Would a Carbon Tax Spur Innovation?

Megan McArdle weighed in yesterday on a debate between Jim Manzi and Ryan Avent on whether carbon taxes (or their equivalent) can spur innovation. Their fight centers largely on whether high gasoline prices in Europe have spurred innovation in the transportation sector. The weight of evidence suggests that the impact has been marginal.

But focusing on transportation distorts the analysis. The cost gap between traditional internal combustion engines and alternative vehicles is huge, while the carbon content of gasoline is relatively small. Even a (politically implausible) $100 per ton carbon tax would increase gasoline prices by only a dollar. No one should be surprised that you don’t get much innovation from that.

Electricity generation, in contrast, is far more price sensitive. A host of near-competitive options already exists. A $100 carbon tax, meanwhile, would more than double the cost of coal-fired electricity, creating big incentives for those who can deliver alternatives. There is thus much more reason to expect a carbon price to drive innovation in electric generation than in transportation.

To be sure, there are countervailing factors. Electric generation assets tend to turn over very slowly – they can be in place for fifty years or more. That makes it harder for any private innovator to capture returns on its investment before others copy it. Many generation assets are also very expensive. That increases the risks for any innovator too. Cars and trucks, in contrast, are replaced more often (though still infrequently compared to typical high-tech products) and are cheaper to test out in the market.

The bottom line, though, is that resolving arguments about the efficacy of carbon pricing by focusing narrowly on transportation is a mistake.