Instrument choice for environmental protection when technological innovation is endogenous

This paper compares, qualitatively and quantitatively, the welfare effects of emissions taxes, auctioned emissions permits, and free (grandfathered) permits, when technological innovation is endogenous. We find that there is no unambiguous case for preferring any of these policy instruments. The relative welfare ranking of instruments depends on the costs of innovation, the extent to which innovations can be imitated, the slope and level of the marginal environmental benefit function, and the number of polluting firms. We illustrate the types of situations when there can be significant welfare discrepancies between the policies and when there are not.