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Business innovation and climate change: Policy makers must favour dynamism
innovation, climate change, dirk pilat, nick johnstone, oecd, cop21

New innovative firms are needed to help step up the fight against climate change. That means new policies to encourage business dynamism, not least in the energy sector.

Everyone accepts that more innovation is needed for fighting climate change. Low-carbon infrastructure and products may well be developing fast, but as OECD and IEA reports indicate, new breakthroughs are needed to shift the balance away from fossil fuel options.

OECD experts have made this point repeatedly: that any effort to limit greenhouse-gas (GHG) emissions and hence global temperature increases to below 2°C will require not only strong policies in areas such as pricing and regulation, but complementary science and innovation policies as well.

However, such policies will be for nought in the absence of a dynamic business environment, particularly one which encourages the entry of new, adventurous firms and the exit of less innovative and less productive firms. “New” firms are often the vehicle through which radical, game-changing innovations enter the market, as older incumbent firms often focus on incremental changes to established technologies. To grasp this point, one only has to look back on how breakthroughs in information and communication technologies have transformed not only global telecommunications but entire economies. Can such a transition be replicated in energy and transport?

The link between business dynamics and the emergence of breakthrough technologies is a concern because start-up rates have been declining in all sectors across OECD countries in recent years. Moreover, the average age of firms in OECD countries has been increasing since 2001. Indeed, OECD analysis published in 2014 shows a negative relationship between firm age and indicators of the degree of radicalness of patented inventions–basically, older firms tend to engage in relatively less radical innovation than young firms.

In the context of climate change mitigation the links between business dynamics and the emergence of radical technologies are particularly important for two additional reasons: first, political (or regulatory) uncertainty can compound market uncertainty, resulting in important disincentives for investment in the kinds of risky technologies which are likely to lead to breakthroughs; second, many of the GHG-intensive sectors, such as energy and transport, are large network sectors with long-term engagements in capital and skills that can act as additional barriers to firm entry and innovation.

Moreover, in the climate area, there is evidence that young firms are a relatively more important source of inventions than is the case in other fields. Firms that patent climate mitigation technologies tend to be younger than in other fields, with an even larger gap for climate mitigation technologies in the electricity sector. Moreover, the nature of the inventions generated by these young firms is different, with climate mitigation technologies drawing more heavily upon advances in basic “science” than in other fields, where inventions are more likely to build incrementally off other inventions.

The role of policy is central to encourage the growth of these young firms and their contribution to climate change mitigation. Insofar as younger firms have a comparative advantage in more radical innovations, and particularly for climate mitigation, good framework policies which encourage experimentation are essential. Since innovation is about trial and error, failure needs to be recognised as a learning opportunity. The policy environment should enable successful firms to grow, some to start anew, and other less productive or innovative firms to exit the market altogether.

Unfortunately, and paradoxically, environmental policies themselves can slow down the process whereby radical environmental innovations are invented and diffused. This is partly an incidental outcome of the fact that many regulations which impose fixed costs, by requiring investment in specific capital equipment, for instance, can serve as a barrier to entry even if entrants and incumbents are treated identically under the regulation. However, the problem can also be one of explicit and intentional policy design, treating entrants and incumbents in a differentiated manner.

Indeed, it is very common for environmental policies to treat production units of varying ages differently, with older plants facing relatively less stringent regulation than entrants. In some cases this may even take the form of “grandfathering” whereby units which have been in operation before some threshold date are exempted entirely from some new regulation. This can further slow capital turnover and exit rates for existing sources, and reduce new investment and the entry of new firms.

The grandfathering of regulations is particularly well-documented in the case of power plants. Researchers in the OECD Environment Directorate have developed a set of country-level measures of environmental policy stringency for different pollutants for “old” and “new” power plants of different sizes. This work shows that new plants often face more stringent regulations. For example, for a representative plant of 60 megawatts of thermal input, new plants have regulations which are 1.6 times and 2.3 times more stringent for particulate matter and nitrogen oxides emissions than is the case for older plants. This clearly has environmental and economic implications.

But it is not only the “sticks” which may be biased against entrants, but also the “carrots”. For example, R&D tax incentives may be less generous to new firms, since they depend not only on R&D expenditures themselves, but also on profitability, as in the case of a credit on corporate income tax. This is hardly helpful for young companies as they strive to become profitable. Instead, such credits reward less productive incumbents, which tend to be less dynamic or innovative.

Meanwhile, climate change forges on, making it more urgent than ever for policy makers to stop favouring incumbents and to give much more room to young firms to experiment with new technologies and organisational models, and to foster their growth. By changing policy orientations in favour of innovation and business dynamism, leaders can unleash the dynamic low-carbon future we urgently need.

References

Andrews, Dan, Chiara Criscuolo and Carlo Menon (2014), “Do resources flow to patenting firms?: Cross-country evidence from firm level data”, OECD Economics Department, Working Papers, No 1127, OECD Publishing.

Calvino, Flavio Chiara Criscuolo, and Carlo Menon (2015), “Cross-country evidence on start-up dynamics”, OECD Science, Technology and Industry Working Papers, OECD Publishing.

Johnstone, Nick et al. (forthcoming) “Environmental policy design, innovation and efficiency gains in electricity generation”, OECD Environment Working Papers, OECD Publishing.

Johnstone, Nick and Florian Egli (2015) “Emerging technologies and firm dynamics: The implications for green growth”, paper to be presented at forthcoming meeting of the Green Growth and Sustainable Development Forum, Dec. 14-15, 2015.

OECD (forthcoming) “Environmental policy design, innovation and efficiency gains in electricity generation”, OECD Environment Working Papers, OECD Publishing.

OECD (2015), Aligning Policies for a Low-Carbon Economy, OECD Publishing.

OECD (2015), The Innovation Imperative: Contributing to Productivity, Growth and Wellbeing, OECD Publishing

©OECD Observer No 304, November 2015