To mitigate global warming with catastrophic consequences, it is crucial to reduce carbon dioxide emissions significantly. But right now, governments and companies are in a bind when it comes to figuring how to accomplish that.
One reason is that while reducing one's emissions is good for all, it is individually costly: reducing emissions is a positive externality. And it’s a challenge to get companies to provide positive externalities, since it brings down their profits. They’re not necessarily going to do it without government pressure, whether it’s immediate or something that’s anticipated down the road.
You might think that the government could simply fix everything by putting hard caps on companies’ carbon output. In reality, though, government power tends to be limited by political pressures and concerns about how regulations will affect the economy.
Additionally, while government regulators have the ability to measure companies’ carbon emissions, that’s just the end result. It’s tougher for them to monitor the investments in green technologies necessary to achieve emissions reduction because it takes time for those investments to lead to innovations that cut carbon output. It’s unlikely that public-sector intervention will fully substitute for insufficient action by private companies. At the same time, it can’t be taken for granted that private sector initiatives will be enough without a degree of government involvement.
This is a serious dilemma because, as we write in our paper, there’s a real risk of insufficient investment in green technologies, which would mean that we won’t curb excessive CO2 emissions.
Is there a way for the private and public sectors to interact so that the necessary investments will be made in green technologies to reduce carbon emissions? We developed an analytical model to answer that question and found that there is indeed a way out of this quandary.
A Self-Fulfilling Prophecy
Governments are pragmatic. What they do in the long term depends upon what will be realistic at some point in the future. But what will be realistic in the future, in turn, depends upon the choices that companies make now.
Companies are also pragmatic. Anticipation is a big part of decisions on investments in technology. Waiting for the other part (the government or the company) to do the first step is sort of a chicken-and-egg situation.
Our analysis shows that when it comes to making decisions about investing in carbon-reducing innovations, companies’ expectations of what the future will be like actually help make it a reality. Here’s how that works. If companies anticipate that caps will be imposed in the future, they will invest now in green technologies so that they are prepared and ahead of the curve when that day comes. What happens, though, is that some companies’ decision to invest in green technology changes the future for everybody, even for other businesses that didn’t make the same sort of commitment. That’s because the investments have positive spillover effects, lowering the aggregate cost of technology for emission reductions.
And when green technology becomes cheaper, the government is more likely to impose emissions caps because regulators can do it without imposing that much economic hardship on companies.
Governments need companies to invest in green technologies to make regulation possible
Now consider a second scenario, in which companies expect that government, for whatever reasons, won’t impose emissions caps. As a result, the companies decide not to invest in green technology.
That puts the government in a difficult situation, because if it imposes emissions caps and it’s too difficult and/or expensive for companies to comply, that could cause jobs to be lost and share prices to plunge on the stock market. Many economists agree that the government will have to impose tough regulations at some point. It’s just that they can’t do it too fast because it could be damaging to the economy.
For things to work, we need companies to invest early in green technologies and, at the same time, for the government to impose emissions caps
For things to work, we need companies to invest early in green technologies and, at the same time, for the government to impose emissions caps. Neither party must go it alone. Instead, the situation requires what we describe in the paper as “equilibrium complementarity,” in which the private and public sector actions have a synergistic effect.
A single investment fund could tip the balance
The study also found that a single player can have a disproportionately large influence on the outcome. A single large investment fund on the scale of BlackRock or Vanguard, or a coalition of investors committed to Environmental, Social, and Governance (ESG) values, could do it. If that big player engages with companies to foster investment in green technology, that could end up tilting the equilibrium toward emissions caps.
It’s important to mention again, though, that in the model we developed, there’s no irrationality. Often, people assume that with ESG, there’s a preference for green companies or that the market isn’t pricing climate risk correctly. Therefore, investing in green companies can make money or improve risk management and risk-averse returns. However, we’re using very standard preferences—companies that try to maximize their proceeds and investors who try to maximize profit. So basically, the baseline model is very simple and rational. We also are factoring in a political economy with a constraint, which is that 10 years from now, governments will only apply laws or regulations that are reasonable in terms of costs to the economy.
How to use the model
The model developed for this study is very generic and conceptual, and it applies to any industry where innovative technological processes for carbon reduction will need to be created through research and development, as opposed to just buying technology that’s out there and implementing it. One important takeaway from the study is that anticipation of regulation is probably the key element in deciding what is rational or not rational for a company to do. Companies need to investigate and think seriously about the plausible path for future regulation and the potential risk of going one way or another.
