Innovating for an Uncertain Market: A Literature Review of the Constraints on Environmental Innovation

This paper aims to summarize the state of academic knowledge surrounding the economics of environmental innovation. Following a definition of environmental technology, the paper enumerates and describes the obstacles or constraints to the development of eco-innovation. Key Findings: • Many of the challenges to innovation in general are mirrored and exaggerated in eco-innovation. • Environmental innovation is fraught with uncertainty: uncertainty about the end-product of a research process, uncertainty about the reception by the market, uncertainty about the ability to appropriate the returns to research while competitors try to produce similar results, and uncertainty about regulatory impacts on the research process and end-result. In addition, there is frequently uncertainty surrounding the pricing of competing as well as complementary goods. • On the other hand, uncertainty itself often stimulates innovation. Policymakers may very well be conflicted about how much structure to provide for innovators, if they truly thrive on some degree of uncertainty. This is further complicated by the fact that the appropriate policy response undoubtedly differs by industry, by technological problem, and even by time period. • This review of economic studies reveals five themes which affect the development of eco-innovations: intellectual property rights (e.g. patents), economies of scale, markets and incentives, system complexity and policy choices. • While developing nations frequently claim that strong intellectual property rights on carbon abatement technologies hinder developing countries’ greenhouse gas abatement efforts, it has been shown that IPRs do not constitute as significant a barrier as claimed since a variety of technologies exist for reducing emissions. In many cases, IPR-protected technologies are not necessarily more costly than those not covered. • Numerous studies have documented the reasons to encourage strong patent law. There is near universal agreement among economists that strong intellectual property rights are an essential prerequisite to the development of environmental technologies. Moreover, most firms indicate that IPRs are essential to the profitability of commercial research, so in its absence they simply will not commit research and development (R&D) funding to the market in question. At the same time, the value of patents, and other forms of protection, varies across industries and across innovations. • One of the challenges of sequential innovation lies in the difficulty in rewarding early innovators for the technological foundations they develop, while also allowing for the reward of subsequent innovators who improve and extend the original technology to new applications. This is particularly applicable in the context of new technologies, such as environmental technologies. • The challenge of achieving efficient scale and reducing per-unit production costs is critical to the success of most innovative products and processes. Since most innovations are subject to economies of scale (or increasing returns to scale), in which higher levels of output are associated with lower per-unit costs, larger firms may be better positioned to develop environmental technologies. • The greater the ease of development and extent to which the innovator will profit from the innovation and appropriate the benefits will both facilitate environmental innovation. However, in the case of eco-innovation, there is uncertainty about actual costs, consumer values, and policy platforms now and in the future. Moreover, the market is complicated by competing technologies (e.g.: fossil fuels) subject to negative externalities in which the user does not bear the full cost of the good. Further, the public goods nature of environmental technology prevents the user (and the innovator) from fully capturing the benefits of the innovation. • The role of federal regulations is critical to the development of eco-innovation. Environmental regulation might lead to cost-saving innovation if a) the fixed costs of innovation are lower than compliance plus production, or b) spillover effects make innovation strategically a bad idea for the firm but a good idea for society, or c) regulation helps to fix incentive problems between managers and owners, or d) regulation helps to clear information flow. • Given that knowledge has positive spillovers, benefits to those who bore none of the cost of acquisition, economists conclude that the amount of R&D provided by private markets will be lower than the socially optimal level. As such, questions emerge as to whether the returns to R&D are sufficient to encourage eco-innovation. • There is an important role for policy in the support or stifling of eco-innovation. Five themes emerge from the papers reviewed. First, there is a clear portfolio of policy alternatives to stimulate innovation or energy-related investment including taxes, subsidies, permits and standards/regulations. Second, there is strong evidence that regulatory policies can be very effective. Third, policy may serve to create a market for previously uncertain or ill-defined environmental commodities. Fourth, current policymakers are frequently unable to muster the political will to enact legislation that is pro-environmental innovation. Fifth, heterogeneity may be a desirable attribute in policy since many environmental issues are local or regional in nature, and thus require local knowledge and solutions. • Across numerous studies there are five themes which resonate with all economists as challenges to eco-innovation: intellectual property rights, economies of scale, markets and incentives, complex systems, and policy. The greatest potential for propelling innovation is usually found in market forces and incentives. Uncertainty, externalities, and subsidies to competing goods undoubtedly hinder the process, but the motivation provided by potential profit is undeniable. However, due to the spillovers associated with eco-innovation and the public goods nature of these technologies, there is a role for government intervention in order to spur an increase in environmental innovation. In this context it is essential for policymakers to find a balance: encouraging competition while guaranteeing a large market for minimum economic scale, reducing uncertainty about future resource prices while keeping alternatives open, offering rights of exclusion to intellectual property holders while not curtailing the ability of sequential innovators to build upon past successes, promoting social goals while respecting market pressures.