Environmental policy and incentives to adopt abatement technologies

In this theory model, we compare a carbon tax and a cap and trade mechanism in their propensity to induce carbon-reducing technological adoption, when investments are undertaken under uncertainty on the demand and/or on the input cost sides. In our setting, firms affect the variance and the correlation of the shocks they are exposed to through their technological choice, making uncertainty endogenous. We analyze a two stage game, under two alternative environmental regulations: carbon tax and cap and trade. The timing of the game is as follows. In stage one, before the state of the world is revealed, each firm chooses whether or not to adopt the low-emissions technology. Adopting firms incur a fixed cost F. Subsequently, in the interim stage, the state of nature is revealed, and uncertainty is resolved. In stage two, firms select the optimal amount of final goods production, and, under cap and trade, the permits market clears. We find that uncertainty associated to a given technology always increases its expected profits under a carbon tax, while under a cap and trade system this is the case only as long as the shocks are not correlated across the firms; if, instead, shocks are perfectly correlated, uncertainty has no impact on profits. As a result, we show that, while under a carbon tax, all of the firms tend to have the same behavior in equilibrium (either of adoption, or non adoption), a cap and trade system induces asymmetric adoption. Finally, we discuss several policy applications of our work, including an analysis of the effects of combining feed-in tariffs with carbon tax or cap and trade. We find that feed-in-tariffs have a detrimental effect on technological adoption when associated to a carbon tax, while their effect is ambigous when associated to a cap and trade mechanism.