The world is eager for energy alternatives that greatly reduce greenhouse gas emissions. But where will the impetus come from for developing cheap, clean technologies? Two primary strategies have emerged: a top-down approach in which government imposes mandates that force companies to change or a bottom-up approach in which entrepreneurs craft solutions that must meet the test of the marketplace.

One of those who believes that government must take the responsibility to push innovation forward is Daniel Esty, a law professor at Yale University and head of the school’s Center for Environmental Law and Policy. He favors government-issued price caps or penalties that, directly or indirectly, compel companies to pay for the carbon dioxide they emit; if a company emits a certain amount, then it must pay a specific fee—a fee high enough to encourage that firm to find less expensive, green solutions.

In contrast is Vinod Khosla, founder of the venture capital firm Khosla Ventures in Menlo Park, Calif., who maintains that government mandates often produce solutions that are uneconomical and therefore not widely adopted. Instead entrepreneurs utilizing private capital—perhaps with some short-term government assistance where needed—are better positioned to provide solutions cheap enough to be employed even in developing countries, necessary because climate change is a global problem. Little government regulation would be required.

The two men’s positions reflect their backgrounds. In the early 1990s Esty, a Rhodes Scholar, was responsible for strategic planning and review of climate change initiatives at the U.S. Environmental Protection Agency. Khosla became a billionaire by co-founding Sun Microsystems and later as a partner with venture capital firm Kleiner Perkins Caufield & Byers. His own firm has invested in dozens of new companies focused on future fuels, electrical efficiency, and solar, geothermal and biomass energy.

Esty: Mandate Limits
Business is already investing billions of dollars in technology to improve energy efficiency and lower greenhouse gas emissions. But with pressure mounting to address climate change in a more sweeping way, Esty believes it is time for governments around the globe to push innovation more vigorously. The way to do that, he says, is to charge for emissions.

Those charges—or “price signals” in financial jargon—come in many flavors. Harm charges, for example, impose a tax on companies that produce specific pollutants; government analyses suggest that a rate of $50 per ton of carbon dioxide emissions would be just high enough to force change. Another signal is a cap-and-trade system. To stay below the government-set limits on emissions, which become more stringent over time, companies must either reduce emissions or buy allowances on the open market from other firms well below the goals.

The first great advantage of price signals is that they create “a strong incentive for companies to be smart for their own operations,” Esty says, and, second, they create “an opportunity for any company that can be a solutions provider to others. With everyone being obligated to reduce emissions, someone who finds a clever way to do it can not only fix their own emissions but also sell their answer to everyone else. That’s the real spur to innovation.”

Esty also urges strict regulatory standards in the construction industry, where current incentives run against investments in energy efficiency. “You probably want to have standards set by fiat that dictate more efficient lighting, more efficient heating and air-conditioning systems, new standards for high-efficiency windows and better insulation, and elements of that sort,” he says. This approach would overcome the problem of developers building as quickly and cheaply as possible “without full attention to the running costs of the buildings. This is where you need a societal-level intervention.”

Fundamentally, Esty notes, price signals can “get the largest number of actors and innovators into the process—to really have the private sector play the role of the engine of innovation and to minimize a government role in trying to pick winners.” His approach provides a level playing field for solutions.

Khosla: Fund Innovators
Khosla admits that governments around the world can set useful price signals that spur innovation. But he worries that the risk of heading down misleading paths is too high, distracting innovators from the most cost-competitive solutions. Khosla argues fervently that innovations must meet the “Mississippi test”: Will average American citizens be able to afford them? So, too, he suggests the “Chindia test”—that fast-growing economies such as those in China and India will adopt cleaner energy only when it is cost-competitive with fossil fuels.

“I depart from the environmentalists,” Khosla says. “Their approach is to promote renewables regardless of cost. I don’t want to do uneconomical things. Even if we can do it in San Francisco, if the cost is not less than the fossil fuel it’s supposed to replace, it won’t be adopted in India and China. Then it’s just a toy and not a scalable solution. This can hurt more than help real environmental solutions. I’m a fan of hybrid vehicles, but they won’t replace current cars. We don’t need a fashionable technology. We need 80 percent of the next billion cars we ship to be highly fuel-efficient. If they’re not economical, we won’t ship them.”

An example of a government-directed pitfall is the money now directed at ethanol derived from corn. Cellulosic ethanol based on noncorn products would be much more efficient. “You get an 80 percent reduction in carbon emissions,” Khosla says. “That’s what the planet needs. I don’t want to make a commitment to technology [like corn ethanol] that is a dead end.” The natural gas–powered autos championed by billionaire T. Boone Pickens also don’t come close to meeting Khosla’s requirements, because they reduce greenhouse gas emissions by 30 percent or less. “It won’t get us to a 60 to 80 percent reduction over time. We would make all that effort to switch infrastructure, but we wouldn’t get past that reduction.”

Private capital, along with governments, should therefore fund innovators who can create those ultimate solutions. Worldwide, institutions such as the World Bank, the Asian Development Bank and the International Monetary Fund “could offer low-cost loans for low-carbon projects, thus reducing the cost of capital,” especially in the developing world, Khosla says. “I’ve also discussed the idea, as others have, of the Clean Development Mechanism, through which rich countries can outsource some of their carbon-mitigation responsibilities to the developing world, where relatively easier, cheaper marginal gains can be found.” He also favors the idea of using economic incentives to combat issues such as deforestation, for example, by banning biofuels from countries that destroy large tracts of forest land to produce them.

Esty’s counterargument is that the world cannot wait around until an innovator happens to stumble on a cheap solution. He also thinks too many venture capitalists and innovators may be more interested in creating the next cool video game because that may have a more immediate market. But Khosla says investors understand that the clean-tech market is huge, and they will pursue it aggressively.