Induced Innovation Promotes Climate Change Adaptation

As climate change unfolds, billions of people will be seeking cost-effective strategies for dealing with the consequences of heat waves, draught, sea level rise and increased natural disaster risk. We will be seeking to consume more electricity (because summer temperatures will rise in many areas around the world), more water (because of climate change’s impact on drought conditions) and facing the challenge of sea level rise. This anticipation of our collective demand for new strategies to adapt creates enormous economic opportunities for entrepreneurs. While the belief in “technological optimism” can border on wishful thinking, it is highly likely that profit seeking entrepreneurs who will have more than twenty years to bring these products to market will be ready as climate change’s blows heat up.

Over the last ten years, environmental economists have devoted substantial effort to investigating the induced innovation hypothesis. Empirical economists have noted an interesting fact. When gas prices go up, car manufacturers subsequently start selling more fuel efficient vehicles. When electricity prices go up, firms start selling more energy efficient appliances. More generally researchers, such as David Popp, have documented that energy related patenting rises during times when energy prices are high. The induced innovation hypothesis posits that as the price of an input of production rises, cost minimizers will substitute away from this factor. Intuitively, as the price of gasoline goes up, more people want to buy the Toyota Prius rather than the Hummer and auto makers will shift their portfolio of vehicles offered and direct their research labs towards designing fuel efficient vehicles.

In the case of climate change this is important, because climate change is likely to lead to higher prices for electricity and water and this will induce innovation to economize on these increasingly scarce resources. For example, if climate change exacerbates drought conditions in the US’ Southwest then water prices will rise. Households will seek more water efficient appliances and the market will have an incentive to supply them. In this sense, climate change will create new market opportunities.

The anticipation that cities will be at risk from climate change encourages innovation. My UCLA colleague Thom Mayne is working with Brad Pitt in New Orleans to design floatable homes that could be sold for less than $200,000. These homes are intended to allow residents to literally float in the midst of the next Hurricane Katrina.
See http://today.ucla.edu/portal/ut/float-house-now-a-home-in-katrina-171762.aspx . Regardless of whether he is working on this project due to altruism or because he is hoping to get rich, the net effect of such efforts is that future Katrinas will have less of an effect on the coastal urban population. Climate change will create numerous such opportunities for entrepreneurs.

The billions of people who will be affected by climate change create a large market opportunity for entrepreneurs. Acemoglu and Linn (2004) demonstrate that the extent of the market for new drugs triggers endogenous innovation. In the presence of fixed costs to developing new products, the scale of the market is a key determinant of whether firms design new products. If there is only one bald man in the world, then no drug company will develop an anti-baldness medicine while if there are 1 billion bald men who are willing to pay for a cure then many drug companies will try. This same logic holds in the case of climate change. If billions of people seek an energy efficient air conditioner to offset hot summers, then there will be sharp incentives to invest in developing such products. Some of these producers will succeed.

While many environmentalists rail against “globalization”, global trade in new products will help to protect the poor around the world from climate change. To protect the poor, they need to consume more electricity. If renewable energy innovation takes place and energy efficient durables are developed, then we can achieve the “win-win” of helping the poor to adapt to climate change without further exacerbating greenhouse gas mitigation efforts.

My optimism over the beneficial role that innovation can play is tempered if climate change is abrupt. There is a “time to build” component to designing new products and achieving economies of scale in production and workers developing the specialized knowledge to cheaply mass produce them.

Interesting legal issues are likely to arise concerning intellectual property that will resemble issues of exporting patented drugs to developing countries. If the innovative nations do not believe that they can collect revenue from poor countries (who will reverse engineer the intellectual property once it exists) how much does this expectation diminish upfront R&D investment? From an equity standpoint, one might wish that such innovators make enough profit from selling their products to the developed world at a relatively high price and then sell their product at a much lower price in the developing world.