National governments set environmental targets and conduct negotiations in terms of total levels of emissions of given pollutants. Environmental innovations which reduce the emissions/output ratio through process upgrading or abatement technologies are critical to the achievement of given emission targets without curbing output and to easing the trade- off between environmental protection and economic growth. Governments can induce such innovations through emission taxes or charges, tradable permits, subsidies and command-and-control regulations concerning technologies.

In Discussion Paper No. 525, Research Fellow Carlo Carraro and Domenico Siniscalco examine the impact of international competition on policies to control industrial pollution related to the production of tradable goods. They develop a model of one polluting industry in an open economy under perfect competition and various forms of oligopoly. A national government seeks to reduce total emissions by specifying a permissible emissions/output ratio for domestic firms, but foreign governments impose no such standards on their own firms. Domestic firms achieve the required standard through costly, emission- reducing technological changes, which may include the environmental upgrading of production processes or add-on, `end- of-pipe' abatement technologies. Information is asymmetric, since the individual firms know their own emissions/output ratios but the government does not.

Carraro and Siniscalco find that international competition implies that costly environmental innovations imposed by a national government require appropriate subsidies, while other instruments such as taxes, permits or regulations distort competition and may lead to de-industrialization. Such optimal subsidies must take account of market structure and differences in the emissions/output ratios of individual firms and must also embody a self-selection mechanism to induce firms to reveal their environmental characteristics: otherwise, all firms will claim to have `dirty' technologies and demand the maximum subsidy. The need for a subsidy can be eliminated through the international coordination of environmental innovation policies, so countries with similar aims stand to gain from policy coordination even if there is no cross-border pollution.

Carraro and Siniscalco conclude that the explicit consideration of international competition influences and may even reverse the optimal choice of instruments available to policy-makers wishing to pursue national environmental targets within an integrated economic area. In conclusion, they propose extending their analysis to incorporate a stochastic relationship between R&D and the reduction of emissions and the diffusion of innovations. If such environmental innovations could be patented and sold, the subsidy could be transformed into a loan, which would benefit the first country to adopt the policy.

Environmental Innovation Policy and International CompetitionCarlo Carraro and Domenico Siniscalco

Discussion Paper No. 525, April 1991 (IT)