Directed technical change and differentiation of climate policy

This paper studies the cost effectiveness of climate policy if there are technology externalities. For this purpose, we develop a forward looking model that captures empirical links between CO2 emissions associated with energy use, directed technical change and the economy. We find our most cost effective climate policy to include a combination of R&D subsidies and CO2 emission constraints, although R&D subsidies raise the shadow value of the CO2 constraint (i.e. CO2 price) because of a strong rebound effect from stimulating innovation. Furthermore, we find that cost effectiveness of climate policy improves if it is differentiated between technologies. Even our rudimentary distinction between CO2 intensive technologies and non-CO2 intensive technologies lead to this result. Such differentiated climate policy encourages growth in the non-CO2 intensive sectors and discourages growth in CO2 intensive sectors by harnessing positive effects of technology externalities on total factor productivity in the former and letting the latter bear relatively more of the abatement burden. This result is robust to whether emission constraints, R&D subsidies or combinations of both are used as climate policy instruments. (c) 2008 Elsevier B.V. All rights reserved.