, Innovation, Mandates, Renewable energy, R&D, Welfare.

JEL codes: H23, O31, Q42, Q55, Q58

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