Wanted: green thumb for the invisible hand

One option for governments to help clean-tech initiatives is to subsidise and invest in them
Carlos Nichloas Fernandes, Business Times 11 Feb 09;

DISRUPTIVE innovations are frequently driven by low-cost, good-enough solutions that change the economics of delivering a product or service. By delivering value in a more cost-effective manner than existing technologies, these innovations exploit the natural behaviour of free markets to rapidly build traction and enable the transformation or creation of an industry. It is this opportunity to economically capture the value of these innovations that excites entrepreneurs and venture capitalists alike.

In his 1776 book Wealth of Nations, the conceptual builder of free-market theory, Adam Smith, articulated that though human motives were driven by self-interest, the invisible hand of free-market competition would tend to benefit society as a whole by keeping prices low.

Free markets consequently form the pillar on which disruptive innovation stands. But what happens when a disruptive innovation has a substantial social component that cannot be captured by the entrepreneurial pioneers without government intervention to correct market inefficiencies?

Just about six months ago, as oil prices skyrocketed towards US$147 per barrel, venture capitalists were delighted at the prospect of clean technologies becoming a competitive alternative to fossil fuels.

However, with the price of oil today hovering at around US$45 per barrel, the prospects of clean technologies being a viable substitute to oil in the near to medium term have largely evaporated. This has resulted in a 25 per cent fall in investment in clean technology projects in the third quarter of 2008 to US$18 billion, according to New Energy Finance.

Market players today pay only US$45 per barrel of oil and externalise the social and environmental costs of each barrel. Free-market principles apply only if the market participants - producers and consumers - experience the consequences of their actions. In the case of polluting carbon emissions arising from the use of fossil fuels, future generations pay the cost for today's participants.

In order to prevent this massive market failure, governments have recognised that they need to intervene.

Government intervention can essentially take two forms - First, governments can implement policies that help consumers internalise the true costs of fossil fuels by introducing a Pigovian tax or a cap and trade system to allocate 'pollution rights' to correct the negative externalities of market activity.

Second, governments can take a more direct approach by subsidising and investing in clean technology initiatives to compensate for market failure, thus enabling innovators to financially capture some of the social value of their innovations.

Of the two forms of intervention, economists favour the former, with free-market fundamentalists opposing the latter.

Proponents of laissez-faire capitalism argue against the direct approach involving government investments and subsidies. Their views are bolstered by two examples: The US government's over-investment in ethanol that resulted in the bio-fuels bust and Germany's generous subsidisation of solar panels, despite receiving little sunlight relative to the rest of the world.

While it is true that government investments may distort market forces and the US and German governments may have made some bad bets on clean technology projects, this anecdotal evidence merely encourages a simplistic view of a complex problem.

There is an important variable to the cost-benefit analysis of the government's role that is not appropriately considered - that variable is the temporal dimension of the global warming crisis.

Fanatic free-market thinking is not the only reason for the opposition to direct government investment and subsidies in clean technologies. The thesis that global warming is real, caused primarily by humans, has catastrophic consequences, and needs to be fixed quickly has often been erroneously presented by the media as an idea that is still disputed in the scientific community.

In reality, a study of 1,000 articles in peer-reviewed journals published between 1988 and 2003 noted that not a single article questioned global warming, its causes and the necessity of immediate action. On the other hand, in a similar study of articles published in mainstream news media it was found that 53 per cent questioned these facts.

Open debate

The reason for unanimous consensus among scientists having been presented as an open debate in the media is the result of a herculean effort by oil companies to fund pseudo science and frame global warming as an uncertainty in an attempt to preserve the status quo and restrict new clean technologies and business models that may be disruptive to their entrenched interests. Deep pockets buy the best marketers and copywriters. Solid science does not.

One of the key word wizards behind these efforts was Frank Luntz, a corporate and political consultant who helps in the selection of words and language that helps his clients turn public opinion on an issue. Because 'global warming' and 'oil drilling' had alarmist or negative connotations, he suggested the use of terms such as 'climate change' and 'energy exploration' to replace them.

In a memo to former US president George W Bush, he stated: 'Should the public come to believe that the scientific issues are settled, their views about global warming will change accordingly. Therefore, you need to continue to make the lack of scientific certainty a primary issue in the debate.'

Scientists believe that global warming will reach a tipping point after which its catastrophic consequences will be irreversible, unless clean technology projects are implemented within the next decade. With credit being as tight as it is, many companies are focusing on cash preservation for the purposes of survival, and are simply unable to invest in greener and cleaner technologies.

Faced with the lofty choice of saving the planet tomorrow, against the goal of mere existence today, most companies will choose the latter.

The notion that carbon taxes and cap and trade systems are the only appropriate solution to global warming is naive. The world needs every tool at its disposal to fight global warming and one approach to the fight should not necessarily preclude another.

With the drop in private investment in clean technologies, governments must jump in to fill the gap in order to stall global warming. The cost of action is high, but the cost of inaction is higher.

The author is the CEO of RecordTV and occasionally teaches courses and seminars on Innovation at INSEAD and the National University of Singapore