“Take for example biofuels. Where is the incentive for a firm to invest in biofuels when there are far more efficient (but more polluting) sources of energy out there already? Why should it compromise its profit making to ‘act green’ so to speak? Firms don’t take into consideration the external benefits, only the internal ones. Its not in a firms interest to look for more sustainable energy sources, so the government must provide incentives to do so.”
You answered your own question by asking it. Firms want to maximize profit and if pollution-intensive forms of energy are more efficient (partially because firms don’t have to pay the costs of pollution), then that’s what they’ll invest in. Pollution aside, that is a good thing for society. If so called green energy isn’t profitable then it’s a waste of resources. Opportunity cost is everything.
That said, the cost of pollution isn’t borne by energy producers or consumers so it’s hard to tell whether or not it would still be profitable if the market were really free.
You’ve also alluded to the fact that firms won’t invest in something that brings external benefits with no internal ones. This is true, but might lead you to believe firms won’t invest if they expect someone else to copy what they’ve researched. Terrence Kealey has done a lot of work on the economics of science and how firms spend on R&D. He found an OECD report that stated that it costs about 60% of the original R&D cost for a new company to copy that technology. However, in order to have the ability to copy others’ technologies, you have to already have the facilities and staff trained and doing research in the relevant field. This basically means you have to invest in new technology in order to be able to copy another firms R&D, so companies that want so called second mover advantages have to also be aiming at first mover advantages.