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

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government has recently enacted punitive tariffs and countervailing duties of up to 250 per cent on Chinese solar imports.9 Following complaints from industry, the European Union is currently investigating options along the same lines. From the perspective of global economic efficiency, it is very hard to make a case for punishing another country’s use of subsidies, as these simply imply financial transfers from foreign taxpayers to domestic consumers. Moreover, in this particular case, Chinese producers are concentrated in labour-intensive downstream segments of the industry http://www.forbes.com/sites/benzingainsights/2012/11/09/chinese-solar-panel-makers-face-punitive-tariffs/ IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy supply chain, in which China has a comparative advantage (De La Tour et al., 2011). Industrial countries such as Germany still maintain their dominance in upstream sectors of the industry, such as silicon production, and provide some of the machinery used by Chinese manufacturers (UNEP, 2012b). It is therefore likely that punitive tariffs and countervailing duties will do more harm than good to the imposing country, raising domestic costs and reducing demand for installations and other components of solar systems, which are produced in those countries, ultimately leading to job losses.10 A similar case has been a trade dispute between the United States and Brazil in the biofuels sector, where the United States maintained massive subsidies (in form of tax credits) to corn-based ethanol producers and tariffs on biofuel imports to protect its domestic industry. While corn-based ethanol is at a clear cost disadvantage vis-à-vis sugarbased ethanol production as in Brazil, a major line of defence for those subsidies has been that the industry has not reached technological maturity yet. U.S. subsidies to ethanol producers have been estimated at US$6 billion for 2009, while the estimated reduction in fossil fuel use achieved by ethanol substitution could have been achieved simply by maintaining tires inflated throughout the year (Karp & Stevenson, 2012). Meanwhile, total subsidies to the fossil fuel industry—the result of both intentional policies and mismanagement—have been estimated at US$10 billion, annihilating any possible greenhouse gas reductions achieved through promoting the biofuels sector. While both the subsidy and tariff on ethanol were phased out in late 2011, implicit subsidies remain and might even increase through mandatory blending requirements. Therefore, the cost of the program is spread over millions of consumers, taking political pressure to remove it off the government budget while locking in the costs and distortions for the entire economy (UNEP, 2012b).

These two examples illustrate the difficulty countries have with both picking winners and withdrawing support to losers. The key challenge is to identify promising sectors, that is sectors that have the greatest potential for learning by doing and for which targeted support and protection may be warranted, if not crucial. Hence, in the absence of clear priorities in terms of technological potential, and the alignment of this potential with domestic capacities, industrial policy instruments should be designed in a way that is as technology-neutral as possible. For example, FITs can be designed to offer the same premium for any low-carbon electricity, leaving it up to producers to choose the technology they use (UNEP, 2012a). Conversely, industrial policies can be tailored to be more technology-specific in cases where growth potential and economies of scale are more obvious. Arguably, this confers an advantage to developing countries that can inform their technological choices by experiences in countries that have successfully been using the technology in question. We have hinted in chapter 3 at the literature for identifying promising avenues for industrial upgrading, notably the concept of latent comparative advantage and the product space.

Instruments

There are a number of instruments governments can use to incentivize the development of green industries. We have already seen that government interventions should aim to redress the market failures at hand, which can be multiple.

Hence, a policy priority should be the removal of existing policy-induced distortions in the economy, as without this, relevant market failures will be harder to identify. In this context, the most obvious measure to level the playing field for green industry is to remove harmful subsidies to polluting sectors of the economy. While aligning market signals more closely with their true values and offering a first step toward incentivizing the emergence of green industries, removal of http://www.guardian.co.uk/environment/2013/feb/19/solar-panel-duty-chinese-imports?CMP=twt_fd IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy such subsidies can free up important financial resources for government policy.11 According to Ellis (2010), a key reason for low energy efficiency in many subsidizing countries is the large distortions in price that result from such subsidies.

Green government procurement is one way for governments to create demand for green products such as clean bus fleets, green lighting solutions and green building design, and is increasingly adopted in both high-income and developing countries. Average government expenditures worldwide are currently almost 60 per cent of GDP12 and can hence be a major driver for creating green demand and supply. Moreover, they can have demonstration effects in that they can help overcome knowledge and information gaps within countries. Key constraints to green public procurement programs in developing countries have been the lack of a supplier base and higher perceived costs associated with green goods (OECD, 2012a). The latter can be considered unfortunate, as they defy the purpose of green public procurement, which is exactly to offer an outlet for socially desirable products at an early stage of commercial development. Moreover, from a global welfare and climate change perspective, there is no reason to discriminate against foreign suppliers (UNEP, 2012b). However, the mismatch between demand and domestic supply suggests that government can be more strategic in devising industrial policies that combine the development of domestic industries with demand through public procurement.





Another way governments frequently intervene in promoting green industry is through subsidies. While subsidies address financial market failures, the presence of other market failures often requires the simultaneous deployment of complementary measures. The most frequent case inherent in the development of new industries is the presence of coordination failures. For example, a number of studies find that while financial constraints are pervasive in the deployment of renewable energy technologies in developing countries, maintenance and after-sales services are equally important and should be an integral component of project planning (see, for example, Barry, Steyn & Brent, 2011; Brunnschweiler, 2010; D’Agostino, Sovacool & Bambawale, 2011). Similarly, the rapid expansion of solar and wind energy in China was accompanied by uneven development of components of the system, as large wind and solar farms were built far from urban areas. The cost of building grid infrastructure to connect producers and users, as well as the electricity losses arising from transmission distance, led to large unused capacity (Karp & Stevenson, 2012).

Given the peculiarities of green industries, investors face substantial additional policy, regulatory, technology and market risks, making it hard for project owners to attract the necessary funds (Corfee-Morlot et al., 2012). While output-based FITs affect revenue streams and can hence improve the risk-reward calculus of investors, investment subsidies more directly target the cost of capital. They can be direct investment incentives such as capital grants, loan guarantees and low-interest loans, or more implicit in the form of tax incentives such as accelerated depreciation, tax credits, tax exemptions and rebates. Since empirical evidence on the effect of these instruments on the development of green industry is scarce, we will highlight a few conceptual issues that may arise, drawing on insights from the literature on traditional industrial policy as reviewed in chapter 3.

A central result from that literature is that government support should be provided in a way that maintains sectoral

competition. Governments typically face two major problems when selectively picking firms eligible for support:

• Firm-level characteristics are hardly observable to government, making it hard to know which firms have the highest potential for productivity improvement.

• Once supported, firms will not necessarily use government resources in the intended manner, leading to suboptimal behaviour.

See, for example, the Global Subsidies Initiative for more resources on the topic: www.iisd.org/gsi/ http://www.heritage.org/index IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy In the economics literature these problems are known as adverse selection and moral hazard, respectively, arising in situations where there is asymmetric information between a principal (in this case the government) and the agent (in this case the recipient firm).

The following comparison of these instruments in light of these considerations draws heavily on Kalamova, Kaminker and Johnstone (2011). Government grants are used mainly to stimulate commercialization of early-stage technologies and form a major part of green stimulus programs throughout OECD countries. Since grants need not be paid back, the risk of moral hazard is particularly pronounced. On the other hand, making grants available regardless of recipients’ asset holdings and project qualities can spread the risk of adverse selection among firms. Such risk is particularly high in the case of loan guarantees, which are promises to banks to pay back loans in case projects fail. While innovative projects with untested technology are necessarily risky, firms whose projects are most likely to fail will tend to be those that seek loan guarantees. The provision of low-interest loans faces similar challenges, as these are often given to firms without a proven track record or using immature technologies that fail to obtain commercial loans on reasonable terms.

Low-interest loans can be allocated directly by state-owned development banks (such as the KfW in Germany) or through subsidizing commercial banks. In both cases, loans on preferential terms do provide an incentive to successfully carry out a project, as loans ultimately need to be repaid. But the preferential interest rates involved may actually lead to overinvestment beyond the desirable level.

While tax-based incentives can be more easily tailored toward meeting certain performance criteria, a major drawback is that some potential beneficiaries, such as new entrants, do not pay taxes. If that is the case, it is important to make support conditional on certain performance criteria, such as productivity change over time. But tax-based support does not provide insulation from moral hazard per se. Accelerated depreciation allows for lower effective tax rates in the early years of an investment and can raise the overall net present value of a project. However, the fact that it is not linked to output per se can create inefficiencies. For example, India has long used accelerated depreciation as its main investment incentive, which has led to shoddy construction of wind farms that sometimes sit unused (Karp & Stevenson, 2012). Investment tax credits can magnify such inefficiencies, being based on installed capacity and offering the deduction of a specified percentage of investment from project developers’ tax liability, in addition to depreciation allowances. Production tax credits have the same function, but are based on actual production and may hence be more conducive to greater efficiency.

A major drawback of all fiscal incentive schemes is their perceived instability, as they usually rely on government budgets and are subject to regular reviews and political negotiations. For example, the stop-and-go character of the expiration and renewal of tax credits for wind power production in the United States is associated with high volatility in investments.13 In general, market-based tests for conditioning support schemes as employed by rapidly industrializing Asian states are more difficult to implement in the case of green industry. A major complication is the absence of a market environment, given the lack of a carbon price and other prevailing environmental externalities. Uncoordinated industrial policies worldwide make it less attractive to use export performance as a reliable benchmark, as exporting per se is less of an indicator of efficiency (see, for example, above on U.S. biofuels, which are also exported to Brazil). These complications call for a more pragmatic way of assessing industrial policies, in terms of trade-offs among various development goals.

See, for example, http://www.ucsusa.org/clean_energy/smart-energy-solutions/increase-renewables/production-tax-credit-for.html IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy Finally, it is worth briefly pondering the question of whether investment incentive schemes should equally apply to international green investments. Currently, such green investment protectionism is not a major feature of the international policy landscape (except in infrastructure as mentioned above), but there are concerns that the rise of green industrial policies might lead to greater protectionism in the future (OECD, 2011). We saw in chapter 3 how countries have had different stances towards attracting FDI. Regarding the effects of foreign-controlled firms on the national economy, we have found that positive spillovers come mainly in the form of backward linkages, and complementary policies are often needed to ensure that horizontal spillovers take place (for example joint ventures).



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