Since William Nordhaus published his seminal work in 1994, economists have coalesced around the need to implement carbon taxes to address the negative externalities of greenhouse gas emissions on temperatures. Under this paradigm, properly designed carbon taxes induce firms to internalize the cost to society of their emissions, thereby restoring the socially optimal allocation. In a 2012 paper, Acemoglu, Aghion, Bursztyn, and Hemous argue that path dependencies and positive spillovers for green technologies imply that directed investment subsidies represent an ideal complement to carbon taxes in delivering the optimal transition toward environmental sustainability. Acemoglu et al. (2016) amplify that message, writing that relying on carbon taxes alone would lead to a much less efficient transition than combining taxes and investment subsidies.
As our society enters its final stretch to reach the Paris Agreement goals, a fast, efficient transition toward a greener economy is crucial. To that end, the mix and magnitude of policy instruments need to be precisely determined; as Larry Fink stressed in a recent letter:
“one of the most important questions we will face is the scale and scope of government action on climate change, which will generally define the speed with which we move to a low-carbon economy.”
Designing a comprehensive policy mix of carbon taxes and directed technological subsidies requires a thorough assessment of the relative merits of these policy instruments. What mix will lead to the best outcomes? Previous studies have relied on frameworks in which firms experience no commitment, moral hazard, or agency issues. While theoretically important, these frictionless benchmarks are not sufficiently informative for policymakers, given the broad empirical evidence documenting the importance of financial frictions in driving firm behaviors.
So, it is crucial to ask: How are the relative merits of carbon taxes and directed technological investment subsidies affected when firms face financial frictions? Do those frictions tilt the scale in favor of either of these policy instruments relative to the frictionless benchmark? We address these questions by focusing on a particular type of friction, namely limited commitment (where either party to a contract can renege on its obligation if a better outside option arises), one key element in explaining empirical evidence in firm dynamics and CEO compensation.
We develop a dynamic corporate finance model featuring limited commitment in which a risk-averse entrepreneur contracts with a risk-neutral financier to fund her project. At the outset, the entrepreneur ties the path of her firm to either a green or a dirty technology, taking as given the policies enacted by the government. The optimal contract entails a joint optimization over (a) the choice of technology (green versus dirty), (b) the entrepreneur’s compensation scheme, and (c) the firm’s investment policy. Either party can renege on the continuation contract should better outside options arise; thus, the contract must satisfy limited-commitment constraints at all times to avoid inefficient contractual termination.
Green and dirty technologies differ in two critical aspects. First, firms operating dirty technologies are more productive than their green counterparts, reflecting the head-start advantage enjoyed by dirty firms over the past century. Second, firms operating green technologies feature higher growth rates, due to growing concern for the environment and the consequent demand for environmentally friendly products and services.
Taken together, cash flows generated by green technologies are more backloaded and have a lower net present value (NPV) than those of dirty technologies. These salient facts drive the entrepreneur’s choice of technology under a given climate policy. Therefore, policymakers should incorporate this important aspect into their decision-making process. Our recent paper delivers key insights on the type and intensity of policy measures necessary for the penetration of green technologies, as well as the most cost-effective strategy in the presence of commitment frictions.
Limited-Commitment Constraints Affect the Size of Interventions
Without government interventions, market participants do not internalize the effects of their choices on the rest of the economy. Entrepreneurs choose dirty over green by virtue of dirty’s higher productivity, hence the need for regulations that compel firms to internalize their environmental impacts. In the frictionless setting, to close the wedge between green and dirty technologies, climate policies need to equalize the NPVs of cash flows they generate.
While the difference in NPVs pins down the scale of incentives needed to hasten the embrace of green technologies in the frictionless benchmark, this approach needs to be suitably modified if financial frictions are present. When the entrepreneur or the financier of a project displays limited-commitment issues, the NPV rule needs to be augmented by accounting for the differential term-structures of cash flows the two technology genres generate.
By analyzing the optimal contract between the financier and entrepreneur, we find that entrepreneurial (financier) limited-commitment constraint makes it more (less) costly for governments to encourage green technology adoption.
Under entrepreneurial limited commitment, the intuition is as follows: Since green technologies have higher growth potential (but lower initial productivity), the cash flows green firms produce are backloaded. As time passes, the green entrepreneur’s outside options grow in proportion to the size of her firm, causing the limited-commitment constraint more likely to bind, thereby making the entrepreneur more likely to default on the contract. To relax the constraint and keep the entrepreneur committed to going green, her compensation needs to be adjusted over time, but this volatility undermines risk-sharing between the financier and entrepreneur. To limit its growth, the green firm suboptimally undercuts investments, with the goal of keeping the entrepreneur’s commitment from binding. These two sources of welfare loss under entrepreneurial limited commitment imply a lower payoff to the entrepreneur at the onset if she chooses the green technology, hence rendering the dirty technology more attractive to her. Thus, when entrepreneurs display commitment issues, the required incentives to close the wedge between green and dirty technologies is higher than the difference in NPVs of the two technologies (i.e., the frictionless benchmark).
By contrast, when the financier has limited commitment, as the front-loaded dirty technology become obsolete over time due to the rise of more eco-friendly alternatives, the financier will have an incentive to walk away from his commitments to financing the dirty firm. To relax the financier’s commitment constraint, the dirty firm must drive down compensation for the entrepreneur over time, thereby compounding optimal risk-sharing, and select suboptimally high investment levels. Consequently, the financier’s limited commitment renders green technologies more desirable. In this case, the level of incentives needed to incentivize green technology adoption is lower than the discrepancy between NPVs of the two technologies.
Which Type of Policy Instrument?
Our analyses show that carbon taxes (respectively directed investment subsidies) are more cost-effective under the entrepreneur’s (respectively financier’s) limited-commitment constraint. Hence, the allocation between directed technological subsidies and carbon taxes depends on which type of commitment friction is present in the economic environment. Intuitively, subsidies designed to boost eco-friendly technologies make investment cheaper for green firms. However, entrepreneurial limited commitment makes green investments less desirable because high growth makes it harder to retain the entrepreneur in the contract, as the commitment constraint is more likely to bind. As a result, this unintended negative effect of investment subsidies undermines the appeal of green technologies.
For this reason, the level of investment subsidies needed to make clean technologies more attractive than dirty ones is significantly higher than the NPV gap between the two technologies. Put another way, because investment, by nature, delivers backloaded cash flows, and because entrepreneurial limited commitment is more problematic in such cases, directed investment subsidies for inducing the adoption of green technology become very expensive.
These results are reversed when the financier (rather than the entrepreneur) features limited commitment. Limited commitment on the financier’s side makes the subsidies needed to incentivize green technologies significantly smaller compared to the frictionless benchmark. Intuitively, financier limited commitment is more of a problem when firms’ cash flows are front-loaded. In this case, as time goes by, the remaining cash flows may result in a negative NPV, and the financier may want to renege on his contractual obligations. Investment subsidies for green firms are highly beneficial because they not only increase green firms’ NPVs by reducing the costs of investments, but also allow them to relax the financier’s limited-commitment constraint by back-loading their cash flows through higher investment rates. Thus, investment subsidies prove to be more cost-effective than carbon taxes in this case due to the positive effect on green firms’ cash-flow structure, which helps to ease the financier’s commitment problem.
Conclusion and Implications
To summarize, we characterize the optimal policies required to propel the economy toward a greener future when limited-commitment frictions exist in the economic environment. We uncover a novel asymmetry between carbon taxes and directed technological investment subsidies and show which of these interventions is more cost-effective depending on which party’s commitment problem is more pronounced. This asymmetry stems from the delicate impacts of any government intervention not only on firms’ NPVs but also on the cash-flow structures specific to each type of technology. Thus, additional considerations regarding the distinct term-structure of cash flows tied to each technology and the extent of each counterparty’ commitment problem are needed to determine the required incentives, as well as the most efficient policy mix to successfully implement the transition toward a carbon-neutral economy.
Our work poses important implications for policymakers regarding the type and magnitude of intervention needed to incentivize green technologies. Because our analysis delivers delicate asymmetric implications depending on whether entrepreneurs or financiers are the ones facing commitment problems, it is crucial that policymakers tailor their policies to the specific economic environment. As such, the goal of our work is to offer additional qualitative guidance for policymakers by suitably augmenting the standard NPV rule in the face of commitment frictions.
Alain Bensoussan is a Professor of Risk and Decision Analysis at the Naveen Jindal School of Management at UT Dallas.
Benoit Chevalier-Roignant is an Associate Professor at the Emlyon Business School.
Nam Nguyen is a PhD Candidate in Finance in Management Science at the Naveen Jindal School of Management at UT Dallas.
Alejandro Rivera is an Assistant Professor of Finance and Managerial Economics Science at the Naveen Jindal School of Management at UT Dallas.
This post was adapted from their paper, “Financing Green Entrepreneurs Under Limited Commitment,” available on SSRN.