Proponents of "economic incentives" frequently state that emissions trading promotes technological innovation.¹ Emissions trading programs authorize polluters to meet pollution reduction obligations by purchasing extra reductions from polluters reducing their emissions below applicable limits. This Article examines the claim that this trading of compliance obligations fosters innovation. This claim relies upon an error in economic theory,² which many economists and lawyers have repeated,³ and on insufficiently analyzed, incomplete anecdotal observation.⁴ There are solid reasons to suspect that an emissions trading program does a poorer job of stimulating innovation than a comparably designed traditional regulation.⁵

In theory, government can require all polluters to purchase allowances from a limited supply at an auction.⁶ Whether or not polluters can trade allowances, this requirement that all polluters purchase allowances for each ton of pollution can create incentives to innovate and reduce pollution. This Article, however, focuses on emissions trading programs that give away limited allowances for free, and then authorize trades to redistribute them. I choose this approach because all existing U.S. pollution trading programs give away, rather than sell, the overwhelming majority of allowances,⁷ and because this focus sharpens analysis of trading's effect on innovation.