Green Industrial Policies don’t offer second best – but first best solutions!

William Hynes

“You know economists; they’re the sort of people who see something works in practice and wonder if it would work in theory” Ronald Reagan

Dani Rodrik argued that the real question was not whether – but how – to do green industrial policies (GIP). This conviction was shared amongst leading scholars and practitioners including Isabel Estevez, Simon Sharpe and Eric Beinhocker when they debated this issue at Rebuilding Macroeconomics (IGP, UCL) in conjunction with the World Bank’s Coalition for Capacity on Climate Action (C3A). The seminar explored:

1) The economic, technological, geopolitical, and environmental context for green industrial policies

There is growing optimism about the green transition from the remarkable fall in the price of renewables, new technological environment (renewable energy, EVs, batteries etc.) and perhaps unexpected benefits of geopolitical competition (China, US through the IRA and soon EU). While climate change is the ultimate global externality, national GIPs have proliferated, not because of global coordination, but because of national motives such as competitiveness and productivity, geopolitical and diplomatic advantage.

Given these multiple challenges facing society, Isabel Estevez called for a broad interpretation of GIPs as productive development strategies to multi-solve (considering not just growth but equity, quality jobs, macro stability) several environmental problems including climate change, biodiversity loss, oceans, air pollution etc.

2) Key concepts, theory, and historical experience

The classical arguments for industrial policies included addressing: 1) externalities and spillovers, 2) co-ordination failures e.g., between upstream and downstream industry needs, and 3) technology specific regulations infrastructure, investments, and skills development. Green industrial policies go beyond this ‘second best’ rationale. If carbon emissions are underpriced and therefore not capturing the social cost of carbon, returns on carbon-reducing technologies are depressed relative to the social returns. Therefore, concerns about competition for subsidies is misplaced and should be welcomed. Indeed, an international subsidy-war for green industries might be just what the world needs.

Estevez outlined how one tool, green public procurement in Ecuador had a significant impact leading to manufacturing spillovers, increases in outputs, fewer imports, and less concentrated and competitive industries. Simon Sharpe outlined a new policy approach which aims to reinforce feedbacks as far more effective. A carbon tax is not about internalizing the externality but should target tipping points. Indeed, Eric Beinhocker argued for a portfolio of policies to promote structural change not just marginal change. The current fossil fuel energy system was not built by taxes on candles and horses but by active, strategic, industrial policy on a massive scale over a century.

The most effective clean energy policies have, on the whole, been ‘carrots’ rather than ‘sticks’ (subsidies rather than taxes). Successful policies rely on collecting evidence of what actually works best, rather than a top-down command approach. Policy instruments that were deployed in the past to develop the fossil system in the US included R&D support, tax incentives, subsidies, tariffs, government procurement, public goods investments and regulatory frameworks. The GIP agenda goes beyond subsidies, encompassing an experimental, collaborative, and iterative approach to upgrading the institutional framework with varied policy instruments. This experimental and feedback approach is the best way to deal with uncertainty and different national advantages rather than trying to design the perfect system at the outset.

3) Analytical frameworks for assessing structural change

Simon Sharpe outlined the analytical tools for assessing 1) Where should competitiveness be built in terms of which sector, 2) How should we build competitiveness using which policies, and 3) What will the macroeconomic effects be? On the first, Economic Complexity Analysis is a promising approach but with a few drawbacks (risk of distortion, fixed set of products etc.) so there was a need to incorporate creation of novel technologies. Simulating sector models called for the development of sector-specific global agent-based models. Most macro modelling is limited to equilibrium approaches with limited industrial sector resolution and interactions. High-resolution disequilibrium macro models would help address this current gap.

4) Political economy and state capacity for implementation

In terms of policy design, subsides have some advantages over taxes, creating winners rather than losers, which can help the political economy for reform by weakening fossil fuels, generating early wins and new interests. For instance, the Inflation Reduction Act (IRA) changed the political balance. Providing incentives (carrots) now is easier than offering (sticks) down the line. This is changing the private sector incentives leading to much bigger outcomes than relying on censure alone.

Despite the positive assessment, speakers emphasized the risks to developing countries of being left behind. Though there are opportunities to connect to green value chains and examples of GIPs in practice in emerging economies such as Indonesia’s ban on nickel processing, green hydrogen production in Chile, Solar PV deployment in India. Global co-operation for some of the poorest countries will be essential on financial and technological resources needed for the transition. This would have the effect of turning sticks into carrots to bring those least able to afford a transition along with the rest of the world.

Green Industrial Policies may well proliferate and there are good reasons to anticipate that they will work in practice as well as in theory – beyond second best, they offer a first best approach to accelerating the green transition.

William Hynes is a Senior Climate Change Economist at the World Bank, an Honorary Professor at IGP UCL and an External Applied Complexity Fellow at the Santa Fe Institute. He is also Co-Director at the World Bank's Coalition for Capacity on Climate Action (C3A).