R&D Subsidies
Reducing carbon emissions

Carbon dioxide emissions may cause global warming. In Discussion Paper No. 1064, Diderik Lund considers the interplay between carbon dioxide emissions and research and development (R&D) in a model where the latter can operate in different directions. Successful R&D may result in a firm producing the same output as before with less input, the `cost saving' effect. But if output increases, then use of the input may actually rise above the previous level, the `profit maximisation' effect.

Governments will seldom be able to distinguish ex ante between R&D which yields increased use of fossil fuels and R&D with the opposite effect. Thus, a realistic restriction is that the authorities can only use a uniform rate of R&D subsidization. A desire to encourage one kind of R&D and discourage another will create the need for a tax on emissions (a carbon tax), or give rise to an additional term in the formula for an optimal carbon tax. The author finds that a small nation's own emissions have negligible effects, and as a result it may regard carbon taxes as distortionary. Such taxes may have other effects, however. When R&D has positive external effects, carbon taxes may correct for some of these, by giving incentives for R&D in particular directions. This may be beneficial when the nation faces a binding international agreement on reducing emissions in a future period. This effect is analysed, for a case with a carbon tax alone, and for two different cases with R&D subsidies as well. Lastly, a different international agreement is considered, under which tax revenue is collected domestically.

Can a Small Nation Gain from Introducing a Carbon Tax Early?
Diderik Lund