Choice of environmental policy in the presence of learning by doing

Many clean energy technologies have experienced rapid cost declines recently as a result of accumulating experience with their production and use. It has been argued that if this relationship between experience and cost continues in the future, then it may make sense to foster market penetration of clean energy technologies on a large scale today, despite their current high costs, in order to drive down their costs in the future. If the magnitude of cost declines is sufficient, then rapid large-scale diffusion of clean energy technologies could even provide discounted social benefits that exceed discounted social costs. However, private firms may not make these investments even when socially beneficial since knowledge gained from investments spills over to other firms, and also because private firms have imperfect foresight about cost declines resulting from learning by doing investments. In this case where diffusion of clean energy technologies would provide a social net benefit, but where private firms are unwilling to invest, it may make sense for a government to adopt a regulatory approach aimed at forcing diffusion of clean energy technologies. This paper tests this hypothesis using the criteria of economic efficiency and finds that such a conclusion is unwarranted in most circumstances-in stead of forcing diffusion through regulatory instruments, government should seek to correct externalities using market-based instruments. In practice however, government chooses policy based on a broader set of criteria, including especially political acceptability. Our analysis shows that in many cases, regulatory instruments are only slightly more expensive than market-based instruments. For this reason, even though regulatory instruments may be more expensive than comparable market-based instruments, they may still be superior when evaluated using multiple attributes like political acceptability. (c) 2006 Elsevier B.V. All rights reserved.