CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

PAPER

SEPTEMBER 2006

Evaluating the

Role of Prices and

R&D in Reducing

Carbon Dioxide

Emissions

CBO
Pub. No. 2731
The Congress of the United States O Congressional Budget Office

CBO

Evaluating the Role of Prices and R&D in 

Reducing Carbon Dioxide Emissions

September 2006

A

PAPER

Preface

The atmospheric concentration of greenhouse gases, most notably carbon dioxide, has 

gradually increased over the last century and, in the view of many climate scientists, is warming the global climate. Two policies—pricing carbon dioxide emissions and encouraging 

research and development of new carbon-reducing technologies—have been discussed as 

methods of limiting current and future emissions. This Congressional Budget Office (CBO) 

paper examines available research on the role that those policies might play in encouraging 

cost-effective reductions in emissions as well as analyses on whether it would be more efficient 

to implement the policies simultaneously or sequentially. The paper was prepared in response 

to a request from the Ranking Members of the Senate Committee on Energy and Natural 

Resources and the Senate Committee on the Environment and Public Works. In keeping 

with CBO=s mandate to provide objective, impartial analysis, the paper makes no recommendations.

Terry M. Dinan prepared this paper under the supervision of Joseph Kile and David Moore. 

Colin Baker, Douglas Hamilton, Arlene Holen, Robert Shackleton, and Thomas Woodward 

provided comments. Outside of CBO, Henry Jacoby of the Massachusetts Institute of Technology, David Popp of the University of Syracuse, Richard Richels of the Electric Power 

Research Institute, and David Montgomery of Charles River Associates International provided comments. (The assistance of external reviewers implies no responsibility for the final 

product, which rests solely with CBO.) 

Christine Bogusz edited the paper, and Loretta Lettner proofread it. Maureen Costantino 

prepared the paper for publication, took the cover photo, and designed the cover, and Lenny 

Skutnik printed copies of the paper. Simone Thomas produced the electronic version for 

CBO’s Web site (www.cbo.gov).

Donald B. Marron

Acting Director

September 2006

Contents

1 Summary and Introduction 1

Policies for Reducing Carbon Emissions 1

The Interaction and Timing of Policies 2

A Global Concern 3

2 Policies for Reducing Carbon Emissions 5

Pricing Carbon to Address the External Costs of Emissions 5

Subsidizing R&D Efforts to Account for Spillover Benefits 11

3 The Effectiveness of Policy Approaches 15

Policy Simulations 15

Results 16

Limitations 18

Boxes

2-1. How Emissions Taxes and Cap-and-Trade Policies Would Work 6

2-2. Would Taxes on Carbon Dioxide Emissions Spur Research and

Development of New Technologies? 8

2-3. Using Prizes to Encourage Technological Improvements 12

CHAPTER

1

Summary and Introduction

Several important human activities—most notably 

the worldwide burning of coal, oil, and natural gas—are 

gradually increasing the concentrations of carbon dioxide 

and other greenhouse gases in the atmosphere and, in the 

view of many climate scientists, are gradually warming 

the global climate. That warming, and any long-term 

damage that might result from it, could be reduced by 

restraining the growth of greenhouse gas emissions and 

ultimately limiting them to a level that stabilized atmospheric concentrations. 

The magnitude of warming and the damages that might 

result are highly uncertain, in part because they depend 

on the amount of emissions that will occur both now and 

in the future, how the global climate system will respond 

to rising concentrations of greenhouse gases in the atmosphere, and how changes in climate will affect the health 

of human and natural systems. The costs of restraining 

emissions are also highly uncertain, in part because they 

will depend on the development of new technologies.1

From an economic point of view, the challenge to policymakers is to implement policies that balance the uncertain costs of restraining emissions against the benefits of 

avoiding uncertain damages from global warming or that 

minimize the cost of achieving a target level of concentrations or level of annual emissions. 

Researchers have studied the relative efficacy—as well as 

the appropriate timing—of various policies that might 

discourage emissions of carbon dioxide (referred to as 

carbon emissions in the rest of this paper), which makes 

up the vast majority of greenhouse gases, and restrain the 

growth of its atmospheric concentration. This paper presents qualitative findings from that research, which are 

largely independent of any particular estimate of the costs 

or benefits of reducing emissions. The paper’s conclusions 

are summarized below.

Policies for Reducing Carbon 

Emissions

The possibility of climate change involves two distinct 

“market failures” that prevent unregulated markets from 

achieving the appropriate balance between fossil fuel use 

and changes in climate. One market failure involves the 

external effects of emissions from the combustion of fossil 

fuels—that is, the costs that are imposed on society by 

the use of fossil fuels but that are not reflected in the 

prices paid for them. The other market failure is a general 

underinvestment in research and development (R&D) 

that occurs because investments in innovation may yield 

“spillover” benefits to society that do not translate into 

profits for the innovating firm. The first market failure 

yields inefficiently high use of fossil fuels; the second 

yields inefficiently low R&D.

Because there are two separate market failures, an efficient response is likely to involve two separate types of 

policies:

B One type of policy would reduce carbon emissions by 

increasing the costs of emitting carbon, both in the 

near term and in the future, to reflect the damages 

that those emissions are expected to cause. 

B The other type of policy would increase federal support for R&D on various technologies that could help 

restrain the growth of carbon emissions and would 

create spillover benefits. 

Policymakers could increase the cost of emitting carbon 

by setting a price on those emissions. That could be accomplished by taxing fossil fuels in proportion to their 

1. For a discussion of the uncertainty underlying estimates of the 

costs and benefits of reducing emissions and the implications for 

policy formation, see Congressional Budget Office, Uncertainty in 

Analyzing Climate Change: Policy Implications (January 2005). 
2 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

carbon content (which is released when the fuels are 

burned) or by establishing a “cap-and-trade” program 

under which policymakers would set an overall cap on 

emissions but allow fossil fuel suppliers to trade rights 

(called allowances) to those limited emissions. Either a 

tax or a cap-and-trade program would cause the prices of 

goods and services to rise to reflect the amount of carbon 

emitted as a result of their consumption. To the extent 

that a carbon tax or allowance price reflected the present 

value of expected damages, 2 such policies would encourage users of fossil fuels to account for the costs they impose on others through their emissions of greenhouse 

gases. 

Researchers generally conclude that the appropriate price 

for carbon would be relatively low in the near term but 

would rise substantially over time, resulting in relatively 

modest reductions in emissions in the near term followed 

by larger reductions in the future. Phasing in price increases would allow firms to gradually replace their stock 

of physical capital associated with energy use and to gain 

experience in using new technologies that emit less carbon. Firms would have an incentive to invest in developing new technologies on the basis of their expectations 

about future prices for emissions.

Federal support could be provided for the research and 

development of technologies that would lead to lower 

emissions. Such technologies could include improvements in energy efficiency; advances in low- or zeroemissions technologies (such as nuclear, wind, or solar 

power); and development of sequestration technologies, 

which capture and store carbon for long periods. Federal 

support would probably be most cost-effective if it went 

toward basic research on technologies that are in the early 

stages of development. Such research is more likely to be 

underfunded in the absence of government support because it is more likely to create knowledge that is beneficial to other firms but that does not generate profits for 

the firm conducting the research. 

The Interaction and Timing of Policies 

Pricing and R&D policies are neither mutually exclusive 

nor entirely independent—both could be implemented 

simultaneously, and each would tend to enhance the 

other. Pricing policies would tend to encourage the use of 

existing carbon-reducing technologies as well as provide 

incentives for firms to develop new ones; federal funding 

of R&D would augment private efforts; and successful 

R&D investments would reduce the price required to 

achieve a given level of reductions in emissions. 

Neither policy alone is likely to be as effective as a strategy involving both policies. Relying exclusively on R&D 

funding in the near term, for example, does not appear 

likely to be consistent with the goal of balancing costs 

and benefits or the goal of minimizing the costs of meeting an emissions reduction target. At any point in time, 

there is a cost continuum for emissions reductions, ranging from low-cost to high-cost opportunities. Unless 

R&D efforts virtually eliminated the value of near-term 

reductions in emissions (an outcome that appears unlikely given reasonable assumptions about the payoff of 

R&D efforts), waiting to begin initial pricing (to encourage low-cost reductions) would increase the overall cost of 

reducing emissions in the long run.

Near-term reductions in emissions achieved with existing 

technologies could be valuable even if fundamentally new 

energy technologies would be needed to prevent the 

buildup of greenhouse gases in the atmosphere from 

reaching a point that triggered a rapid increase in damages. Near-term reductions could take advantage of lowcost opportunities to avoid adding to the stock of gases in 

the atmosphere and could allow additional time for new 

technologies to be developed and put in place. That additional time could prove quite valuable, given that R&D 

efforts are highly uncertain and that the process of putting new energy systems in place could be slow and costly. 

Determining the appropriate mix of policies to address 

climate change is complicated by the fact that future policies would be layered on a complex mix of current and 

past policies, all of which affect today’s use of fossil fuels 

and their alternatives as well as the amount of R&D. The 

analyses reviewed in this paper typically do not account 

for existing policies or for the administrative costs of implementing a carbon-pricing program or of initiating 

a larger (and perhaps redesigned) R&D program for 

carbon-reducing technologies. However, the qualitative 

2. By discounting future damages to the present, the costs and benefits of undertaking actions that reduce climate change are placed 

on a common temporal footing. The discount rate chosen to compare avoided future damages (benefits) and costs is controversial. 

For a discussion, see Congressional Budget Office, Uncertainty in 

Analyzing Climate Change and The Economics of Climate Change: 

A Primer (April 2003). 
CHAPTER ONE SUMMARY AND INTRODUCTION 3

conclusion reached in those analyses—that costs would 

be minimized by a combination of gradually increasing 

emissions prices coupled with subsidies for R&D—is not 

likely to be affected by such considerations.3

A Global Concern

The causes and consequences of climate change are global, and reductions in U.S. emissions alone would be unlikely to have a significant impact. Cost-effective mitigation policies would require coordinated international 

efforts and would involve overcoming institutional barriers to the diffusion of new technologies in developing 

countries, such as India and China. If a domestic carbonpricing program significantly increased the prices of U.S.-

produced goods—and was not matched by efforts to 

reduce emissions in other countries—it could cause 

carbon-intensive industries to relocate to countries without similar restrictions, diminishing the environmental 

benefits of a domestic program. 

However, successful domestic R&D efforts, whether 

funded by the public or private sector, could lower the 

costs of reducing carbon emissions in other countries as 

well as within the United States. Some new technologies, 

such as those that yielded improvements in energy efficiency, might be deployed without additional incentives. 

Other innovations, such as sequestration technologies or 

alternative energy technologies that reduce carbon emissions but cost more than their fossil-fuel-based alternatives, would be unlikely to be deployed without financial 

incentives to reduce carbon emissions. 

3. An exception to this would be if the net benefits of reducing carbon emissions were too small to justify the costs of administering 

either or both policies.

CHAPTER

2

Policies for Reducing Carbon Emissions

Rising emissions of carbon dioxide from the combustion of fossil fuels, and the resulting increases in the 

concentration of carbon in the atmosphere, raise concerns about the prospect of climate change and the costs 

that could be imposed on society. If policymakers chose 

to take action to reduce the level of carbon emissions, 

they would face two distinct “market failures” that would 

prevent the free market from settling on the amount of 

carbon emissions that would be best for society. In general, distinct market failures are best addressed by separate 

policy instruments. 

One market failure arises because the combustion of fossil 

fuels may create external costs that are borne by society as 

a whole—particularly by future generations—but are not 

reflected in the prices that people pay for those fuels, or 

for the services that the fuels provide. As a result, firms, 

households, governments, and other organizations would 

be likely to consume more fossil fuels—and emit more 

carbon—than would be best for society. Setting a price 

on carbon emissions that reflected their external costs 

would correct that market failure. 

The other market failure arises because the research and 

development of new technologies for reducing carbon 

emissions are likely to result in spillover benefits. Such 

benefits are realized by other firms as a result of the innovating firm’s R&D effort but do not generate profits for 

the innovating firm. Thus, firms tend to engage in less 

R&D on carbon-reducing technologies than would be 

best for society. Increasing public funding for the development of new carbon-reducing technologies would correct that failure, as long as the spillover benefits of such 

activities exceeded their costs.

Current policies in the United States both encourage and 

discourage firms and households from using fossil fuels, 

but no existing policy provides systematic incentives for 

users to account for the potential costs of carbon emissions. Current U.S. policies also provide subsidies for 

R&D that at least partially compensate for spillover benefits; determining whether those subsidies are sufficient, 

however, is beyond the scope of this paper. 

Pricing Carbon to Address the External 

Costs of Emissions 

The costs of carbon emissions could be built into the 

price of consuming fossil fuels directly by taxing such 

fuels or indirectly by allowing the market to set a price on 

carbon emissions through a cap-and-trade program. A tax 

could be imposed on fossil fuel producers and importers 

on the basis of the carbon content of their fuels, a socalled upstream tax. Alternatively, an upstream cap-andtrade program would require producers or importers to 

pay for the right (called an allowance) to sell goods and 

services that ultimately led to carbon emissions. The cost 

of the tax or the allowance, like any other cost, would be 

reflected in the price producers charged for goods and 

services that resulted in carbon emissions (see Box 2-1). 

Either approach could be designed to provide firms with 

an incentive to capture and sequester carbon emissions, 

thus reducing net emissions into the atmosphere, as well 

as to reduce their initial emissions.

The Effects of Pricing

Establishing a price for carbon emissions would cause the 

costs of using fossil fuels to rise to reflect their carbon 

content, with the largest percentage increase for coal, followed by oil and then natural gas.1 Higher fossil fuel costs 

and the resulting increases in the prices of services, such 

1. Under an upstream system, fossil fuel producers and importers 

would pay the tax or purchase the allowance, and fossil fuel prices 

would increase accordingly. Those price increases would filter 

through the economy, increasing the prices of goods and services 

in proportion to the carbon emissions that their production and 

consumption generated. 
6 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

Box 2-1.

How Emissions Taxes and Cap-and-Trade Policies Would Work

Policymakers could take several approaches to limiting carbon dioxide emissions. One approach—a tax 

on those emissions—would raise the cost of emitting 

carbon dioxide, thereby encouraging households and 

firms to cut their emissions as long as the cost of doing so was less than the tax. That approach would set 

an upper limit on the cost of individual reductions in 

emissions (at the level of the tax) but would not ensure that any particular emissions target was met. 

A second approach—a cap-and-trade program—

would set an overall limit on the level of carbon dioxide emissions but leave the decisions about where and 

how the necessary reductions should be made to 

households and firms. Under that approach, policymakers would establish an overall cap on emissions 

but allow regulated firms to trade rights to those 

emissions, called allowances. That trading would permit firms that could reduce their emissions most 

cheaply to sell some of their allowances to firms that 

faced higher costs to reduce their emissions. Such an 

approach would limit the overall level of emissions 

but would not place any explicit limit on the cost of 

individual reductions. 

Under a third, hybrid approach, policymakers would 

set an overall cap on total emissions, but they would 

also establish an upper limit on the price of allowances, referred to as a “safety valve” price. If the price 

of allowances rose to the safety-valve price, the government would sell as many allowances as was necessary to maintain that price. Thus, if the safety valve 

was triggered, the actual level of emissions would exceed the cap. The cap would be met only if the price 

of allowances never rose above the safety-valve price. 

Research has shown that, given the uncertainty associated with the costs and benefits of carbon-reduction 

policies, a tax on carbon dioxide emissions (or a capand-trade program with a safety valve) would result 

in significantly higher expected net benefits than a 

cap-and-trade program with a fixed cap.1 A tax would 

motivate people to limit their emissions up to the 

point at which the costs of doing so were equal to the 

tax. If actual costs were less than, or greater than, anticipated, people would limit their emissions more 

than, or less than, policymakers projected. However, 

emissions would be reduced up to the point at which 

the cost of doing so was equal to the expected benefits (provided that the tax was set at the efficient 

level). In contrast, a strict cap on emissions could result in actual costs that were far greater (or less than) 

expected and, therefore, exceeded (or fell below) the 

expected benefits.

Either a tax on carbon dioxide emissions or a capand-trade program could be designed to provide incentives for firms to sequester carbon. For example, a 

tax credit for sequestration could be implemented in 

conjunction with a tax on carbon dioxide emissions. 

Likewise, firms could be permitted to reduce their allowance requirements by sequestering carbon. 

1. For a more detailed discussion of this point, see Congressional Budget Office, Limiting Carbon Dioxide Emissions: 

Prices Versus Caps, CBO Issue Brief (March 15, 2005). 
CHAPTER TWO POLICIES FOR REDUCING CARBON EMISSIONS 7

as electricity, would provide incentives for emitters to 

make changes in their behavior or operations that would 

conserve energy (such as driving less and turning down 

thermostats); to invest in more-efficient appliances and 

equipment; and to make greater use of renewable fuels to 

heat water and power vehicles. The carbon price would 

also provide an incentive for electricity producers to decrease the carbon intensity of the electricity that they produced. That decrease could be accomplished by switching 

to fossil fuels with lower carbon contents (for example, 

from coal to natural gas), by generating electricity from 

nuclear power or renewable fuels, or from converting coal 

to gas and capturing and sequestering the carbon.2 The 

magnitude of the incentive created for those activities 

would depend on the price of the carbon.3 

Carbon pricing would encourage cost-effective reductions in emissions at any given point in time because it 

would provide firms, households, governments, and 

other organizations with a uniform incentive to undertake the broad array of activities that would reduce emissions. A worldwide pricing policy would be more efficient than one that was limited to the United States 

because carbon is a global pollutant. A uniform worldwide price for carbon would provide an incentive for 

emitters that could make reductions at the lowest cost to 

do so, regardless of national boundaries. Establishing a 

domestic price for carbon emissions would minimize the 

cost of achieving a given level of reductions within the 

United States, but that same quantity of reductions could 

be obtained at a lower cost under coordinated policies 

that set an equal price for carbon emissions throughout 

the world. 

Setting a current price for carbon emissions and announcing planned future carbon prices not only would 

induce firms and households to change their behavior but 

also would increase their demand for technologies that 

would reduce emissions. That increase in demand would 

in turn create incentives for firms to research and develop 

new methods of improving energy efficiency, producing 

energy from renewable sources, and sequestering carbon.4

Moreover, as firms gain more experience with low-carbon 

technologies, they may learn how to produce them at a 

lower cost.5

Some researchers suggest that future carbon taxes would 

not provide adequate incentives for R&D if a firm anticipated that policymakers might lower the carbon tax—

and thus reduce the firm’s return on its R&D investment—once it successfully developed a new technology. 

That concern could be valid only for a technology that 

would be expensive to develop and, once developed, 

could reduce a significant fraction of the world’s carbon 

emissions at a low per-unit price (see Box 2-2).

Setting Prices

A carbon tax or cap, and the resulting increase in fossil 

fuel prices, would impose costs on the economy; consequently, policymakers may wish to balance those costs 

against the anticipated reduction in climate-related damages. An efficient per-ton price for carbon would reflect 

the damages that are anticipated from a ton of carbon 

emissions. Damages from today’s emissions would occur 

in the future, and their expected magnitude can only be

2. Electricity producers would have incentives to sequester carbon 

only if they were required to pay the tax directly or to hold the 

allowance for each ton of carbon they emitted. If the tax or allowance requirement was imposed upstream—on producers and 

importers of fossil fuels—electricity producers would have an 

incentive to minimize their use of carbon-intensive fuels, but they 

would not have an incentive to sequester carbon emissions unless 

special provisions were made. See Congressional Budget Office, 

Issues in the Design of a Cap-and-Trade Program for Carbon Emissions, CBO Issue Brief (November 25, 2003). 

3. Note that higher prices for fossil fuels resulting from an increasing 

scarcity of those fuels would also promote decreased use. However, 

fossil fuel use would still exceed the socially efficient amount 

because the prices would not reflect the external costs of carbon 

emissions.

4. Studies have demonstrated the effectiveness of higher energy 

prices in stimulating R&D on renewable energy technologies. For 

example, see David Popp, “Induced Innovation and Energy 

Prices,” American Economic Review, vol. 92 (2002), pp. 160-180.

5. For a discussion of how near-term abatement can lower the cost of 

future carbon reductions by creating opportunities for learning by 

doing, see Michael Grubb, “Technologies, Energy Systems, and 

the Timing of CO2 Abatement,” Energy Policy, vol. 25, no. 2 

(1997), pp. 159-172; Arnulf Grubler and Sabine Messner, “Technological Change and the Timing of Mitigation Measures,” 

Energy Economics, vol. 20 (1998), pp. 495-512; and B.C.C. van 

der Zwann and others, “Endogenous Technological Change in 

Climate Change Modeling,” Energy Economics, vol. 24 (2002),

pp. 1-19. 
8 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

estimated with a high degree of uncertainty.6 Provided 

that the price of carbon was set equal to the current value 

of the damages anticipated from today’s emissions, carbon pricing would give emitters an incentive to undertake reductions when the cost of doing so would be outweighed by the expected benefit—that is, the avoided 

damage. 

The relationship between near-term and future carbon 

prices would determine the pattern of reductions in emissions over time. In general, gradually rising prices have 

been found to be most efficient—that is, most likely to 

Box 2-2.

Would Taxes on Carbon Dioxide Emissions Spur Research and

Development of New Technologies?

A tax on carbon dioxide emissions would create a 

market for technologies that could reduce those emissions. Emitters would find it worthwhile to purchase 

those technologies provided that the cost of doing so 

was less than the cost of paying the tax. Current taxes 

would create incentives for current reductions in 

emissions, and expectations of future taxes would 

provide firms with an incentive to invest in the 

research and development, or R&D, of new 

technologies. 

Some research has suggested that announced future 

taxes may not provide an adequate incentive for firms 

to develop a fundamentally new technology for reducing carbon dioxide emissions. That research is 

based on the argument that the government may 

have an incentive to reduce carbon taxes, and correspondingly returns to investors, after costly R&D was 

undertaken. Specifically, policymakers might announce one set of future taxes—which would reflect 

the full costs of developing and deploying such a 

technology—but then reduce those taxes once the 

technology was developed.1 If that occurred, emitters 

would be willing to pay less for the new technology 

than the initially announced taxes would suggest. If 

firms anticipated that policymakers would reduce the 

tax once the new technology was introduced—and 

that the tax reduction would cause the innovating 

firm to be unable to recoup some of its R&D costs—

then firms would be less willing to undertake the initial R&D investment to develop the technology.2

What set of circumstances might lead to the outcome 

described above? Policymakers might be motivated to 

reduce taxes on carbon dioxide emissions after a firm 

successfully developed a new technology in the case 

of a technology that could reduce a significant fraction of the world’s emissions—for example, by producing carbon-free energy—at a low and relatively 

constant per-unit cost. In that case, the new technology would warrant a decrease in the tax because it 

would be expected to so greatly reduce the future 

atmospheric concentration of carbon dioxide that the 

marginal damage from current and future emissions

1. For a discussion of this argument, see W. David Montgomery 

and Anne E. Smith, “Price, Quantity, and Technology Strategies for Climate Change Policy,” in Human-Induced Climate 

Change: An Interdisciplinary Assessment (Boston, Mass.: Cambridge University Press, forthcoming).

2. As the amount of emissions reductions provided by the new 

technology increases, the price premium necessary to cover 

the fixed R&D costs decreases.

6. That measure of expected damages depends on many uncertain 

factors, including the time that carbon lingers in the atmosphere, 

the path of emissions in the future, the change in climate associated with higher atmospheric stocks of carbon, the physical damages associated with changes in climate, and the value of those 

damages. For a discussion of those factors, see Congressional Budget Office, Uncertainties in Analyzing Climate Change: Policy 

Implications (January 2005).
CHAPTER TWO POLICIES FOR REDUCING CARBON EMISSIONS 9

Box 2-2.

Continued

would be lessened.3 Maintaining the tax once the 

new technology was introduced would induce some 

reductions in emissions that would be unwarranted 

on the basis of the resources required to achieve them 

and the now lower benefits (avoided damages) that 

they would create. An efficient tax reduction would 

be more likely to prevent the innovating firm from 

recouping its R&D costs if those costs were large and 

if the cost of providing an additional unit of the new 

technology was relatively constant. Thus, the contention that a firm would be dissuaded from developing 

a new technology out of concern that its introduction 

would trigger a tax reduction that would prevent the 

firm from recovering its R&D costs could be valid 

only for a technology that met two criteria: it would 

be very expensive to develop, and it would be able to 

reduce a significant share of the world’s carbon dioxide emissions at a low, and relatively constant, perunit cost. 

A technology that fits that case has not been identified, but some so-called silver bullet technologies are 

being explored. Concern that policymakers might 

lower a tax on carbon dioxide emissions once such 

potential technologies were developed could 

strengthen the case for funding research on them; 

nevertheless, that concern would be unlikely to pose a 

general disincentive to other forms of technological 

innovation that could play an important role in addressing climate change. Finally, even in the case of a 

silver bullet technology, policymakers could be reluctant to make a tax reduction that eliminated the innovating firm’s return on its R&D investment if such 

an action was expected to discourage future R&D on 

other carbon-reducing technologies.

Concerns that policymakers might lessen the stringency of the policy once a technological innovation 

occurred are less likely to apply to a cap-and-trade 

program that does not include a safety-valve price 

(see Box 2-1). In that case, technological innovations 

would encourage policymakers to increase—not 

decrease—the stringency of the cap (because the cost 

of achieving any given cap would be reduced), and 

firms’ ability to recoup their R&D expenses would 

depend primarily on their ability to patent their innovations. (Spillover benefits could still provide a rationale for using public funds to supplement private 

R&D efforts.) Inclusion of a safety valve could cause 

a cap-and-trade program to function in a similar 

manner to a carbon dioxide tax and, thus, could lead 

to concerns about a tax decrease following a technology innovation under the same set of circumstances 

described above. 

3. Specifically, policymakers would find it efficient to reduce 

the tax to the point at which the firm’s marginal cost of 

reducing a ton of carbon dioxide with the new technology, 

which would increase as more of the new technology was 

deployed, was equal to the marginal damage of emitting an 

additional ton of carbon dioxide, which would decline as 

more of the new technology was deployed. The efficient tax 

would just cover the cost of producing the marginal unit of 

the new technology, but the firm would earn profits on inframarginal units (which have production costs below the tax). 

Firms’ profits on those inframarginal units may not fully 

cover the cost of developing the new technology. That situation is most likely to occur when the cost of producing an 

additional unit of the technology is relatively insensitive to 

the amount produced and when the R&D costs are very 

large. Technologies that were not expected to provide enough 

reductions in emissions to significantly lower the atmospheric concentration of carbon dioxide in the future would 

increase the efficient amount of emissions reductions but 

would not be expected to trigger a tax decrease. For a demonstration of the latter point, see Lawrence H. Goulder and 

Stephen H. Schneider, “Induced Technological Change and 

the Attractiveness of CO2 Abatement Policies,” Resource and 

Energy Economics, vol. 21 (1999), pp. 211-253.
10 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

result in a pattern of reductions that would best balance 

costs and benefits over the long run.7

 

Gradually rising carbon prices would lead to steady reductions in emissions (relative to the baseline trend). 

Phasing in reductions would allow firms to gradually replace the capital stock that affects carbon emissions—including housing stock, appliances, automobiles, industrial equipment, and power plants—with newer capital 

that would lead to lower emissions, such as more energyefficient houses, or power plants that generate electricity 

from sources that do not emit carbon. In the absence of 

economic incentives to reduce carbon emissions, such 

replacements would be unlikely to occur, and a new generation of carbon-intensive capital stock could be put in 

place—perhaps necessitating premature retirements of 

that stock in the future.8 

By providing incentives for relatively low-cost reductions 

in emissions today and delaying more significant reductions until the future, policymakers would allow time for 

new technologies to develop. Analysts’ opinions about the 

appropriate timing of reductions in emissions vary, in 

part, because of different assumptions about how likely it 

is that technological advances would occur and how 

costly achieving those advances would be.9 

Current Policies That Provide Incentives and 

Disincentives for Fossil Fuel Use

Numerous policies affect the consumption of fossil fuels. 

Policies that directly or indirectly encourage the use of 

fossil fuels include federal support for highway construction and various tax provisions that promote the domestic 

production of oil and natural gas. Policies that discourage 

the use of fossil fuels include the federal gasoline tax, 

subsidies for mass transit, and various tax provisions that 

promote alternative fuels such as ethanol, biogas, and coal 

synfuels.

Those policies provide conflicting incentives for households and firms to use fossil fuels. Further, even the policies that discourage fossil fuel use do not do so on the basis of the extent to which the fossil fuels contribute to 

climate change. In contrast, a tax or cap on carbon emissions would provide an incentive for households and 

firms to take those external costs into account—providing the greatest discouragement for the use of coal, which 

releases the most carbon when it is burned.10 Such a tax 

or cap would encourage a more complete range of activities that could reduce carbon emissions (including im- 7. As a first approximation, intertemporal efficiency would require 

that carbon prices rise at the real (inflation-adjusted) rate of interest minus the rate at which carbon was absorbed into the ocean 

and thus disappeared from the atmosphere. See William D. 

Nordhaus, Life After Kyoto: Alternative Approaches to Global 

Warming Policies, Working Paper No. 11889 (Cambridge, Mass.: 

National Bureau of Economic Research, December 2005), p. 9. 

Because damages stem from the accumulation of carbon in the 

atmosphere, they are expected to be greater in the future than in 

the present. The efficient price of carbon increases over time to 

represent the growing weight placed on future damages as they 

become closer in time.

8. The baseline capital stock could become more or less carbon 

intensive as the relative prices of fossil fuels and alternative technologies changed over time. However, in the absence of carbon 

pricing—or in anticipation of it—there would be no incentive for 

firms or households to make choices on the basis of the carbon 

emissions that resulted from the different technologies. As a result, 

even models that suggest that a stated target for the atmospheric 

concentration of carbon could be met with little divergence from 

baseline emissions in the near term find that some near-term 

reductions would have value (this is reflected by a positive 

“shadow price” for such reductions). For an example, see Richard 

Richels and Jae Edmonds, “The Economics of Stabilizing Atmospheric CO2 Concentrations,” Energy Policy, vol. 23, no. 4/5 

(1995), pp. 373-378. Information about the shadow price of carbon was based on personal communication with the lead author. 

9. Some models incorporate information about specific alternative 

energy technologies, including their initial price and the prospects 

that their costs would fall. Those models—called bottom-up 

models because of the detail that they contain on specific technologies—tend to be relatively optimistic about the prospects for 

technological advancement but typically fail to represent the costs 

that might be associated with research efforts. Top-down models, 

in contrast, tend to have better information on the links between 

environmental policy and macroeconomic performance (better 

capturing the costs of R&D efforts), but they have considerably 

less detail about specific alternative energy technologies and tend 

to be less optimistic about the prospects of cost reductions. For a 

more complete discussion of the strengths and limitations of topdown and bottom-up models, see Leon E. Clarke and John P. 

Weyant, “Modeling Induced Technological Change: An Overview,” in Arnulf Grubler, Nebojsa Nakiconovic, and William D. 

Nordhaus, eds., Technological Change and the Environment (Washington, D.C.: Resources for the Future, 2002), pp. 343-349; and 

David Popp, “Entice-BR: The Effects of Backstop Technology and 

R&D on Climate Policy Models,” Energy Economics, vol. 28 

(2006), pp. 189-191. 

10. Carbon emissions would be roughly 80 percent higher if a given 

amount of heat was generated by coal (or 50 percent higher if generated by fuel oil) rather than by natural gas. See www.epa.gov/air 

market/epa-ipm/chapter8.pdf.
CHAPTER TWO POLICIES FOR REDUCING CARBON EMISSIONS 11

provements in energy efficiency, the use of renewable 

energy sources, and, depending on the design, sequestration), not just those that are targeted by a specific tax 

credit.

Subsidizing R&D Efforts to Account for 

Spillover Benefits 

Even if the external costs of carbon were incorporated 

into prices for fossil fuels, firms might invest less in research and development than would be best from society’s 

point of view. That outcome would be likely if firms’ 

resulting profits were expected to fall short of society’s 

benefits. The extent to which that outcome would occur 

depends, in part, on the nature of the research, existing 

patent laws, and existing tax provisions. 

The Benefits of Supporting R&D

The development of some technologies to reduce carbon 

emissions entails basic scientific research. That basic research may create knowledge that is beneficial to society; 

however, because it may not result in patentable inventions, such research may be underfunded in the absence 

of federal support. The role of basic research—and the resulting creation of spillover benefits—is likely to be particularly large in developing fundamentally new technologies that are a long way from the marketplace but that 

could provide large amounts of carbon-free energy, or 

carbon sequestration, at a low cost. (For example, some 

researchers have considered the possibility that hydrogen 

fuel could be manufactured from high-efficiency solar 

processes or that low-resistivity power lines could distribute solar electricity between continents, time zones, and 

day/night cycles.)11 

Other research is likely to be tied to the development of 

technologies that are much closer to the marketplace (for 

example, improvements in vehicles’ fuel efficiency or in 

the generation of electricity from wind) and, thus, firms 

would be more likely to profit from that research. However, even if patents allowed firms to profit from their 

R&D investments, the level of R&D that would maximize firms’ profits could still fall short of the level that 

would be best for society. Society’s benefits would include 

the value of any new innovations that were inspired by 

the patented invention but that were not covered by the 

patent, and the extent to which the benefits created by 

the patented invention (theoretically measured by an individual’s willingness to pay for it) exceeded the price 

charged for it.

The divergence between private profits from R&D and 

social gains is not unique to investments designed to reduce carbon emissions. Rather, that divergence is characteristic of R&D investments in general—particularly for 

basic research and less so for research that is more clearly 

linked to commercial applications. Measuring the gap 

between firms’ profits from R&D and society’s benefits is 

difficult, but some analysts think that it could be quite 

large.12 Should the gap between social benefits and private profits be less than those researchers estimated, the 

efficiency gains from subsidizing private R&D efforts 

would be diminished. 

The Costs of Supporting R&D

Determining the appropriate amount of resources to devote to subsidizing research efforts is complicated by the 

fact that research can be costly and outcomes are uncertain. Federal funds devoted to R&D would impose an 

opportunity cost in that they could not be used for other 

spending priorities, to lower taxes, or to reduce the deficit. Further, federal funds devoted to inducing more 

R&D on alternative energy technologies or sequestration 

could impose a second opportunity cost by “crowding 

out” R&D in other sectors of the economy. For example, 

such policies might discourage private R&D spending by 

coal extraction firms or in other, seemingly unrelated,

industries, such as civil engineering and computer software. The latter effect might occur because the policyinduced R&D in one area could bid up the price of key 

research inputs, such as highly qualified engineers,

11. For a more complete description of these and other ideas, see Kenneth Caldeira and others, Climate Change Technology Exploratory 

Research (Washington, D.C.: Climate Policy Center, December 

2005). 

12. Estimates of social rates of return (society’s benefits) resulting 

from private investments in research and development are highly 

uncertain, but some researchers suggest that they average as much 

as 30 percent to 50 percent. In contrast, private marginal rates of 

return are estimated to be between 7 percent and 15 percent. See 

research cited in David Popp, R&D Subsidies and Climate Policy:

Is There a >Free Lunch=? Working Paper No. 10880 (Cambridge, 

Mass.: National Bureau of Economic Research, October 2004), 

p. 4; and Edward Mansfield, “Macroeconomic Policy and Technological Change,” in J.C. Fuhrere and J. Sneddon Little, eds., 

Technology and Growth, Conference Proceedings (Boston, Mass.: 

Federal Reserve Bank of Boston, 1996), p. 191. 
12 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

Box 2-3.

Using Prizes to Encourage Technological Improvements

The federal government has traditionally funded research and development through the use of tax credits; research grants or contracts to private or academic 

institutions; or research at federally funded facilities, 

such as the national laboratories. Such means of 

funding subsidize the cost of conducting the research 

rather than provide a monetary award for a successful 

outcome.

In recent years, analysts and policymakers have considered using prizes as a way to spur technological improvements that would lower the cost of reducing 

carbon dioxide emissions—such as improvements in 

energy efficiency, renewable energy sources, or the 

development of fundamentally new energy sources 

that emit no carbon dioxide.1

 Prizes have been used 

to a limited extent to encourage technological developments for hundreds of years. One of the earliest 

well-known uses of prizes was an award offered by the 

British government to inventors who designed instruments capable of accurately measuring longitude. In 

that case, the goal was to reduce the number of ships 

lost by the Royal Navy. A more-recent example of a 

federally funded prize is the Defense Advanced Research Projects Agency’s “Grand Challenge.” That 

prize, awarded for the development of driverless vehicles, aims to reduce battlefield casualties of U.S. 

troops. Several prizes have been offered by private 

entities as well, leading to technological improvements in the areas of aviation and automobiles, 

among others.

The use of prizes has several advantages over costsubsidizing approaches: 

B Firms that conduct the research bear the risk of 

failure—that is, they absorb the costs of unsuccessful endeavors. Having researchers, rather than 

the federal government, bear those costs makes 

sense for at least two reasons: researchers are likely 

to have better information on the likelihood of the 

success of different endeavors, and the research facility itself has the most control over whether it is 

spending its research dollars effectively.

B Federal award money is directly linked to a successful outcome, with the winning firm unknown 

at the outset. As a result, federal money could be 

less influenced by competing goals that policymakers might have, such as providing employment or research facilities for their states or 

districts.

B If prizes entail fewer bureaucratic hurdles than the 

traditional grant or contract process, then they 

may encourage the participation of smaller firms, 

those without previous involvement in federally 

funded research efforts, or both. Some anecdotal 

evidence indicates that technological breakthroughs are more likely to come from more 

unorthodox entities.

B The prestige associated with winning a competition can offer firms a further incentive to 

participate.

The use of prizes can have disadvantages as well:

B If the technological improvements sought are risky 

and expensive, then the prizes necessary to induce 

them would need to be large.

B If the necessary research is thought to be expensive, then the use of prizes could actually discourage the participation of smaller research entities, 

which could not cover the costs themselves and 

may not have access to credit. 

1. For a more detailed discussion of the points made in this box, 

see the statement of Douglas Holtz-Eakin, Director, Congressional Budget Office, Economic and Budgetary Issues with 

Cash Prizes to Achieve NASA’s Objectives, before the Subcommittee on Space and Aeronautics, Committee on Science, 

U.S. House of Representatives (July 15, 2004); and Richard 

G. Newell and Nathan E. Wilson, “Technology Prizes for 

Climate Change Mitigation,” Discussion Paper 05-33 

(Washington, D.C.: Resources for the Future, 2005).
CHAPTER TWO POLICIES FOR REDUCING CARBON EMISSIONS 13

Box 2-3.

Continued

B If an award attracted many participants, resources 

could be wasted as researchers duplicated one another’s efforts. While relevant, this limitation is 

not restricted to prizes. Such duplication can occur as firms attempt to be the first to patent an 

outcome as well. That problem could be reduced 

by structuring the competition so that the number 

of competitors is narrowed over time (through the 

use of intermediary hurdles) or by requiring competitors to pay to participate. 

B Firms would be reluctant to participate if they 

thought that the government might renege on the 

prize if attitudes toward the prize’s goals changed. 

To avoid such a possibility, the government could 

establish a private-sector escrow account or purchase an insurance policy that would guarantee 

that the funds would be available. 

At least four different design considerations may influence the likelihood that offering a prize will lead to 

technological improvements. First, the technological 

target must be as specific and measurable as possible, 

yet broad enough to allow for creative efforts. Capturing the correct balance could be difficult. For example, a general goal of reducing carbon dioxide 

emissions at a given cost could lead to a wide variety 

of technological innovations. Some may clearly be 

more desirable than others, though, because they 

would increase—or reduce—other forms of pollution 

(such as nuclear waste). Policymakers may want to 

take those other costs into account and to specify 

such considerations beforehand. Focusing climate 

technology prizes on one research area (such as solar 

energy) at a time may provide one possible solution. 

Second, the amount of the prize must be set sufficiently high to induce participation, but not so high 

as to provide excessive rewards. Finding the correct 

balance could be difficult, particularly if the competition is expected to last for an extended period. As 

described in the main text of this paper, the private 

rewards from firms’ innovations (that is, their profitmaking potential) are determined by the market for 

carbon-reducing technologies, which, in turn, depends on government policies. Should policies that 

provide incentives for carbon reductions emerge in 

the future, the private rewards from firms’ innovations would be higher than if such policies did not 

emerge. Ensuring—or restricting—firms’ access to 

patents for their innovations is one way that policymakers could influence both the amount of the prize 

and the public availability of the research outcomes. 

Allowing winning firms to patent their innovations 

would increase the number of participants, reduce 

the magnitude of the prize necessary to ensure participation, or both. However, it would also limit the 

availability of the technology to the public. Further, 

private firms are likely to have more information 

about the costs that research endeavors might entail 

than the policymakers who are responsible for setting 

the magnitude of the reward. Some researchers have 

suggested that the latter problem might be resolved 

by letting researchers bid for the size of the prize they 

would accept if their efforts were successful.

Third, the conditions for winning would influence 

the speed and quality of the outcomes. A contest with 

a cash award could be structured as a tournament 

(contest) or as a race (first past the post). A tournament, which specifies an objective and a time limit, 

guarantees an award to the party that has made the 

most progress toward the specified goals. It encourages participation—parties with substantial uncertainty may enter on the basis of partial insights—but 

can impose high costs on the government for evaluating many participants’ relative progress toward the 

stated goals. In contrast, a race specifies a welldefined goal (the post to pass) and makes an award 

only if that goal is achieved. A downside of a race is 

that it could reward a suboptimal outcome because a 

competitor who was developing a superior technology may finish second. 

Finally, clarity in the rules is essential. Unclear or 

unenforceable rules can lead to costly litigation and 

reduce incentives to participate.
14 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

computer experts, and scientists.13 Although the magnitude of that effect is unknown, it could be significant. 

Finally, identifying investments with the highest potential 

returns can be challenging, although federally funded 

prizes have been suggested as one method of doing so 

(see Box 2-3 on pages 12 and 13). 

Studies have reached conflicting conclusions about 

whether or not fundamentally new technologies for providing carbon-free energy, or for sequestering emissions, 

would be necessary to prevent the concentration of carbon in the atmosphere from exceeding targeted levels.14

Such studies, however, provide little guidance for R&D 

funding decisions because they do not consider either the 

costs or the benefits of developing the new technologies.

Current Policies That Support R&D

Two tax provisions encourage firms’ R&D efforts, 

thereby increasing the level of R&D they undertake:15

B Firms may receive a nonrefundable 20 percent income 

tax credit for certain research expenditures (such as 

salaries, time-sharing costs for computers, and contracts). That provision has expired but is expected to 

be extended.16

B Firms may deduct certain research expenditures as a 

current business expense, even though those expenditures are likely to generate patents with a useful life 

extending beyond a single tax year.

Those provisions are designed to encourage firms to undertake research on all different forms of technology improvements, not just ones that would reduce carbon 

emissions. Such tax provisions can increase the profitability of firms’ R&D efforts but cannot make up for the lack 

of a market for a new technology. Thus, in the absence of 

carbon pricing, those tax provisions would be unlikely to 

motivate firms to undertake R&D on carbon-reducing 

technologies that would not be profitable for other reasons (such as rising energy prices). Should carbon pricing 

be implemented, however, those tax provisions could help 

boost the amount of investment by closing the gap between private and social gains from the development of 

new carbon-reducing technologies.

In addition to those tax provisions, the federal government directly funds research that could lead to lower carbon emissions. Examples include research aimed at making advances in producing energy from nuclear fuels, 

hydrogen, and renewable fuels (such as biomass and solar) as well as efforts to improve the energy efficiency of 

vehicles, buildings, and industrial processes. 

In the absence of carbon pricing, federal support for research on carbon-reducing technologies could help make 

up for the lack of a profit motive for private firms to undertake such efforts as well as the spillover benefits that 

private research would have generated. Thus, the efficient 

amount of federal R&D funding depends, in part, on 

whether or not policymakers establish policies, such as a 

carbon tax or cap, that create incentives for private firms 

to invest in new technologies.17

13. See Austin Goolsbee, “Does Government R&D Policy Mainly 

Benefit Scientists and Engineers?” American Economic Review, 

vol. 88 (1988), pp. 298-302. 

14. For example, one study concluded that incremental improvements 

in existing technologies could limit carbon emissions over the next 

50 years to a trajectory that would avoid a doubling of the preindustrial concentration. See S. Pacala and R. Scolow, “Stabilization Wedges: Solving the Climate Problem for the Next 50 Years 

with Current Technologies,” Science, vol. 305 (August 13, 2004). 

In contrast, another study concluded that currently known technologies have severe deficiencies that limit their ability to stabilize 

the global climate. See Martin I. Hoffert and others, “Advanced 

Technology Paths to Global Climate Stability: Energy for a Greenhouse Planet,” Science, vol. 298 (November 1, 2002). 

15. See Congressional Research Service, Tax Expenditures: Compendium of Background Material on Individual Provisions (S.PRT. 108-

54), pp. 59-70.

16. Since 1981, when this tax credit was first enacted, it has been 

extended 10 times, most recently through December 31, 2005. 

Although the statutory rate of the credit is 20 percent, the actual 

cost reduction is less than 20 percent (13 percent for some expenditures and 6.5 percent for others) because of certain rules governing how the credit is computed. 

17. In the absence of carbon pricing, the research subsidy would 

simultaneously reduce the distortions in research incentives caused 

by two market failures. See Lawrence H. Goulder and Stephen H. 

Schneider, “Induced Technological Change and the Attractiveness 

of CO2 Abatement Policies,” Resource and Energy Economics, vol. 

21 (1999), pp. 211-253. 
CHAPTER

3

The Effectiveness of Policy Approaches

The policy tools for reducing carbon dioxide emissions include pricing such emissions to discourage the use 

of fossil fuels and subsidizing the research and development of technologies that would reduce emissions. Those 

policy tools could be used individually or together (either 

simultaneously or sequentially). The empirical evidence 

available to evaluate policy options is limited, but that 

which is available can be used to inform simulation models. Those models can be used to compare the potential 

for R&D subsidies and carbon-pricing policies to increase net benefits from reducing carbon emissions or to 

evaluate the costs of achieving a given target for emissions. Those simulations suggest that the most efficient 

means of reducing carbon emissions would include applying both policy tools simultaneously; the gains from 

R&D alone would be unlikely to eliminate the value of 

near-term reductions in emissions and, thus, to obviate 

the benefits of near-term pricing. 

Policy Simulations

The basic approach of models that simulate climate 

change policies is to measure the trade-off between 

consumption today and consumption in the future—

where consumption is broadly defined to include the 

value of goods sold in markets, such as agricultural 

products, and the value of nonmarketed goods, such as 

ecosystems or longer life spans. Efforts to limit greenhouse gases in the near term would reduce the amount of 

resources that could be devoted to current consumption 

or to other investments. However, because those efforts 

are undertaken to reduce potential climate change damages in subsequent time periods, they lead to greater consumption in the future. 

Policies are “efficient” if they maximize the present value 

of consumption over time. In other words, efficient policies would achieve the best balance between the reduction 

in current consumption that would result from today’s 

carbon-reducing policies (policy costs) and the increase in 

consumption—measured in present-value terms—that 

future generations might enjoy as a result of those policies 

(policy benefits). Alternatively, policies may efficiently 

meet a given emissions-reduction target if they do so with 

the lowest possible reduction in consumption over time.

Although simulation models are the best method currently available to evaluate policy options that address 

climate change, they are beset by uncertainties. Key uncertainties associated with measuring the costs of policy 

options include: 

B The magnitude of emissions in the absence of policies—the lower those emissions are expected to be, the 

fewer reductions will be needed to meet a given target 

and the lower the costs will be; 

B The costs of achieving a given reduction in emissions; 

and 

B The effectiveness of policy tools in bringing about the 

lowest-cost reductions at a given point in time or in 

stimulating the development of new technologies. 

Key uncertainties associated with measuring the benefits 

of policy options include: 

B The effects of reductions in carbon emissions on the 

average global temperature; 

B The distribution of reductions in global temperatures 

across seasons and regions, and the effects of those 

changes on other characteristics of climate, such as 

rainfall, severity of storms, and sea level; 

B The effects of changes in regional climates on natural 

and human systems, such as agricultural crops, property, species, and human health; and 
16 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

B The valuation of policy-induced reductions in damages to natural and human systems.1

Given the tremendous uncertainties involved in measuring policy costs and benefits, quantitative recommendations about the most efficient levels of prices or R&D 

subsidies are liable to be highly inaccurate. Qualitative 

policy recommendations about the appropriate timing, or 

relative importance, of policies are most robust if different modeling efforts reach similar conclusions or if a 

given model comes to the same qualitative conclusion 

when key assumptions are altered over the relevant range 

of potential values. 

Results

The Congressional Budget Office identified three published analyses that simulate the effects of both emissions 

pricing and R&D.2

 While CBO recognizes the limitations of those modeling efforts and does not endorse any 

specific quantitative results, those models suggest that a 

combination of the two approaches—pricing emissions 

in the near term and funding R&D—would be necessary 

to reduce carbon emissions at the lowest possible cost. 

Further, they suggest that the largest gains in efficiency 

are likely to come from pricing emissions rather than 

from funding R&D. The simulation results described 

below reflect policies that are implemented at the global 

level.

One modeling effort concluded that the net benefits resulting from an R&D policy that balanced the costs and 

benefits of R&D efforts would be less than half of the net 

benefits that would result from an efficient carbon tax 

policy with no R&D subsidies.3

 Further, that effort 

found that the R&D policy would not reduce the benefits of near-term pricing of carbon because it would not 

reduce the value of near-term reductions in emissions. 

Two limitations of that modeling effort are that it did not 

examine the combined effects of the two policies, and it 

did not include an alternative energy technology (such as 

solar or wind generation); rather, R&D subsidies led to 

improvements in energy efficiency.4

A second researcher, using a model that included the possibility that R&D could improve both energy efficiency 

and an alternative energy technology, found that subsidizing R&D would provide only a small increase in net 

benefits relative to the maximum gains available if policymakers enacted only an efficient carbon-pricing policy.5

Further, the results suggested that subsidizing R&D 

would cause little change in the efficient price of emissions, or the amount of reductions, in the near term. To 

test the sensitivity of the findings to changes in assumptions, the researcher assumed that the additional R&D 

induced by subsidies would not crowd out any other research. That assumption did not change the researcher’s 

qualitative results.6

1. See Congressional Budget Office, Uncertainty in Analyzing Climate Change: Policy Implications (January 2005), for a more 

detailed discussion of the uncertainties associated with the costs 

and benefits of climate policies.

2. Those models assume that carbon pricing would stimulate less 

private investment in R&D than would be best for society given 

the existence of spillover benefits. Further, they assume that public 

funds would subsidize private R&D efforts. Their conclusions, 

therefore, do not stem from assumptions about the success or failure of federal R&D programs.

3. R&D benefits were assumed to include both spillover benefits and 

the reduction in external costs that would result from the new 

technologies. 

4. That modeling effort also estimated that an efficient tax on carbon 

emissions would lead to about twice the level of reductions in 

emissions that would result from an efficient R&D subsidy. See 

William D. Nordhaus, “Modeling Induced Innovation in Climate 

Change Policy,” in A. Grubler, N. Nakicenovic, and W.D. 

Nordhaus, eds., Modeling Induced Innovation in Climate Change 

Policy (Washington, D.C.: Resources for the Future Press, 2002). 

Nordhaus assumes that technology improvements are exogenous 

in the carbon-tax-only case. 

5. Net benefits increased by 7 percent when R&D subsidies were 

added to a carbon-pricing policy. See David Popp, “Entice-BR: 

The Effects of Backstop Technology and R&D on Climate Policy 

Models,” Energy Economics, vol. 28 (2006), pp. 188-222. Popp 

does not report the change in efficient prices and emissions reductions under the sensitivity analysis. Another analysis (which did 

not include a backstop technology) by Popp found that the net 

benefits associated with an efficient R&D subsidy were only 11 

percent of the maximum gains available with an efficient carbonpricing policy and an efficient R&D subsidy. In contrast, the net 

benefits associated with the carbon-tax-only case were 95 percent 

of the potential maximum gains. To test the robustness of his 

results, Popp assumed that the returns to energy R&D were twice 

as high as the returns to other forms of R&D, and under that 

assumption he still found that the net benefits of an efficient 

R&D strategy would amount to less than 55 percent of the potential gains from the combined pricing/R&D subsidy approach. See 

David Popp, R&D Subsidies and Climate Policy: Is There a >Free 

Lunch=? Working Paper No. 10880 (Cambridge, Mass.: National 

Bureau of Economic Research, October 2004).

6. Under that assumption, Popp found that an R&D subsidy would 

increase potential net benefits by an additional 30 percent.
CHAPTER THREE THE EFFECTIVENESS OF POLICY APPROACHES 17

A third modeling effort examined the ability of carbon 

pricing and R&D subsidies to minimize the cost of 

achieving a specific reduction in carbon emissions—in 

this case, 15 percent—rather than to maximize net benefits. That effort concluded that carbon pricing would 

achieve the target at a significantly lower cost than would 

an R&D subsidy for alternative energy sources. The cost 

of achieving the reductions with a carbon tax was roughly 

11 percent of the cost of achieving the reductions with an 

R&D subsidy. Further, combining both policies would 

reduce the cost of achieving the emissions target by only 

9 percent when compared with the cost of reaching it 

with only a carbon tax.7

Those models suggest that pricing emissions would contribute more to minimizing the cost of reducing emissions than would subsidizing investments in R&D. 

Given the uncertainties described above and the global 

nature of the simulation models, the quantitative results 

of such models should be viewed as very imprecise and 

corresponding conclusions about domestic policies 

should be made with caution. However, the qualitative 

finding that a cost-effective approach to reducing 

emissions would entail both funding R&D and pricing 

carbon in the near term is likely to be robust for several 

reasons: 

B At any point in time, there is a cost continuum for 

emissions reductions, ranging from low-cost to highcost opportunities. Unless R&D efforts were to virtually eliminate the value of near-term reductions in 

emissions, waiting to begin initial pricing (to encourage low-cost reductions) would increase the overall 

long-run cost of reducing emissions. Given reasonable 

assumptions about the costs of and gains from nearterm R&D, the possibility that R&D would eliminate 

the value of near-term emissions reductions appears 

unlikely.

B Both pricing emissions and funding R&D would impose costs on the economy. Consequently, reducing 

emissions in the most cost-effective way would entail 

balancing the costs—and the expected payoffs—of 

both policies.

B Analyses that consider the costs and benefits of both 

carbon pricing and R&D all come to the same qualitative conclusion: near-term pricing of carbon emissions 

is an element of a cost-effective policy approach. That 

result holds even though studies make different assumptions about the availability of alternative energy 

technologies, the amount of crowding out caused by 

federal subsidies, and the form of the policy target 

(maximizing net benefits versus minimizing the cost 

of reaching a target). 

The models described above are not well suited to account for the possibility that greenhouse gases could 

build up to a critical level, or threshold, in the atmosphere and thus could trigger a rapid increase in damages. 

Some analysts suggest the potential existence of such a 

threshold could call into question the value of making 

near-term reductions using existing technologies. In order 

to avoid passing such a threshold, it may be necessary 

to develop fundamentally new technologies that could 

provide a large share of the world’s energy needs without 

releasing carbon or that could sequester similarly large 

shares of carbon emissions. Near-term pricing of emissions would impose costs on the economy but would 

not ultimately prevent any such threshold from being 

crossed—and large-scale damages from occurring. However, near-term pricing could have substantial value even 

under such circumstances. That value could stem from 

three sources:

B Near-term reductions in emissions could delay the 

crossing of a critical threshold and thus the point at 

which severe damages might occur. That delay has intrinsic value because the farther in the future that 

damages occur, the less value they have in the 

present.8

7. See Stephen H. Schneider and Lawrence H. Goulder, “Achieving 

Low-Cost Emissions Targets,” Nature, vol. 489 (September 1997), 

pp. 13-14. In addition, those researchers demonstrated that the 

merits of a tax and of R&D subsidies are sensitive to the magnitude of prior distortions created by existing subsidies to R&D for 

alternative and fossil-fuel-based energy. A carbon tax can help 

undo, or exacerbate, an existing imbalance between incentives for 

R&D on alternative and fossil fuels. Further, the desirability of 

subsidizing R&D on alternative energy technologies depends not 

only on the existence of knowledge spillovers from such research, 

but on the magnitude of those spillover benefits relative to spillover benefits from R&D in other sectors and on whether a carbon 

tax is in place. See Lawrence H. Goulder and Stephen H. 

Schneider, “Induced Technological Change and the Attractiveness 

of CO2 Abatement Policies,” Resource and Energy Economics, vol. 

21 (1999), pp. 211-253. 

8. Future damages are discounted to reflect the fact that, in a growing economy, future generations would have more resources with 

which to address such damages. 
18 EVALUATING THE ROLE OF PRICES AND R&D IN REDUCING CARBON DIOXIDE EMISSIONS

B Near-term reductions in emissions could allow time 

for fundamentally new technologies to be developed 

and put in place. That additional time could be essential to avoid crossing a critical threshold, given that the 

timing, and eventual outcomes, of R&D efforts are 

highly uncertain and that the process of putting new 

energy systems in place could be slow and costly.

B Near-term pricing could motivate current reductions 

in emissions whose cost is less than the present value 

of the expected (but uncertain) cost of reducing emissions using future technologies. 

Limitations

Determining the appropriate mix of policies to address 

climate change is complicated by the fact that future policies would be layered on a complex mix of current and 

past policies, all of which affect the use of fossil fuels and 

their alternatives. Current policies subsidize the production and use of both fossil fuels and their alternatives. In 

addition, other existing federal, state, and local policies 

influence decisions about fossil fuels in less direct ways. 

While those existing policies serve other objectives, they 

also influence current and future carbon emissions. 

The models that estimate the costs and benefits of pricing 

carbon emissions do not account for existing policies, and 

it is unclear how the quantitative conclusions of those 

models would be altered by their inclusion. The qualitative conclusion that a gradually increasing price on carbon emissions is likely to help minimize the costs of reducing carbon emissions is likely to be robust. No current 

policy attaches a cost to all fuels on the basis of their contribution to climate change; as a result, firms, households, 

governments, and other organizations do not face an incentive to take those costs into account in their production and consumption activities. 

The picture for federal subsidies for R&D is also complex. New technologies are eligible for patents and are 

currently subsidized through general tax credits for R&D 

expenses. In addition, the federal government provides 

direct funding for some low-carbon energy sources, such 

as solar, nuclear, and wind power. Determining whether 

the magnitude of those subsidies, or the design and direction of the federal subsidy program, is appropriate is beyond the scope of this paper. To the extent that there 

are additional spillover benefits from R&D on carbonreducing technologies, providing additional subsidies for 

R&D could be efficient.9 Further, in the absence of carbon pricing, an R&D subsidy for carbon-reducing technologies could be justified by the external costs of carbon 

emissions; however, an R&D subsidy would offer a less 

direct method of reducing those external costs. 

Administering a carbon-pricing program or initiating a 

larger R&D program for carbon-reducing technologies 

would entail costs. A full accounting of policy costs 

would entail weighing those administrative costs against 

the increase in net benefits that the policy would create. 

Available research indicates that the costs of implementing a carbon cap-and-trade program, or a tax on carbon 

emissions, are likely to vary significantly depending on 

where the cap, or tax, is placed. Placing the cap, or tax, 

upstream—on fossil fuel producers and importers—

could minimize program costs. An upstream design could 

also provide incentives for firms to sequester carbon, as 

well as reduce their emissions, but the costs of implementation would probably be higher.10

Further, the models described above assume that policies 

are implemented in a perfect fashion. For example, they 

assume that a carbon tax would equalize the costs of reductions in emissions across all sources at a given point 

and would, in the absence of spillover benefits, lead to 

efficient investments in new technologies. In the case of 

R&D subsidies, they assume that federal subsidies would 

augment private R&D efforts up to the efficient point, 

with no distortions in the type of research that would be 

conducted, and that once the new technologies were developed, their cost savings would be fully captured. In re9. In the absence of additional R&D subsidies, relatively large spillover benefits from R&D on carbon-reducing technologies could 

also reduce the economic costs of a carbon tax. By redirecting 

research toward those technologies, the carbon tax would both 

internalize the costs of carbon emissions and help reduce the 

under-funding of private research efforts (due to unaddressed 

spillover benefits) in that area. For a discussion of that point, see 

Goulder and Schneider, “Induced Technological Change and the 

Attractiveness of CO2 Abatement Policies.” Further, if spillover 

benefits (what remained after accounting for existing subsidies) 

are small for R&D on carbon-reducing technologies (relative to 

other types of R&D), then providing additional subsidies for 

R&D on carbon-reducing technologies could be inefficient in that 

it could crowd out higher-valued research in other areas.

10. For a discussion of implementation issues, see Congressional Budget Office, An Evaluation of Cap-and-Trade Programs for Reducing 

U.S. Carbon Emissions (June 2001) and CBO’s Comments on the 

White Paper “Design Elements of a Mandatory Market-Based 

Greenhouse Gas Regulatory System” (March 12, 2006). 
CHAPTER THREE THE EFFECTIVENESS OF POLICY APPROACHES 19

ality, both policies would fall short of that theoretical 

ideal. 

Finally, this study discusses policies designed to reduce 

carbon emissions in the United States. However, the 

causes and consequences of climate change are global, 

and the most cost-effective mitigation policies would require coordinated international efforts. Policies designed 

to promote low-cost reductions in emissions in rapidly 

developing countries, such as India and China, will be an 

important part of the policy mix for addressing climate 

change, though they are not addressed in this paper. If a 

domestic carbon-pricing program led to significant increases in the prices of U.S.-produced goods that were 

not matched by other countries, then carbon-intensive 

industries might choose to relocate to countries that do 

not have similar restrictions, diminishing the effectiveness 

of a U.S. carbon-pricing program. Adjusting the cap or 

tax to offset those effects could increase the cost of administering the program. Conversely, the establishment 

of a U.S. carbon-pricing program could affect the incentives of other countries to adopt similar restrictions. 

Moreover, successful domestic R&D efforts would lower 

the costs of reducing carbon emissions in other countries 

as well as within the United States. The extent to which 

those new technologies would be deployed at home and 

abroad would depend on whether incentives to reduce 

carbon emissions were put in place, or whether they 

could be cost-effective for other reasons, such as by providing energy at a lower cost than existing fossil fuel 

sources. 




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