Carbon policy has the capacity to influence the direction of innovation in the energy system. Here we provide evidence that when the energy costs comprise a higher fraction of the costs of production, a carbon tax or other equivalent policy (e.g., renewable portfolio standards) creates incentives such that the economy will choose technologies that use energy more efficiently.

Higher energy prices, induced by policy decisions, lead to improved energy-use efficiency via this mechanism. The induced efficiency improvements not only help the economy grow more rapidly, delivering a higher standard of living than would otherwise be predicted, but also reduce the amount of energy consumed and carbon dioxide emitted per dollar of output. This suggests that previous studies have been insufficiently optimistic about what carbon prices could do for the economy and how much carbon prices would reduce the amount of energy and emissions per dollar of economic activity.