Energy is a double market failure

Moving down the R&D chain to concrete technological solutions that are designed for direct implementation by businesses—for example, a cleaner production method—one might think that a market-based platform could actually serve as a good incentive mechanism. After all, such technological solutions may be readily and easily commercialized. Yet, even in this context, it appears that patent incentives cannot adequately promote the development of climate change technologies, as market demand tends to significantly underrepresent the social value of green products and processes.

The reason why a systematic gap between market demand and social value exists in this context has to do with the fact that a cleaner environment constitutes a public good, from which we all benefit, whether we contributed to it or not.121 Thus, just like pollution is a classic example of a negative externality,122 acting in an environmentally responsible manner often has positive externalities.123

Consider, for example, a manufacturing firm that debates whether to implement a new technology designed to reduce the amount of greenhouse gas emitted during production. Beyond any direct benefits that the firm might reap as a result of implementing such a technology,124 by positively impacting the state of the environment, this step could also have substantial beneficial effects on numerous third parties.125 Yet, in making its decision whether to purchase and implement such a technology or not, a profit-maximizing firm is likely to focus predominantly on its direct costs and benefits, while failing to account for such indirect benefits to others.

The costs involved in implementing a climate change technology may include purchasing or licensing fees, significant switching costs, and ongoing increased costs of operation.126 Despite these costs, a firm could still find it beneficial to green its operations. First, it may choose to do so to comply with regulation or reduce its environmental costs and liabilities.127 In addition, in certain instances, a firm may decide to switch to a greener technology in order to satisfy the preferences of its consumers.128 Such a decision may also be based more generally on considerations of public relations,129 or on the firm’s attempt to comply with its own corporate social responsibility (CSR) policy.130 Finally, some corporate executives may act, at times, out of genuine concern for the environment, even when it does not seem to align with the short-term goals of the firm.131 Nevertheless, in most cases, a profit-maximizing firm is not likely to assign a significant weight to the indirect benefits that others may derive from the positive impact of its actions on the state of the environment.132

Hence, as a general matter, businesses would not be willing to invest in green technologies equal to an amount reflecting the social value of such technologies. Notably, this would impact both the level of demand by industrial firms for environmental innovative solutions developed by others and the incentive of such firms to engage in user innovation designed to “green” their own operations.133 Overall, the aggregate signal produced by the patent system, in its reliance on market demand, is not likely to incentivize the development of climate change technologies designed to be implemented by businesses at a socially optimal level.134

The challenge we face here is, in essence, a “double market failure.”135 One market failure has to do with the public good characteristics of knowledge, as a result of which an inventor may not be able to appropriate a large enough share of his or her invention’s market value.136 The patent system is designed to resolve this market failure by granting inventors exclusivity over their inventions.137 Yet, another market failure, which plays a role in this particular context, has to do with the public good characteristics of the state of the environment. As a result of this market failure, the invention may fail to have a significant market value, to start with, and this is something that market exclusivity cannot help resolving. In other words: “Pollution creates a negative externality, and so the invisible hand allows too much of it. Technology creates positive externalities, and so the invisible hand produces too little of it.”138 Innovative technologies for pollution reduction are thus “doubly underprovided by markets.”139