Optimal climate policy under exogenous and endogenous technical change: making sense of the different approaches

How does technical change affect economically optimal emission trajectories? Many low-carbon technologies, such as photovoltaic (PV) cells, wind energy and batteries, have become much cheaper in recent decades. Technical change can be an argument to postpone emission abatement, to wait for technology to become cheaper. Conversely, it can be an argument for earlier abatement, when abatement itself is the driver of future cost reductions. Whether technical change means prioritising or postponing emission abatement also depends on the economic objective. This can be either cost-benefit analysis, where the goal is to find a welfare-maximising balance between abatement costs and avoided climate damages (benefits); or it can be cost-effectiveness analysis, where the objective is to minimise abatement costs to stay below a given temperature.

In this paper, the authors assess, both qualitatively and quantitatively, the effect of technical change on optimal climate policy in integrated assessment models (IAMs), which provide key inputs to decision-makers for economically efficient climate policies. They also develop a transparent model to represent the key features of technical change and reproduce how costs differ between scenarios with early vs. later abatement.

Key messages for decision-makers

• Technical change is one of the key assumptions in any IAM that estimates mitigation costs. By conducting a systematic survey of how technical change is currently represented in the main IAMs, the authors find that a diversity of approaches continues to exist. This makes it important to conduct an up-to-date assessment of what difference technical change can make to IAM results.
• The effect of technical change on carbon prices differs markedly depending on whether it is a function of time, i.e. exogenous, or cumulative past emissions abatement, i.e. endogenous, and if clean technology deployment is incentivised by carbon prices or a dedicated deployment subsidy.
  • Deployment of abatement technologies brings down their cost and is referred to as endogenous technical change because the process does not happen without climate policy, such as the declining cost of PV cells. This can be through learning-by-doing, economies of scale, R&D that requires feedback from deployment, etc.
  • When cost reductions are unrelated to the deployment of a technology, the process is called exogenous, resulting in the technology improving through the passage of time; for example, the development of lithium-ion batteries for smartphones, which was helpful for the development of electric cars.
• Under cost-benefit analysis, technical change reduces optimal long-term emissions and temperature substantially.
• Under cost-effectiveness analysis, technical change has a small effect on transient emissions and temperatures, but it has a large, negative impact on carbon prices almost irrespective of the policy instruments available.
• Fast exogenous technological change creates an incentive to abate later, with less initial abatement, as the reduced abatement costs in the future are anticipated.
• By contrast, fast endogenous technological change has almost no effect on initial abatement because cheap future abatement depends crucially on early abatement – and the policymaker anticipates this. Each tonne of abated emissions will make future abatement even cheaper, referred to as the ‘endogenous future gain effect’.
• This endogenous future gain effect is excluded in 18 of the 22 models studied in our survey. Adding the endogenous future gain incentive in these models would lead to earlier optimal abatement.
• Early-stage R&D into green technologies, for which deployment is not yet required, theoretically has the same dynamic properties as exogenous technical change, even though it is developed in anticipation of future abatement.