It is well-known that market demand significantly influences innovation and the development of industries.1 This is of particular relevance in the green economy, where government plays an important role and public policies are frequently implemented to promote green transformation. Demand-oriented policies have the potential of crowding in investments and speeding up transformation while creating new jobs and fostering technological innovation. In emerging economies, green demand-oriented policies may be crucial for the creation of domestic opportunities for latecomers. Deliberate and targeted policies such as incentives for both consumers and users, feed-in tariffs, purchase mandates, portfolio standards, public procurement and investments in new infrastructure or experimental projects are important elements of demand-focused green industrial policies. The use of such mechanisms can effectively support learning and the development of capabilities in local firms, thereby improving the country’s innovation system. Demand-led strategies also entail significant risks, however. If they are inadequately designed and managed, they will yield only low or even negative returns on investment.
What are the key conditions and relevant dynamics to be on the lookout for when developing a demand-led green industrial strategy? We derived insights on renewable energy industries in China in a recent study, and devised a history-friendly model of latecomer development in the global green economy. Our aim was to identify the factors, conditions and dynamics that affect the relative success of demand-driven efforts to catch up and to become a leader in green industry. The results of our analysis can help policymakers frame support policies to avoid aborted or failed attempts at catching-up and to become green industry leaders.2
Creating green demand windows
Our analysis focused on three renewable energy industries in China in which local market and domestic demand played an important role before they began to expand at the global level, namely wind, biomass and hydropower. These three industries developed at different times and have different technological characteristics. However, they were all significantly influenced by the timing and sequence of policies, technological developments and firms’ learning. Based on the individual experiences of these industries, we devised a history-friendly simulation model to develop a baseline scenario and compare it with counter-factual experiments. This allows us to discuss different scenarios for sectoral trajectories that might arise from major increases in domestic demand.
In our model, firms from advanced economies are the first to enter a new green industry, thus becoming the ‘incumbents’. Over time, a few latecomer country firms enter the industry as well. Before a demand-led industrial strategy is devised, latecomer firms start benefitting from a lower cost of production, but also face an initial capabilities gap compared to the incumbents because they are less mature and less experienced. The local market alone cannot drive a catching up process due to its limited scale and the tentative nature of domestic firms’ early demonstration projects.
Building on this scenario, public interventions can expand the base of industrial users and individual consumers of green products and services. We use the term ‘demand window’ to refer to major boosts in domestic demand that result from the introduction of public policies.3 This ‘trigger learning’ by domestic firms can later be used in export markets. In our history-friendly simulations, we set the parameters to generate a case of leadership change driven by demand.4 The baseline simulation explores the effects of a ‘demand window’ in terms of both promoting a learning process and capability-building in latecomers and initiating a catching up process. The figure below presents the development of latecomer market shares in this baseline scenario. As soon as the window of demand opens, the latecomers’ global market share rises and progressively expands.5
Ensuring market protection
One of the key factors in sustaining China’s strategy of demand-led catching-up in green industries has been protectionism. To single out this effect in our model, we run an experiment in which an internal window of demand opens up in less protected markets, both at home and abroad. The figure below shows the development of the latecomer country’s global market share in this scenario. Because protectionism favours latecomer firms by shielding them from highly competitive incumbent firms, they have the possibility in response to an increase in demand of taking advantage of the larger domestic market, albeit at a slower rate compared to the baseline history-friendly simulation. The removal of protectionism allows a larger number of incumbents to penetrate the latecomer market and benefit from the induced extension of the market.
The policy message arising from this experiment could be that protectionism is a necessary condition if the green demand window is to develop its full effect. Obviously, there may be trade-offs in terms of access to technological spill-overs from incumbent firms operating in the local market, which could be of relevance. This is the case, for example, in the context of rapid technological change. However, protectionism may also give rise to potential problems of rent-seeking behaviour; this is the reason why protectionism must be temporary until domestic firms accumulate a sufficiently high level of capabilities that make them competitive in global markets.6
Keeping tabs on technological discontinuities and being strategic about timing
To exploit a window of demand, policymakers and other stakeholders need to be mindful of any major changes in technology once green industrial policies have been put in place. Our simulation exercises suggest that technological discontinuities, which take place after a window of demand has opened, could reduce that window’s effectiveness in the process of industrial development. This is illustrated in the figure below, which presents the results of an experiment in which we introduce technological discontinuity after the window of demand has opened. The adoption of new technology is key for access to a superior set of techniques, but could be limited by technological lock-ins by existing firms in already established technologies.7 The main message from a policy perspective that we derive from this experiment is that the co-occurrence of different disruptions (in terms of demand and technologies) is not always necessarily positive for latecomer development and can sometimes have disadvantageous effects.8
This experiment suggests that even if local industry protection measures are carefully designed and implemented, the successful exploitation of demand windows to catch up and industries’ overall trajectory depends on a range of other factors. As our history-friendly model indicates, these include the relationship between the demand window and the characteristics of technological change in industry. Our simulation experiment suggests that the creation of a demand window might not translate into tangible catching-up opportunities if they are followed by major technological discontinuity.9 The reason is that incumbents with greater and more advanced know-how have better opportunities to broaden their existing capabilities in the new major technology while latecomers tend to continue using the technology they have just successfully moved into. The implication is that policymakers need to be mindful of the timing of demand creation in relation to technologies’ dynamics.
Taking note of learning rates
When an industry is completely new (as is the case for latecomers) and is characterized by uncertainty and experimentation, the accumulation of capabilities needed for commercialization is likely to take a long time. This extended period of capabilities accumulation may prove beneficial for latecomers when a major technology emerges, even after the window of demand opened. This is the scenario presented in the figure below. The modest performance of latecomer firms in the initial phase of demand creation actually evolves into a strength as a radical new technology emerges because initial capability accumulation, coupled with a low global market share, implies that latecomer firms are less likely to incur technological lock-ins but have some accumulated capabilities to move into the radical new technology. Such a situation may arise in the future with the advent of radical new green technologies.10
Managing green demand windows in the real world
Since real-life experiments are not possible when it comes to the implementation of sustained and costly policy initiatives, simulations can help highlight some of the key conditions that might influence the trajectories of latecomers in the context of demand-led strategies. Through our research, we aim to contribute to the discussion from a theoretical perspective.
We have demonstrated that windows of demand need to be supplemented by (temporary) protectionist measures and be combined with policies that incentivize the adoption of new technologies. Obviously, such a strategy might be politically contentious in the real world and its feasibility will depend on the characteristics of national and international institutions, their underlying political economy and power relations. Hence, the points made here should be interpreted with caution.
Demand-led industrial development trajectories are complex and difficult to manage. The sequence and order of events in the catching-up process play a fundamental role.11 It is precisely this sequencing and interplay of events that can essentially be discussed using simulation models as the primary analytical tool. This is especially useful for policymakers. However, our model does not help predict the advent of events: there is a real risk that major technological change destroys much of the technology-specific learning and capability-building which the demand window has helped to create. Such sequences of events must be carefully considered when introducing policies. Policies should therefore include sunset clauses, and their effects must be continuously monitored and evaluated.
Finally, policymakers must consider complementarities: when promoting latecomer development, i.e. a single policy (such as one that creates a demand window) may not be sufficient. A wide range of other policies may need to be introduced in conjunction, but will have to take account of feedback from and complementarities among different parts of the relevant sectoral systems of production and innovation in which they are placed. Moreover, such policies cut across environmental, industrial and innovation domains. They therefore carry a high risk of coordination failure: continuous efforts to co-design policies across ministries and government agencies need to remain at the top of the agenda.
Disclaimer: The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of UNIDO (read more).
Have your say
What is your opinion on the IAP?
