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«© 2013 The International Institute for Sustainable Development © 2013 The International Institute for Sustainable Development ...»

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Industrial Policy for a Green


Johannes Schwarzer

June 2013

www.iisd.org © 2013 The International Institute for Sustainable Development

© 2013 The International Institute for Sustainable Development

Published by the International Institute for Sustainable Development.

International Institute for Sustainable Development

The International Institute for Sustainable Development (IISD) contributes to sustainable development by advancing

policy recommendations on international trade and investment, economic policy, climate change and energy, and management of natural and social capital, as well as the enabling role of communication technologies in these areas.

We report on international negotiations and disseminate knowledge gained through collaborative projects, resulting in more rigorous research, capacity building in developing countries, better networks spanning the North and the South, and better global connections among researchers, practitioners, citizens and policy-makers.

IISD’s vision is better living for all—sustainably; its mission is to champion innovation, enabling societies to live sustainably. IISD is registered as a charitable organization in Canada and has 501(c)(3) status in the United States.

IISD receives core operating support from the Government of Canada, provided through the International Development Research Centre (IDRC), from the Danish Ministry of Foreign Affairs and from the Province of Manitoba. The Institute receives project funding from numerous governments inside and outside Canada, United Nations agencies, foundations and the private sector.

IISD’s TRI-CC Program This work is an output of IISD’s Trade, Investment and Climate Change Program (TRI-CC). Related research will aim to deepen understanding of energy intensive industries, so as to better understand the effect of policies on these sectors. In particular, it forms part of an assessment of trade impacts of BCAs in developing countries, and will be followed by a complementary analysis of how BCAs affect exports from South Africa. Related research will aim to deepen understanding of energy intensive industries, so as to better understand the effect of policies on these sectors.

Together, these analyses will inform research on the practical aspects of developing and implementing a BCA system.

Other similar areas of work in the TRI-CC Program include developing guidance for policy makers in elaborating and implementing BCAs, deepening understanding of climate policy for the steel and cement sectors, and work on emerging issues such as GHG-intensity standards and subsidies for green industrial development. Under TRI-CC’s Investment and Climate Change theme, IISD will work with host country governments to develop policies that help catalyse flows of climate friendly investment.

IISD’s work on the TRI-CC Program is supported by the Governments of Norway and Sweden, and by the MISTRA Foundation’s ENTWINED Program.

Head Office 161 Portage Avenue East, 6th Floor, Winnipeg, Manitoba, Canada R3B 0Y4 Tel: +1 (204) 958-7700 | Fax: +1 (204) 958-7710 | Website: www.iisd.org Industrial Policy for a Green Economy June 2013 Written by Johannes Schwarzer IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © ii Industrial Policy for a Green Economy Executive Summary Industrial policy, defined as a set of policies that selectively favours the development of certain industries over others, runs counter to the concept of a market economy and is hence a controversial topic in economic theory. Nonetheless, governments around the world with economies at various stages of development continue to use such policies in order to proactively influence their countries’ economic development. In recent years, environmental considerations have increasingly shaped policy debates, and green industries are being supported through industrial policies that target the development of industries with relatively less harmful effects on the environment.

Economic justifications for industrial policy While in principle market forces should guide the process of determining the optimal productive structure of an economy, the general case for government intervention in economics comes into play when markets are either distorted or incomplete. The following examples illustrate the most common rationales for government support to industry.

Marshallian and Inter-Industry Externalities

The presence of localized, industry-level externalities leads to formation of industry clusters, which benefit from synergies such as knowledge spillover among firms, labor pooling, or input-output linkages, where upstream firms provide inputs for downstream firms, taking advantage of low transportation costs. These benefits automatically increase with the size of the sector, which in turn necessarily becomes more productive. Until the industry cluster has reached a critical size, it will be unprofitable, producing at inefficiently low productivity and unable to compete on international markets. Temporary government support to the “infant” industry may help it take off and eventually become competitive. Such spillovers may also arise between different, complementary industries.

Coordination Failures

Coordination failures come about because many projects require simultaneous investments in order to be viable. If these investments are made by independent agents, there is little guarantee that each agent, acting in its own self-interest, would choose to invest, leading to a suboptimal equilibrium.

Self-Discovery and Diversification

Economic development and structural transformation go hand in hand with the “discovery” of economic activities that are new to a country. Therefore, entrepreneurs entering such activities contribute disproportionally to a country’s selfdiscovery of its industrial capabilities, because an entrepreneur’s success signals the profitability of a new sector. This can generate significant economy-wide demonstration effects (positive spillovers) and emulation by new entrants, which diminishes the ability of the initial investor to appropriate her benefits. As the entrepreneur would have to privately bear the costs in case of failure, an economy might end up with a suboptimal number of pioneer entrepreneurs and fail to diversify.

–  –  –

Financial markets do not always possess sufficient information to accurately assess the risks involved in the financing of new industry projects, and financial intermediaries may hence fail to grasp profitable opportunities, making government intervention necessary.

Learning by doing

Technical change and productivity improvements may be a function of the very activity of production. Therefore, an infant industry might become profitable only after some time of operating under protection, in order to gain the necessary experience for enhancing competitiveness.

Environmental Externalities

Markets usually fail to adequately price the environmental effects of economic activity, and this can lead to economically viable but socially undesirable economic activity. The government has an important role to play in “levelling the playing field” for green industries, aligning private returns more closely with social returns.

Traditional Industrial Policy Throughout the 19th and beginning of the 20th century, targeted government intervention in trade and industry has been widespread during the catch-up phase of all currently developed countries, including the United Kingdom, Germany and the United States. The main policy tools were tariffs and other trade restrictions to protect domestic industries from foreign competition. As the emergence of modern government institutions endowed governments with a larger toolbox for industrial policy, countries gradually expanded their support schemes from protection toward more active support. Latecomers to industrialization during the second half of the 20th century, notably in Latin America and Asia, all used very similar policy instruments, such as tariffs, quotas, import licensing, foreign exchange rationing and various forms of subsidies to substitute imports with domestic production—a strategy that came to be known as import substitution industrialization. Apart from favourable credit concessions by development banks, domestic firms also benefited from various forms of fiscal incentives such as tax breaks, duty drawbacks on imports, accelerated depreciation on capital equipment and direct subsidies.

Best practices The literature on industrial policies is large, but faces common challenges in evaluating the impact on countries’ performances. Nevertheless, a number of empirical regularities allow to distil some best practices.

Industrial Policies Should Be Only a Subset of a Broader Industrial Agenda The successful deployment of industrial policies requires a sound enabling policy framework that is conducive to improving the business climate and economic competitiveness more generally. A number of complementary policies are needed to overcome potential bottlenecks, such as education policies to increase relevant skills in the domestic workforce, R&D support, or provision of adequate infrastructure.

–  –  –

Protectionism is a thorny policy issue, with many pitfalls that may actually contribute to crippling domestic industries.

There is evidence that import protection, for example, may be a viable tool for industry promotion, assuming that trading partners do not retaliate. This assumption is, however, highly unlikely in today’s international economic reality, as such measures will necessarily conflict with foreign interests. Even then, the evidence seems to suggest that protection needs to be focused on consumption goods rather than intermediate input goods. Further, a distinction needs to be made between homogeneous and differentiated goods, as there is greater potential in differentiated goods for developing niche industries.

Because of two major findings, the next two best practices must be considered together. These findings are that successfully industrializing countries have complemented protection with active domestic industry support, and that governments have historically been unable to design adequate sectoral protection patterns.

Industry Support Should Be Provided in a Transparent Way that Maintains Competition and Is Incentive Compatible All forms of industry support are fraught with the threat of special interest capture, so steps must be taken to ensure transparent criteria for selecting support recipients. Not only is picking winners inherently difficult for governments, who have less knowledge concerning firm-specific characteristics than, for example, managers, it also encourages wasteful use of resources by incumbents and discourages the entry of more innovative new firms. Hence, industry support should not discriminate among firms within the promoted industry. In this context, the ability of governments to withdraw support in case of underperformance is equally important. Sunset clauses that link government support to performance criteria have been instrumental in ensuring that government aid to industry acts as an incentive for productivity in successfully industrializing Asian countries. The advantage of basing such performance criteria on export data has the double advantage of ensuring that firms are exposed to the dynamics of the international market and providing a reliable indicator of industry success.

The evidence concerning foreign direct investment is particularly clear on the need for well-defined policy objectives.

Attracting foreign direct investment in downstream sectors appears to stimulate upstream domestic industry, whereas active policies are needed to ensure horizontal spillovers for domestic industries operating in the same sector. Here, the challenge is to achieve an adequate balance between offering an attractive investment framework for foreign investors and setting the right incentives for technology and knowledge transfers. While local-content requirements, subcontracting and joint ventures have been used extensively in China, it remains unclear whether countries with smaller markets can impose such regulations on multinationals without affecting their investment decisions. In any case, the literature agrees on the importance of fostering a country’s absorptive capacity as a key determinant for technology transfer, necessitating, for example, active policies to develop an aptly skilled domestic workforce.

Close Collaboration Between Governments and Industry to Optimize Information Flow In order to design adequate support schemes, policy makers need to be clear about which market failures need to be addressed. The answer to this question involves the identification of industries with potential for positive spillovers, inter-industry and input-output linkages, perceived bottlenecks to coordinate investments, the nature of financial constraints and credit market imperfections. A defining feature of successful industrial policy has thus been regular knowledge exchange between high-level government and industry representatives to ensure the continued relevance

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Strengthening Government Capacity to Avoid Government Failure Government capacity to correctly anticipate trends and effectively withdraw support once it is no longer necessary calls for a highly competent bureaucracy, with highly skilled people taking key roles and accordingly competitive pay, which also helps insulate officials from corruption.

Targets of Industrial Policy Are Country-Specific

Economists have long argued for countries to upgrade their industrial structure according to their comparative advantage.

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