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Green growth

Many countries have plans for a "green recovery" from the pandemic, in which the invention and diffusion of "clean" technologies and practices are central. How can environmental and broader industrial policies be combined to achieve growth that is strong, sustainable and inclusive? Economists study what drives innovation and growth - and how these can be steered towards delivering a zero-carbon future.

Despite renewed international commitment, the world is reducing greenhouse gas emissions far too slowly to limit global warming to "well below 2°C and preferably 1.5°C", as set out in the Paris Agreement. The Intergovernmental Panel on Climate Change has highlighted the immense dangers of going beyond 1.5°C and it is clear that action must now be accelerated to avoid catastrophic and irreversible damage.

This coming decade is critical, and choices made now on what investments to make - in infrastructure, innovation and human, natural and social capital-- will decide whether the world is locked into systems that produce high carbon emissions or whether it reorientates to follow a low-carbon growth path. The Covid-19 crisis has wrecked economies worldwide and new, good-quality jobs need to be created urgently. While many countries have set out plans for a "green recovery" from the Covid-19 crisis, these must now be converted into policy actions.

Over the last 30 years, research at the Centre for Economic Performance (CEP) has contributed to our understanding of the determinants of productivity and innovation, showing how to deliver long-term, sustainable growth.

CEP published its first London School of Economics and Political Science (LSE) Growth Commission report in 2013, setting out a blueprint for inclusive and sustainable growth in the UK. In this report, the Growth Commission recommended support for innovation, investment in skills and wide-ranging changes to the way infrastructure was commissioned, delivered and financed.

A second LSE Growth Commission report was published in 2017. By then, policy-makers had made good progress on infrastructure planning and financing for investment and innovation. But the 2017 report repeated the need to increase investments in skills, and re-emphasised the need for a long-term industrial strategy in the UK, with strong institutions to govern it and key social goals - such as environmental sustainability and improving health and social care outcomes - at its core.

In this and subsequent work, CEP researchers have focused not only on the amount of economic growth but also its direction, considering in particular the extent to which policies can reorientate growth towards a green path.

Net zero and the recovery from Covid-19

In 2019, the UK set itself a legal target of reaching net-zero greenhouse gas emissions by 2050. Energy and clean growth minister, Chris Skidmore, said that the economic opportunities of becoming a greener economy would drive prosperity. Nine months later, the Covid-19 pandemic struck, creating the biggest downturn for 300 years.

CEP researchers are helping to inform policies on a green recovery with a series of reports on sustainable growth produced with colleagues at the LSE's Grantham Research Institute, underpinned by a body of research on innovation and growth.

Early in the pandemic, CEP published a report highlighting the strategy, investments and policies that would enable the UK to "build back better" from Covid-19. A year on, a paper by Nicholas Stern and Anna Valero on innovation, growth and the transition to net-zero emissions summarised the theoretical and empirical evidence on the opportunities, drivers and policies for innovation-led sustainable growth. A core message is that investment in clean innovation, which can support the transition to net-zero emissions, and its diffusion will be key to tackling the climate crisis, and restoring inclusive and sustainable growth.

Creative destruction - with a purpose

Innovation is the key driver of long-run productivity growth. Innovative firms that introduce new products and processes drive growth via the Schumpeterian process of "creative destruction", which propels economic change.

In a body of work stemming from the early 1990s, economists Philippe Aghion (a CEP associate) and Peter Howitt have built this concept into models of endogenous growth. In a recent book, Aghion and his co-authors, set out the evolution of the related research, including that on the environment and "directed technical change" - which considers how technical change can be orientated towards clean innovation.

A key conclusion is that with the right type of clean innovation, we can improve living standards while using fewer natural resources and cutting emissions. But the right sort of innovation - radical and involving the transformation of entire systems in many cases will not happen at the scale and pace required without incentives, regulation, government spending and pressure from civil society.

And while some industries will be created and thrive, there will also be losers. Therefore, for growth to be inclusive, an implication of this research is that policies will be needed to support those people and places who suffer from the "destruction" side of the process.

How can policies increase innovation and direct it towards clean technologies?

CEP research has contributed to our understanding of how to raise the amount of innovation in the economy. This is summarised by Nicholas Bloom, John Van Reenen and Heidi Williams in a toolkit for policy-makers, which rates the evidence and benefits for policy tools such as direct grants for research and development (R&D), skilled immigration and improving human capital. Given the scale and urgency of tackling the climate crisis, the presence of multiple market failures and path dependencies, there is also a strong case for "mission-based" policies that influence the direction of innovation towards clean solutions.

When private markets fail to bring about the innovation needed to tackle the climate crisis, government intervention is needed. A key justification for government support for R&D (in general) is the existence of knowledge spillovers - the indirect spread of knowledge to those who didn't put money into the initial research or development. This contributes to market failure as it means that, even with an effective system of intellectual property rights, private firms may underinvest in R&D as they don't capture all the financial returns on their investments.

While individual firms may hesitate, those wider benefits for whole sectors support the case for government investment on behalf of society. In fact, CEP research has found that when it comes to clean technologies, knowledge spillovers (measured using forward citations in patents related to energy production and transport) tend to be higher than those generated by their "dirty" counterparts. This suggests that there is an enhanced case for government support for clean R&D not just to reach net zero, but also to improve economic growth.

Analysing clean innovation using patents data

One way to analyse clean innovation is to use patents data. This approach has the advantage that patents data is available across countries, over time, and with details that allow easy classification of clean innovations.

Patents also show where innovators are, and include citations of other patents. These citations give researchers an idea of the quality of a patent (by showing how useful it is to other inventors) and allow for the calculation of knowledge spillovers (how influential it is).

A CEP analysis used this approach to compare the spillovers of clean and dirty technologies in energy production and transport technologies, finding that, on average, clean patents receive 43 per cent more citations than dirty ones.

A disadvantage of using patents data is that not all innovations are patented. Broadly speaking, innovations in the service sector are less likely to be patented than in manufacturing; and innovations that relate to new processes within firms tend not to be patented. Complementary analyses are therefore also needed to gain a broad understanding of (clean) innovation.

Further market failures arise when innovative firms are unable to raise finance for their innovation (it can be hard to access loan finance without tangible assets for collateral); and equity investments can be hard to raise for early-stage ideas that have not yet been demonstrated or patented.

To date, investments in early-stage clean technologies appear to have been viewed by many investors as more risky than the dirty alternatives that occupy established positions, as this review of research by Stern and Valero points out. On the diffusion side, analysis in emerging markets highlights how financial and managerial constraints are hampering firms' ability to put in place clean technologies or practices.

Environmental externalities also justify government support for clean technologies. In the absence of a robust carbon price, polluters do not pay the full costs of the climate change caused by their emissions - which reduces the incentives for them to invest in clean technologies.

Conversely, markets do not capture the benefits for society associated with decarbonisation, such as cleaner air and improved health. So, leaving the introduction of clean technologies to the market without government regulation or support is unlikely to work - certainly not at the scale and pace necessary to mitigate climate change.

Encouraging industry to take a new path

Over and above the various market failures outlined above, path dependencies in how new technologies are produced, implemented and taken up make it hard to shift from dirty to clean technologies and sustainable growth quickly (as is required) without coordinated intervention from government.

This is a key insight from the research on endogenous and directed technical change, including CEP research providing empirical evidence from the car industry, which demonstrates how policies can direct innovation towards clean technologies and production, avert environmental disaster and achieve sustainable growth.

That analysis concludes that the optimal policy consists of both a carbon tax to raise the costs of emissions and direct encouragement to develop clean technologies such as subsidies for clean R&D. Path dependency also implies that once clean technologies are sufficiently advanced, they will benefit from their own patterns of path dependence, and so policy incentives will no longer be required.

Another implication is that delay is costly: a longer transition phase means an extended period of slower growth.

Firms invest in cleaner innovation when facing more environmentally-motivated customers

Beyond government action on the "supply side", other key forces shape the amount and direction of firm innovation - including on the demand side. Firms are more likely to invest in innovation in areas where demand is large and growing; and product market competition also shapes firm innovation.

CEP research has shown a complementarity between product market competition and pro-environmental attitudes of consumers. Thus, firms invest in cleaner innovation when facing more environmentally-motivated customers, and this effect is stronger when firms face tougher competition for their customers. These findings suggest that public campaigns to promote citizens' environmental responsibility are likely to be an important policy lever for stimulating clean innovation in firms.

Informing innovation and industrial policy for a green recovery

The evidence suggests that clean growth is possible with the right policy frameworks in place. Recent years have demonstrated that clean technologies are particularly effective at generating economies of scale in production and innovation, as witnessed in the rapidly falling costs of renewable energy, battery storage and electric vehicles.

With global demand for clean products and technologies set to increase rapidly, countries that take early action in these areas may be able to go to scale quicker, establish markets and thus reap significant growth benefits. A key question for policy-makers is how to best target investments and design policies to promote the development of a given country or region's current and potential future competitive strengths, and to avoid the pitfalls of attempting to "pick winners" - which is when governments provide support for particular industries or firms through tax incentives, favourable regulation or subsidies. A number of policy mistakes occurred in the 1960s and 1970s as governments supported declining industries in which they had no comparative advantage - British Leyland in the UK is a famous example.

CEP research by Ralf Martin, Sam Unsworth, Anna Valero and Dennis Verhoeven identifies areas where UK innovation (measured using patents) can generate growth benefits while also tackling the major social challenges of climate change and Covid-19.

They begin by identifying areas where the UK has a "revealed technological advantage" in innovation - that is, the UK's share of patents in a particular technology field is higher than the global share of patents in that field. Figure 1 shows this is the case in clean energy, in particular in ocean and wind energy: in "Covid core" technologies (vaccines and medical equipment) and in biotechnology and pharmaceuticals more broadly.

Figure 1: UK "revealed technological advantage" in key areas of innovation graph showing UK revealed technological advantage in key areas of innovation, source: Martin et al. (2020)
Note: The length of each bar on the horizontal axis shows the RTA; the width of each bar on the vertical axis reflects the number of patents in each category. RTA is defined as the share of UK's patents in a particular technology field relative to the global share of patents in that field. Analysis based on PATSTAT over 2005-2014. Source: Martin et al. (2020).

Understanding the potential economic impacts of innovation support

While the UK might have relative strengths in some areas of innovation, this does not necessarily mean that government support for such areas would generate economic benefits. So, the researchers then set out a new methodology that estimates the national returns to public R&D subsidies for different types of technology - accounting for variation in private returns and (localised) knowledge spillovers.

This analysis demonstrates that public R&D investments in biotechnology, pharmaceuticals and "Covid core" technologies can be expected to deliver among the highest returns of any technology area in the UK (Figure 2). Ocean and wind energy technologies also generate relatively high returns.

Figure 2: UK returns to public R&D investments across technologies, 2005-14 graph showing UK returns to public R&D investments across technologies, 2005-14, source: Martin et al. (2020)
Note: The Figure reports average returns to public R&D subsidies by technology area. The calculations account for direct and indirect knowledge spillovers occurring within the UK, variations in private R&D returns, variation in R&D costs and differences in the responsiveness to subsidies between different technology areas. This is based on the 'IStra-X' indicator as developed by Guillard et al. (2021). The length of each bar on the horizontal -axis shows the IStra-X value; the depth of each bar on the vertical -axis shows reflects the number of patents in each category. Source: Martin et al. (2020)

The geographical spread of innovation

The same report shows that areas that specialise in Covid-related innovation tend also to be places where a large share of overall UK innovation occurs: including the "Golden Triangle" between London, Oxford and Cambridge, together with parts of Scotland. On the other hand, areas that specialise in clean technology are more spread out - and include the Midlands and North of England.

Figure 3: Distribution of patenting across Great Britain graph showing distribution of patenting across Great Britain, source: Martin et al. (2020)
Note: Panel A gives the share of total patents by NUTS2 region. Panels B and C show the share of each region's innovation that is "Covid-related" and clean respectively. Covid-relevant includes Covid core and Covid supporting as previously defined. Analysis based on PATSTAT over 2005-2014. Source: Martin et al. (2020).

A "win-win-win" strategy

Together, this evidence suggests a triple win from support for clean innovations. A sustainable growth strategy could simultaneously achieve net zero, improve productivity and contribute to levelling up.

But given the displacements that have resulted from the Covid-19 crisis and pre-existing inequalities across and within local areas, it will be important to deliver tangible benefits to people and places, and thereby help to gain the public support that is so necessary for the transition.

A recent report finds that net-zero-aligned investments can generate jobs across the UK in the short run, while building productive capacity for innovation-led growth in the medium to longer term. More broadly, these and other investments in the restoration of natural capital and active travel infrastructure will generate other attractive co-benefits including clean air, improved health and living standards.

A rich body of research identifies and models key forces driving clean innovation in particular sectors. The challenge for researchers is to build on these models to inform structural change across the economy in the face of largescale uncertainty.

Beyond patents, empirical analysis is increasingly using broader indicators of innovation to study the development of "clean" products or processes that are not patented. CEP research will continue to build on these areas on the "firm-side", while also considering the impacts of net zero on people and places in terms of the jobs created and lost in the transition - helping to inform policies for future growth that is stronger, cleaner and more equitable.

By Anna Valero

Net zero in the UK

In June 2019, the UK put its commitment to reduce emissions of greenhouse gases to net zero by 2050 into law. This followed the recommendation of the Climate Change Committee (CCC), which advised that net zero by 2050 was required for the UK to meet its 2016 Paris Agreement commitment to keep global warming under 2C.

While the UK produces less than 1 per cent of global emissions, by demonstrating a path to net zero, it hopes to set an example for others. This is particularly important given the fact that the UK is hosting the 26th UN Climate Change Conference of the Parties (COP26) in 2021, which will be critical for driving global climate action.

The CCC has made clear that reaching net-zero will need a step-change in climate policy. And it also made clear that the public need to be involved, through a switch to low-carbon alternatives to current fossil-fuelled heating systems and transport, and through making different lifestyle choices. It adds that that net zero will involve costs and benefits that will be felt unevenly across society.

The CCC also states that net zero "must be a central influence over our recovery from the Covid-19 economic crisis. Investment for net zero is a solid basis for economic renewal".