Industrial Policy Reloaded: Shaping industrial ecosystems towards sustainable prosperity

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Climate change is the most pressing grand challenge of the 21st century – perhaps the greatest, truly global challenge humankind has ever faced. In international fora, such as the latest United Nations Climate Change Conference (COP26), it has been often emphasised that “we are all in this together”. In reality, climate change impacts countries, social groups, industries, and places      in very different and asymmetric ways. Climate change risks will increase inequalities within countries – where workers are expected to pay the highest cost for the green transition and industrial restructuring; and between countries – with developing countries already bearing the costs of a climate change crisis not of their making, in a context of limited financial and technological support and looming debt spirals.^[1] Shifting away from an unsustainable economic model centred around fossil fuels is key to overcome climate change and mitigate its disproportional impact on societies and countries.

In its most recent roadmap towards “Net Zero by 2050”, the International Energy Agency (IEA) highlighted the need for a dramatic acceleration in clean energy investments, rapid deployment and diffusion of available technologies, and implementation of climate policies across more than 400 sectoral and technology milestones.^[2] The IEA also denounced how countries’ commitments have often felt short in implementation. Specifically, the rate of energy-efficiency improvements must increase three times more than the average rate achieved over the last two decades. A 4% per year average increase to 2030 is necessary for economic growth to be decoupled from energy consumption. On the technological end, this requires a five-fold increase in energy capacity from solar and wind technologies, as well as the exploitation of numerous opportunities arising from advanced battery technologies, hydrogen electrolysers, and direct air capture and storage. Supporting this energy transition calls for an estimated $90 billion of public investments to be mobilised globally, new measures redirecting finance away from new coal plants, and crowding-in further clean energy investments on the order of more than $4 trillion.

Against this global scenario, countries face both the challenge of mobilising large technical and financial resources and the challenge of directing them towards sustainable structural transformation. In this paper, we start from questioning the extent to which standard market-fixing and macroeconomic expansionary measures will be able to direct and shape new industrial ecosystems in economies across the Atlantic. Second, we advance a strategic industrial policy approach for deep industrial restructuring. This is followed by a discussion on specific industrial policy instruments – including public finance, procurement, and various types of technology services – and how conditionalities and policy alignments are central to balancing risks and rewards in the process of green transition. We conclude with some reflections on the need to rebuild state capacity for the successful implementation of this strategic industrial policy approach.

The challenge of deep industrial restructuring: Why we need to go beyond market-fixing and macroeconomic policy

The IEA’s Net Zero Agenda has stressed just how significant the magnitude of financial resources and investments required to address the climate change crisis is. However, the largest and most advanced economies astride the Atlantic – the United States (US) and the European Union (EU) – are not short on financial resources. Instead, they are facing a more fundamental political economy challenge, namely the restructuring of their industrial sectors – especially the most energy-intensive – towards new models of sustainable prosperity, including new patterns of sustainable production and consumption. If we focus on the supply side, this means opening feasible pathways for incumbents – firms and workers – towards new production, technological, and organisational models. These pathways need to favour and direct new “green entrants” while at the same time manage the exit of “brown firms” from specific industries or technology paradigms. In most cases, turning the existing “brown firms” into “green firms” will call for “deep” industrial ecosystem restructuring. It is deep as it entails coordinated changes within firms and across value chains.

Addressing the political economy challenge of deep industrial restructuring cannot be achieved with “horizontal” measures, that is, policies relying mainly on market-pricing coordination. It needs a “strategic” policy approach that, first, goes beyond a market failure-fixing framework and, second, that is not limited to expansionary macroeconomic measures, which are often not sufficiently selective in driving and coordinating deep industrial restructuring. Let us turn to these two policy approaches – often underpinning the EU and US New Green Deals – and see why they might not be enough.

Carbon pricing is a good example of market-fixing policies.^[3] Although these measures might have some role to play,^[4] there has been an increasing recognition of the fact that markets have failed to internalise environmental costs at the scale and speed required. Markets alone have also proven incapable of promoting the development and widespread diffusion of green technologies and steer economies towards a much-needed energy and industrial transition. The reason is that the market performs poorly in allocating and committing resources under conditions of uncertainty, especially when productive and technology assets are highly specialised, and when specific markets do not exist yet.^[5]

Similarly, expansionary macroeconomic measures can play an important role, but they are likely to be insufficient. They can be used to create demand for green products and jobs, as well as for overheating the overall economy and, in doing so, stimulating private-sector investments in new technologies and industries. However, expansionary macroeconomic policy – the favoured approach of Democrats in the US – also tends to over-rely on markets and uncoordinated demand expansion, while underestimating the level of industrial coordination and deep restructuring that is needed. Moreover, even if expanded demand can be sufficiently channelled in the direction needed for a green transition, macroeconomic measures tend to assume that productive, technological, and organisational capabilities will adjust and develop accordingly. This is a very problematic assumption, given the de-industrialisation and industrial concentration experienced in many states and regions in the US and EU, hence the lack of productive, technological, and organisational capabilities.

In sum, market-fixing measures, such as carbon pricing and macroeconomic measures of the type promoted in the EU and US Green New Deals, can play a role, but they will not be sufficient. Although stemming from different economic paradigms, these two policy approaches share too much faith in the market as an incentive and coordinating mechanism for deep industrial restructuring. They are also not sufficiently strategic, and they often overlook differences across productive sectors, technologies, and places. In what follows, we advance a more strategic policy approach for deep industrial restructuring.

Towards industrial policies for deep ecosystems restructuring

The strategic industrial policy approach to the climate change crisis that we advance here starts with the recognition of three sets of political economy challenges. These are about (1) understanding, leveraging, and managing differences across sectors and places, (2) accelerating the speed of energy transition and industrial restructuring, and (3) directing innovation and its diffusion towards sustainable prosperity.

Understanding, leveraging, and managing differences across sectors and places

The first political economy challenge is about understanding, leveraging, and managing differences across sectors and places, hence their different needs, capabilities, as well as opportunities for deep industrial restructuring. Understanding these differences is a first key step towards targeting and coordinating policies for the restructuring of highly heterogeneous and place-specific industrial sectors of the economy. Globally, the energy sector generates around three-quarters of greenhouse gas emissions,^[6] and it is therefore central to this industrial restructuring. However, decarbonisation cannot be limited to the energy sector. All industrial sectors – from agro-food and garments to chemicals and steel, aerospace, and automotive industries – contribute to climate change differently in direct, but also indirect and mediated ways. Therefore, each industrial sector requires different restructuring approaches and targeted strategies.

Each industry (and firms within them) are also part of complex industrial ecosystems involving interdependent production, consumption, and technological activities spanning along and across regional and global value chains. Although decisions about these activities and their impact on climate change are interdependent, achieving coordinated decisions across actors and places towards a more sustainable economy model is difficult, given the dispersed and disaligned interests, power, and ownership. In the US, for example, the fossil fuel industry in West Virginia, represented by Senator Joe Manchin, has been a major obstacle to the Biden climate programme.^[7] Similarly, sectoral incumbents and interests remain disaligned across European nations,^[8] where industrial capacity has increasingly concentrated around the manufacturing core of Germany, and the development of the energy sector (and energy security policy) has followed different pathways, from nuclear to gas and renewables.

Across developing and middle-income countries, needs, capabilities, as well as opportunities for deep industrial restructuring are also highly heterogeneous. These countries, however, share a fundamental problem, that is, the lack of domestically owned productive, technological, and organisational capabilities, including the lack of state capacity in implementing and enforcing green industrial policy.^[9] Although these countries need financial resources for both climate change mitigation and adaptation, without developing their own productive and state capabilities, they will remain dependent on advanced countries. Indeed, under these circumstances, green finance and debt relief from advanced countries will flow into developing countries and immediately flow back to advanced countries to get access to green technologies.

Accelerating the speed of energy transition and industrial restructuring

In the last two centuries, major energy transitions – for example the shift from wood to coal, or coal to oil – unfolded over several decades and were delayed by technology lock-ins and resistance to change. However, evidence at varying scales and sectors suggests opportunities for a relatively faster transition.^[10] Sovacool provides compelling evidence of energy transitions from the adoption of cookstoves, air conditioners, and flex-fuel vehicles that, in aggregate, affected almost one billion people and needed only one to sixteen years to unfold.^[11] This points to the fact that targeted interventions at the sectoral and sub-sectoral levels can have better chances to accelerate energy transition, especially if these measures are not simply “encouraging entry” of new technology or actors, but if there are also policies “facilitating the exit” and restructuring of incumbents.^[12] In fact, facilitating an exit via industrial restructuring is as important as promoting the diffusion of new technologies via subsidies such as feed-in tariffs schemes, which have been widely adopted by Germany and other EU countries.

Directing innovation and its diffusion towards sustainable prosperity

The third major challenge is to promote the widespread diffusion and continuous innovation of renewables and other low-carbon technologies and, in doing that, seize the related employment opportunities arising from a green transition. Since 2009, the dramatic decline in the cost of electricity from renewables – solar photovoltaics and wind, on-shore in particular – has offered a viable pathway for accelerating energy transition.^[13] Non-renewable energy technologies rely on limited, geographically concentrated, and non-reproducible resources – that is, fossil fuels. On the contrary, renewable energy technologies are manufactured under a regime of increasing returns, whereby costs decline along steep learning curves and with increased installed capacity.^[14] Continuous innovation is needed however because even manufactured technologies can hit non-reproducible resource boundaries – for example, batteries for electric mobility rely on lithium.^[15] Continuous innovation in manufacturing processes and product technologies for energy generation can shift non-reproducibility boundaries and reduce reliance on non-reproducible resources. Furthermore, renewable technologies need innovation and investment in transmission and storage infrastructures to support an industrial economy.

Green technology innovation and diffusion, as well as complementary investments in enabling infrastructures, should not be seen from a supply-side perspective only. They are, in fact, major sources of new intermediate and final demand of green products and services, which can generate investments and job creation while opening pathways for incumbents to restructure their industries. Creating and exploiting these new sources of demand to generate broader support for energy transition is as important as promoting supply-side innovation and industrial restructuring.    

Reloading industrial policies: Instruments, risks, and rewards

Historically, the state has played a key role in addressing structural transformation challenges through a variety of industrial policies.^[16] The state at different levels of governance can play a key inter-temporal and spatial coordinating function beyond fixing markets.^[17] The state can reshape industries, align incentives among institutions and organisations, build coalitions of interest, and provide technological and organisational innovation with directionality. This does not necessarily mean preselecting technological pathways to the exclusion of others or limiting private-sector initiatives. On the contrary, the state can steer the search for both sector-specific and cross-sectoral solutions; de-risk experimentation and innovation efforts; crowd-in private investments by committing infrastructural investments or by creating demand; promote competition among alternative solutions; and enable the absorption and diffusion of different technological innovations.

These goals can be achieved with different industrial policy instruments and packages – including public finance and public procurement – and also by setting standards and providing technology services along the entire innovation/production chain, from basic research to the full deployment and diffusion of new technologies. These are explained in some detail below.

Public finance: Directing finance matters more than increasing the amount of finance available, as directionality is what makes finance transformative and capable to crowd-in resources.

From an innovation directionality perspective, more finance is not always the solution. It is the specific type of finance (public vs private; conditional vs unconditional; concessional loans vs grants) and how it is directed towards addressing sustainability challenges and industrial restructuring that matter most. Public financing is not simply important in terms of delivering a portfolio of viable innovative solutions and crowding-in private investors. It is also critical in addressing problems associated with effective scaling-up and the deployment and diffusion of new technologies, especially in those areas of the innovation chain where finance is more limited (”valley of death” in EU policy). Green finance products and services must be designed while taking into account what is needed from a “production-innovation” perspective, and how green finance can be aligned with other industrial policy instruments, such as public procurement.

Public procurement: Public procurement can be used to discover and experiment with functional solutions to challenges posed by the climate crisis. 

Demand-side measures – especially procurement policies – can play a central role in energy transition, especially given the important role that the public sector plays in energy infrastructure management. Public procurement can be used to create (or increase) the demand for products – goods and services – as well as emerging technologies. Public procurement can also be designed around problems and solutions – that is, functional procurement – something that is often  contemplated but little used, for example in the EU.^[18] Procurement and hybrid forms of finance that combine grants, concessional finance, and procurement contracts are already being used among US federal agencies (e.g. ARPA-E), including at the state level (e.g. NYSERDA).

Standards and technology services: The adoption of new technologies needs system-level coordination and services to increase diffusion in the industrial ecosystem.

The state can also set the standards and regulatory requirements (e.g. emissions, performance targets, energy intensity) under which new goods and technologies are both produced and deployed. Standards-setting is of central importance: It can be used to shape the emerging markets and industry, but also to provide coordination across innovation and technology investments, shifting competition away from areas where industry coordination delivers better payoffs. Technology services and access to infra-technologies (such as data, prototyping, and metrology systems) via institutions such as the Fraunhofer in Germany or the laboratories of the National Institute of Standards and Technologies also matter greatly in the scaling-up of a decentralised and more resilient energy system. Manufacturing extension services can also help small and medium-sized firms with the adoption of sustainable manufacturing processes and technologies along sectoral value chains.

Balancing risks and rewards via conditionalities and policy alignment

In the design of each of these industrial policy instruments, various types of conditionalities can be introduced to reflect risk–reward arrangements functional to sustainable prosperity. These conditionalities can operate ex ante by setting different types of requirements about the types of firms that can access incentives or by selecting the types of activities supported. They can also operate ex post by setting specific requirements concerning firms’ future performances or corporate governance decisions (e.g. limiting stock buy-backs or dividend distribution). Attaching conditionalities to policies such as financing and procurement, but also company bailouts, investment-attraction schemes, business restructurings, etc., is no longer a taboo; international experiences from Austria and France during the Covid-19 pandemic are testaments of these public–private conditionalities. Conditionalities are a way to steer financial resources strategically and ensure that they are retained and reinvested within productive business organisations to improve their social, economic, and environmental outcomes.    

Furthermore, the effectiveness of these industrial policy instruments is likely to increase if they are efficiently aligned.^[19] For example, aligning industrial and competition policies to support sustainable transitions along sectoral value chains is becoming increasingly critical in governing global value chains and digital platforms.^[20] A rapid green transition and deep industrial restructuring are better achieved using a diversity of approaches and business models to ensure an optimal degree of dynamic and healthy competition among firms. Concentration in certain markets and industrial value chains can limit the emergence of new, innovative entrants. It can also result in a situation in which powerful firms controlling regional, national, and global value chains shift the costs of industrial restructuring down the chain, where less-powerful firms are fiercely competing with one another. In Europe, for example, the proposed supply chain law in Germany will potentially turbo-charge accountability for social and environmental impacts.  It is supported by major businesses as well as across the political spectrum in Germany. A similar measure may instead be adopted at the EU level, taking into full account how this law will impact EU-level value chains, competition at each stage of the chain, and how different firms will bear the costs of deep industrial restructuring, which is indeed about firms as well as market-competitive structures.     

Rewiring the state for public purpose

The industrial policy approach envisioned here relies on a wide range of targeted instruments and coordinated interventions across sectors with a common mission,^[21] that is, shaping industrial ecosystems towards sustainable prosperity. This approach could be described as a new form of economic planning being directed towards achieving systemic change and providing a rapid response to the climate change crisis. This form of strategic industrial policy goes far beyond hands-off innovation policies, which have been dominant over the last two decades in the US and Europe, at least until the Covid-19 pandemic. The pandemic has represented an important stress test of the resilience of these advanced economies and their governmental capacity to coordinate a response to major systemic shocks. One of the main lessons learnt is that the type of targeted and coordinated interventions that extreme events such as a pandemic or climate change require cannot be implemented by a government with limited capacities.^[22] Governments across Europe and the US itself no longer have the state capacity that characterised the post–Second World War reconstruction phase, when indicative planning and strategic industrial policy were widely used. Hence, an industrial policy for a green transition, as the one envisioned here, can only be framed as part of a broader reconsideration of the role of the state in the economy and a significant rewiring of state capacity at different governance levels.