Balancing Upside and Downside

1
Balancing Upside and Downside

• Question what is more important that the upside
  potential of making research investment is
  increased by virtue of the fact that other firms
  have banked, or that the downside risk of loss
  associated with not making the research
  investment is decreased by virtue of the fact
  that other firms have banked?
• Answer the decrease in downside risk is more
  important, if we assume managerial risk aversion
  on part of firm managers, which is a generally
  accepted assumption
• Why are managers generally risk averse no
  portfolio diversification in human capital

2
And on and on

• We may observe even less investment if other
  firms understand that their having banked makes
  Firm X less likely to invest, since that
  understanding will make them even less likely to
  invest, and Firm Xs recognition of that fact
  will make it even less likely to invest, which
  will make the other firms even less likely to
  invest, and so on.

3
Objections

• Why cant firms outside polluting industry be the
  source of new pollution control/reduction
  technology?
• Perhaps they can but industry actors have special
  knowledge
• Historical record suggest regulated, polluting
  firms often key source of pollution
  control/reduction innovations (e.g., car
  industry).

4
Objections co.

• Isnt banking a temporary problem anyway,
  reflecting only market immaturity?
• Maybe, to some extent depend on why firms bank,
  we have limited empirical analysis

5
Objections co.

• Doesnt banking actually facilitate innovation by
  making pollution reductions through
  overcompliance more appealing?
• Yes banking has both pro-innovation and (I
  argue) anti-innovation effect the question is
  how they balance.
• Pro- and anti-innovation effects operate
  differently as a temporal matter the fact that
  firms have banked in the past deters innovation,
  but the prospect that firms can bank in the
  future has a pro-innovation effect. All we can
  really say for sure is that the more banking on
  net has occurred in the past, the stronger the
  anti-innovation effect will be relative to the
  pro-innovation effect.

6
Possible Implications

• We should study levels of innovation in trading
  markets/regimes with different banking rules to
  test hypothesis that unlimited banking may result
  in less innovation than limited banking
• Admittedly, hard to structure study relatively
  few trading regimes, all different in many
  respects,
• Also hard to identify changes in banking rules
  within a trading regime so its difficult to do
  before-and-after studies of innovation rates
  and/or quality of innovation

7
Possible Implications, co.

• Even if we cant empirically assess significance
  of bankings anti-innovation effect, or can do so
  only very crudely, maybe the possibility that
  banking can deter innovation is enough to justify
  efforts to reduce some of the forces leading
  polluting firms to bank large numbers of
  allowances.
• For example, (1) government could engage in more
  post initial allocation auctions to enhance
  allowance market liquidity and lower
  purchase/sale transaction costs, (2) changes in
  tax treatment to make bank or sell decision a tax
  neutral one