a b s t r a c tInternational emission trading is an important flexibility mechanism, but its use has been often restricted on the ground that access to international carbon credits can undermine the domestic abatement effort reducing the incentive to innovate and, eventually, lowering the pace of climate policy-induced technological change. This paper examines the economics that is behind these concerns by studying how a cap to the trade of carbon offsets influences innovation, technological change, and welfare. By using a standard game of abatement and R&D, we investigate the main mechanisms that shape these relationships. We also use a numerical integrated assessment model that features environmental and technology externalities to quantify how limits to the volume, the timing, and the regional allocation of carbon offsets affect climate policy costs and the incentive to invest in innovation and lowcarbon technologies.Results indicate that, for moderate caps on the amount tradable emissions permits and sufficiently high technology spillovers, global innovation and technical change would increase and that this additional innovative effort could lead to economic efficiency gains. The numerical analysis confirms that when constraints are close ଝ This paper is part of the research carried out by the Sustainable Development Programme of Fondazione Enrico Mattei. Financial contribution from the PLANETS project funded by the European Commission under the 7th framework programme is gratefully acknowledged. The usual disclaimer applies. We would like to especially thank Prof. Sjak Smulders for the many comments and suggestions which have helped to considerably improve this manuscript.*