Even if countries want reduce dependency, this should be done while engaging with China because completely delinking is not possible, write Mari Pangestu (University of Indonesia) and Novia Xu (CSIS).

Authors: Mari Pangestu, World Bank, and Novia Xu, CSIS

Decarbonisation in Asia is urgent considering the region accounted for 53 per cent of global CO2 emissions in 2021 and continues to grow. The most effective solution to address the impacts of CO2 emissions should remove fossil fuel subsidies and implement a carbon tax — but for many countries this is politically infeasible.

Governments worldwide have turned to industrial policy to meet net zero commitments through subsidies, tax incentives, infrastructure evolution, research and development support and regulations — so-called green industrial policy. Green industrial policy demonstrates that the free market is not working well enough to fast-track the green economy transition. The case for green industrial policy is strong because, as long as the spillovers from green technologies are diffused globally through trade and investment, it increases the competitiveness of green industries. The issue with green industrial policies concerns its implementation and implications for developing countries.

China’s subsidies, tax exemptions for electric vehicle (EV) purchases, state-driven strategic investments and regulations have supported its dominance in clean energy technology and EV supply chains. China’s investments, technological development and the scale of its own domestic demand have pushed out competition while facilitating the green transition by lowering global wind, solar and battery technology costs to compete with fossil fuels.

The EU is presently the frontrunner in green policy. By 2030, the EU Fit for 55 Plan aims to cut greenhouse gas emissions by 55 per cent from 1990 levels. This ambitious target involves reforming the EU Emissions Trading System and the Carbon Border Adjustment Mechanism, which imposes carbon taxes on energy intensive imports. The novel Renewable Energy Directive has also imposed restrictions on land-based products like palm oil. These restrictions will heavily impact the palm oil industry and exporters are seeking alternatives.

The United States does not use carbon pricing at the national level, instead it relies mostly on tax credits and subsidies to promote decarbonisation. Its green industrial strategy includes the Inflation Reduction Act, Infrastructure Investment and Jobs Act and the CHIPS and Science Act. To counter China’s dominance in clean energy sectors, diversify supply chains for clean energy manufacturing, EV batteries and critical minerals and boost growth and jobs, Washington aims to reduce domestic emissions by 40 per cent by 2030.

In 2022, the US Congress authorised a US$4 trillion investment, US$500 billion of which went to climate-related efforts, mostly through the Inflation Reduction Act. Still, this ‘made in America’ approach’s reliance on free trade agreements does not support resilient green supply chains.

The prioritisation of domestic industries will come at the expense of global production, especially if supply chain networks shut out firms from ‘countries of concern’. This approach will likely decrease efficiency, increase costs and slow the pace of green technology adoption. It has also lead to a diversification of supply chains which could result in the exclusion of developing countries who are fiscally constrained from similar subsidies.

Recent US and EU policies prioritise domestic interests and promise job creation, domestic manufacturing and technological capabilities, but at the expense of lower-cost global production and technological diffusion. This makes the green transition less accessible and more expensive, especially for developing nations that need it most. This approach has also impeded countries with critical minerals from developing the capacity to supply global markets. Developing countries are constrained from using subsidies, tax credits and regulations. Instead, they rely on trade restrictions or supply-side local content requirements to increase the value added of their resources.

Against this backdrop of rising green industrial policy, there are a few advisable strategies. Getting the relative price of carbon right is an important first step. This requires politically challenging decisions to reduce or eliminate fuel subsidies, coal price caps and electricity subsidies as well as repurposing subsidies to compensate poorer households. If fossil fuels are the ‘lower-cost’ source of energy, it will be difficult to transition to renewable energy.

It is also important to manage the implications of the global green transition. Developing countries will need support and capacity building to meet the required standard, respond to carbon leakages and navigate the emerging policy environment. They should be assisted through the diffusion of knowledge and technology. If advanced economies want to reduce their dependency on China, this should be done through engagement and collaboration.

Diversifying away from China’s green technology dominance will be slow and costly. The United States should instead coordinate with its allies and find ways to meet domestic priorities while remaining open to Chinese investment in selected sectors such as EV batteries.

For green industrial policy to be effective, it should not serve multiple objectives, such as job creation and derisking. Subsidies and tax credits can be justified as green industrial policy for innovation, manufacturing capability and diversification. Still, green industrial policies will be costly and ineffective if they ban exports and require local production without developing the necessary infrastructure and industry.

Job creation in green industries, for instance, would require skills upgrading and complementary policies for human resource development. All the lessons learned about the principles of good industrial policy should also be adhered to. This includes ensuring the policies are well-targeted, transparent, include sunset clauses and, most importantly, fall within the capacities of the administering institutions.

Mari Pangestu is Professor of International Economics at the University of Indonesia. She is the former managing director of Development Policy and Partnerships at the World Bank.

Novia Xu is Researcher at the Department of Economics, Centre for Strategic and International Studies (CSIS).

An extended version of this article appeared in the most recent edition of East Asia Forum Quarterly, ‘Industrial policy 2.0’, Vol 15, No 4.

View Entire Post