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

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However, a few successful countries have demonstrated that industrial policies may contribute to a substantial shift in what countries are best at producing. While there is still considerable disagreement on which sectors offer the greatest return on industrial policy, recent research offers (sometimes competing) avenues of identifying them. While government policy should certainly be informed by those studies, it should also be clear that there is currently no blueprint that fits across all countries. Hence, picking winning sectors should occur through careful examination of both the literature and strategies identified through country-specific government-industry collaboration.

Green Industrial Policy With increased evidence for the detrimental effects of conventional economic activity on the environment, policymakers around the world have been looking for ways to stimulate more environmentally friendly growth paths for their economies. And with green industries booming in recent years, governments are largely resorting to green industrial policies to foster their domestic development and carving out a competitive edge for their countries. Therefore, green industries are essentially infant industries, with all the characteristics of conventional infant industries and subject to the same opportunities and challenges of promoting them. However, given the inability of markets to price environmental externalities, green industries are, to a much larger extent, driven by policies that support the market through the stimulation of both demand and supply. While a first-best policy would need to price the externalities at hand, there are various reasons why countries are not able to do so. Hence, green industrial policies are used as a (second-best) alternative.

This peculiar function makes green industrial policy distinct from traditional industrial policy in at least three ways:

First, the scale of government intervention required is much larger in green industries, which fundamentally rely on government policy to build their markets. The size of future markets for green industries is largely determined by future government policy. For example, the less stringent future emissions ceilings are, the less profitable current investments will be. Industries that are reluctant to undertake green R&D or adopt green technologies can therefore be nudged into undertaking such investments through green industrial policies. At the same time, future government policy is a function of current investments, as the practicality of future carbon taxes, for example, depends on the future availability of alternative fuels, which in turn depends on current investments.

–  –  –

Third, the absence of a competitive market makes performance-based evaluation of green industrial policy much harder in practice. The immaturity of the sector globally and uncoordinated industrial policies worldwide contribute to various distortions, which would, for example, render export data as indicators of a program’s success less useful than they proved to be in successfully industrializing Asian nations.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © vii Industrial Policy for a Green Economy Table of Contents Executive Summary

1.0 Introduction

2.0 Economic Justifications for Industrial Policy

Marshallian and Inter-Industry Externalities

Coordination Failures

Self-Discovery and Diversification

Credit Market Imperfection

Learning by Doing

Environmental Externalities

3.0 Traditional Industrial Policy

Industrial Policy Instruments

Comparative History

Early Industrialization

Industrial Policy After World War II: State-Led Industrialization

Assessment: Does Industrial Policy Work?

Trade Protectionism

Trade Promotion

Foreign Direct Investment

Industrial Policy Targets

Best Practice

4.0 Green Industrial Policy

Green Industries

The Greening of Industry

Green Industry

Renewable Energy

Green Industrial Policies

Regulatory and Control Mechanisms

Environmental Taxes

Industry Protection

Industry Support

5.0 Conclusion

6.0 References

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © viii Industrial Policy for a Green Economy

1.0 Introduction A central empirical finding of the discipline of development economics is that the beginning of sustained economic growth is associated with a structural transformation of the economy. As countries grow richer, one observes a concomitant diversification of the productive structure away from agriculture toward non-traditional sectors such as manufacturing and, later, services. This process of industrialization took off with the Industrial Revolution, which started in Britain during the 19th century but was far from universal and was largely confined to a few Western European states and former British colonies, such as Australia and the United States (Maddison, 1995). While a number of countries, notably in Asia, have been able to catch up with Western economies through accelerated industrialization, a large majority of countries have failed to do so, leading to an unprecedented divergence in per capita income levels across countries (Pritchett, 1997). Meanwhile, total growth of manufacturing was phenomenal, with world steel production, for example, growing by a factor of six between 1950 and 2000 (Worldsteel (2009) as cited in UNEP (2012b)). It has only been since 1995 that a certain reversal of patterns has been observed and manufacturing has become a major driver of economic growth in developing countries, nearly doubling their GDP, while manufacturing value added has declined in certain industrial economies (UNEP, 2012b).





By promoting job creation and economic growth, industrialization has enormous potential to transform societies, raising living standards and narrowing the gap between rich and poor within as well as among countries. Nevertheless, modern industry is facing a whole range of relatively new challenges. Traditional economic growth has been associated with excessive environmental pressures such as resource depletion and ecosystem degradation. Today, industry alone accounts for approximately one-third of global final energy use and almost 40 per cent of total energy-related carbon dioxide emissions (International Energy Agency, 2009). Modern economic growth needs to be decoupled from production of environmental pressures, severing the link between economic goods and environmental “bads” (UNIDO, 2011). But the quest for greener industries (such as through greater resource efficiency) is far from being a purely environmental one and is in fact a core driver of economic competitiveness and sustainable growth (Smith, Hargroves & von Weizsäcker, 2012). Reducing the ecological footprint of industry has thus become an integral part of sustainable economic development, and promotion of green industry promises to strike a balance between traditional considerations of industrial development and efforts to reduce the environmental impact of such development.

While there appears to be widespread consensus among both policy-makers and researchers on the necessity for countries to develop sound industrial sectors, much disagreement remains on the adequate means to do so.

Neoclassical economic theory puts much faith in the workings of a free market and views government departures from “policy neutrality” to be warranted only when attempting to rectify market failures. But even though contemporary development theory centres on the pervasiveness of such market imperfections in developing countries, economists are generally skeptical of governments’ abilities to address those properly (Rodrik, 2009). Nevertheless, following great disappointment with the results of laissez-faire policies, as exemplified by what Williamson (1990) crystallized as the “Washington Consensus,” industrial policy has recently made a spectacular return to the public scene (Rodrik, 2010). And as concern grows about the adverse effects of climate change, which Stern (2008, p. 1) famously described as the result of “the biggest market failure the world has ever seen,” the aspiration for getting industrial policy right has gained new momentum and urgency.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy This paper reviews successes and failures of both traditional and more recent green industrial policy in order to distil lessons learned on what works and what doesn’t. We will adopt a strictly national welfare perspective, while at times hinting at frictions that might occur when international interests are at stake. For the purpose of this paper, we will define industrial policy very broadly as a set of policies that selectively favours the development of certain industries over others. In the case of green industrial policy, this definition extends to those industries with a relatively less harmful effect on the environment. We will provide a more detailed discussion of green industries in chapter 4.

We will begin by providing an overview of economic arguments for industrial policies, embedding the concept of market failures in the broader context of industrial development and economic growth. The third part of the paper then proceeds with a rough classification of industrial policies and summarizes their use in a historical context, before reviewing the literature on their effectiveness and distilling a few best practices. Chapter 4 then turns to a more detailed look at the emergence of green industries and provides a summary and initial assessment of policies used to favour the emergence of those industries. Chapter 5 recapitulates the main findings and concludes with a brief outlook.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy

2.0 Economic Justifications for Industrial Policy Nobel Prize−winning economist Paul Samuelson was once asked whether he could name one proposition in the social sciences that is both true and non-trivial. “Ricardo’s theory of comparative advantage,” he replied (Samuelson, 1995, p. 22). The concept of comparative advantage was first articulated nearly 200 years ago by David Ricardo (1817) and represents one of the most influential ideas in international economics (see, e.g., Costinot & Donaldson (2012) and Eaton & Kortum (2012)). The central proposition of the basic Ricardian model (and indeed most of its more recent extensions) is that factors of production specialize in different economic activities based on their relative productivity differences. In his original example, Portuguese workers were relatively better at producing wine than cloth compared with English workers. Hence, Portugal had a comparative advantage in the production of wine. David Ricardo was able to show mathematically that Portugal would be better off by specializing in the production of wine and using its export proceeds to purchase cloth from England instead of producing both goods by itself. Conversely, England was more efficient than Portugal in the production of both goods (it had an absolute advantage in the production of both goods), but would still gain from specializing in the production of cloth only and trading it for Portuguese wine. In a more contemporary setting, observers often argue that many developing countries have a comparative advantage in the agricultural sector, due notably to low labour costs. Accordingly, these countries would do best by specializing in agricultural goods and exchanging them for goods from other sectors such as, say, industrial goods on the world market.

The conviction that countries would gain from comparative advantage−driven trade has been a major engine behind post−World War II trade liberalization initiatives, whether they were multilateral under the auspices of the General Agreement on Tariffs and Trade or the World Trade Organization, regional, or even unilateral (Kowalski, 2011). For the optimal pattern of Ricardian production specialization is achieved by market forces and requires openness to trade and competitive pressures to reap the ensuing benefits in terms of country welfare. Any substantive attempt to alter the production structure, such as through active government industrial policy, would reduce these gains or even render them negative.

While in Ricardo’s time it seemed reasonable to confer Britain the status of having a comparative advantage in the production of cloth, it would be very hard to make that same case today. Obviously production patterns change over time, and a country’s comparative advantage in one sector today does not preclude the possibility of having a comparative advantage in another tomorrow. The thought that comparative advantage may be endogenous to growth has led a number of economists to develop the notion of latent, or dynamic comparative advantage (see, e.g., Krugman, 1987; Grossman & Helpman, 1993; Redding, 1999; Lin, 2012).

Not all goods are alike in terms of their consequences for economic performance, and specializing in some sectors may be more beneficial to economic growth than specializing in others (Hausmann, Hwang & Rodrik, 2007). If developing countries with a comparative advantage in the agricultural sector were to specialize as David Ricardo would have advised them to do, it is questionable whether they would achieve the degree of structural transformation associated with economic development. Recent empirical research emphasizes that countries’ ability to achieve structural change toward more productive sectors is indeed a main driver of economic growth in several countries in Africa, Asia and Latin America (McMillan & Rodrik, 2011).

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy

FIGURE 1. RELATIVE IMPORTANCE OF ECONOMIC SECTORS1 BY INCOME LEVEL

Percentage of GDP. Data source: World Development Indicators, World Bank.

Industry: manufacturing, mining and construction; services: personal, professional and public-sector services and utilities.

The World Bank defines middle-income economies as those with per capita GNI in 2003 between $766 and $9,385 measured with average exchange rates over the past two years.



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