7. The importance of innovation for a resilient net-zero transition

This chapter draws on contributions to the horizontal project carried out under the responsibility of the Committee for Industry, Innovation and Entrepreneurship and the Committee for Scientific and Technological Policy.

Some of the carbon-free technologies necessary to reach net-zero emissions already exist, but are still too expensive to be fully competitive with carbon-based alternatives and deployed rapidly and at scale (IPCC, 2022[1]). However, climate targets cannot be achieved by only deploying existing technologies, e.g. mature forms of renewable energy such as wind and solar. Other technologies such as green hydrogen are still in their infancy and need to be further developed and have their costs reduced to allow rapid scale-up. According to the International Energy Agency’s (IEA) Net‐Zero Emissions by 2050 Scenario, half of the global reductions in energy-related CO2 emissions through 2050 will have to come from technologies that are currently at the demonstration or prototype phase (IEA, 2021[2]). Even within technologies sectors that are for the most part considered mature, such as renewable energy, there is room for breakthrough innovation, for example in geothermal or concentrated solar power (IEA, 2017[3]; IRENA, 2018[4]).

In heavy industry and long‐distance transport, the share of emissions reductions from technologies still under development today is even higher. For example, decarbonisation of the manufacturing industry requires not only the adoption of technologies that are close to the market such as a massive increase in renewable electricity generation to enable the electrification of low-temperature heat processes, but also the deployment of many technologies that are still far from maturity, notably bio-based products and green hydrogen (Anderson et al., 2021[5]).

Alongside low-carbon technologies, climate neutrality will rest on innovation in other domains, in particular digital technologies and recycling. The digital transformation could be a key enabler for reaching climate goals, thanks to technologies such as smart meters, sensors, artificial intelligence (AI), the Internet of Things (IoT) and blockchain, and to digitally-induced changes in business models and consumption (OECD, 2020[6]; OECD, 2019[7]). Improved recycling technologies can also contribute to decarbonisation by reducing the need for fossil-based feedstock in the chemical industry or primary steel in the metal industry. Mechanical or chemical recycling can transform existing products into new feedstock, thereby closing the materials chain, but many options need further technological development and cost reductions to be deployed widely.

This chapter considers the need for innovation to ensure a successful and resilient transition, reviewing recent policy trends and suggesting ways to enhance government efforts to support technological development.

The current pace of low-carbon innovation is not in line with the carbon neutrality challenge. Climate related innovation as measured by patent filings has decreased as a share of inventions in all technology areas over the past decade (Figure 7.1). Following a period of strong growth between 2004 and 2011, innovation efforts in climate-related technologies have declined recently as a share of total patenting, from 12.6% of global patents in 2011 to 9.0% in 2020. Between 2005-2011, the number of climate-related inventions patented globally grew at an average annual rate of 16.3%, while innovation in all technologies only grew at 6.2% per year on average.

Climate innovation efforts started to decline around 2012, however, despite the ambitious climate objectives and signing of the Paris Agreement in 2015. Since 2012, climate related inventions patented globally increased at an average rate of 0.3% per year (with over 5% decreases in 2014 and 2015) while overall innovation continued to grow at an average pace of 4.6% per year. Importantly, the decrease in low-carbon patenting affects nearly all technologies with the exception of energy storage (batteries) and can be observed across nearly all major innovating countries around the world, except Denmark.

In contrast with frontier innovation efforts as measured by patent filings, deployment of existing technologies seems to be on the rise, as suggested by the growth of trademark filings for climate-related goods and services observed over the last two decades (Figure 7.2). This proportion has tripled in the US and in Japan (from 1% to 3%) and has nearly quadrupled in Europe (from 2% to 8%). As for patents, a decrease was observed around 2012-2014, but the trend has picked up again in the most recent available years. This suggests that while firms have reduced research and development (R&D) efforts toward climate-related technologies, diffusion and commercialisation efforts have continued to increase.

Data on venture capital investment in green start-ups confirms the focus of investors on the deployment of relatively mature technologies, as opposed to the development of exploratory solutions. A new database of clean-tech start-ups developed by the OECD shows that there has been a large increase in global venture capital (VC) investment in climate-related start-ups in the last decade, from USD 3.1 billion in 2010 to USD 18.6 billion in 2020 (Figure 7.3).

However, after a peak in 2018, global VC investment in green start-ups has decreased in the last two years. The share of total VC funding going to climate-related start-ups has remained fairly stable. This suggests that growth in VC funding for clean-tech start-ups partly reflects the global growth in VC funding across all sectors of the economy. Importantly, the sharp increase in green VC observed since 2017 is to a large extent driven by large and late-stage funding rounds of more than USD 250 million, which accounts for more than 50% of total funding between 2016 and 2019. The share of VC directed at seed funding (representing very early-stage investment into novel technologies) amounts to only 3.5% of total VC for green start-ups across the 2010-2020 period, against 7.8% for non-green start-ups.

The growth of climate-related trademarks compared with the decrease in climate-related patents and the decreasing share of green venture capital directed at seed and early-stage funding suggest that the business sector is currently focusing on diffusion and commercialisation of existing technologies rather than on the development of new innovations.

Evidence indicates that this focus is a direct consequence of a policy emphasis on deployment rather than on R&D support. Indeed, the slowdown in low-carbon innovation corresponds to a recent levelling-off of concrete climate policy measures across OECD countries, particularly so for innovation-related policies. Public expenditures on research, development and demonstration for low-carbon technologies, as reported by the IEA’s Energy Technology RD&D Budgets Data Explorer, have remained broadly flat (as a percentage of GDP) over the last 30 years (Figure 7.4), despite pledges by Mission Innovation, a global initiative of 22 countries and the European Commission, to double clean energy research and development funding between 2016 and 2021. Between 2016 and 2019, total public expenditures on energy RD&D across all IEA Member countries increased by less than 20% to EUR 19 billion.

There is heterogeneity across countries in terms of public R&D budgets devoted to low-carbon innovation. Eighteen OECD countries devoted more than 3% of their national R&D budgets to R&D in low-carbon technologies in 2022 (or in the latest available year), the maximum being 8.9% in France (due to large nuclear R&D), 8.0% in Belgium and 7.1% in Finland.

The contrast with support for deployment and adoption is striking. For example, European countries spent EUR 458 million in 2018 to support R&D activities in wind and solar power. The cost to society implied by subsidies for the deployment of wind and solar technologies that same year represented EUR 78 400 million – 150 times more than public R&D expenditures (Figure 7.5). The ratio is smaller in the US and in Japan, but across these three major economic players the emphasis is clearly on support for deployment.

Given the wide range of barriers and market failures discouraging low-carbon innovation, the theoretical justifications for science, technology and innovation policies specifically targeting these technologies are sound and well established. This includes the existence of positive externalities in the form of large knowledge spillovers, which have been shown to be 60% larger for low-carbon than for high-carbon technologies (Dechezleprêtre, Martin and Mohnen, 2014[8]), but also learning-by-doing, which occurs when costs to manufacturers or users fall as cumulative output increases (Rubin et al., 2015[9]). For example, production costs in renewable energy typically fall by around 15% each time the cumulative installed capacity doubles, with higher learning rates in earlier stages of deployment (Grubb et al., 2021[10]). The presence of learning-by-doing provides a strong justification for deployment subsidies. In the renewable electricity domain, these subsidies have taken the form of feed-in tariffs and auctions, which have been instrumental in inducing the massive cost reductions observed in the last couple of decades (Nemet, 2019[11]).

Imperfections in the market for capital such as risk aversion and asymmetric information also limit the amount of private capital available for low-carbon R&D. Firms developing clean innovations seem to face particularly high financial constraints, as shown by Howell (2017[12]). Another major market failure is related to the traditional problem of environmental externalities. Because carbon pollution (and the damages it generates) is not priced by the market, the market for technologies that reduce emissions will be limited because the lack of economic incentives imply low financial returns. This in turn reduces incentives to develop such technologies.

Beyond market failures, a number of factors create inertia in economic systems and therefore impede innovation. These include systemic barriers to change and innovation; barriers to competition; lack of co-operation within innovation systems; and prevailing norms and habits; as well as technology lock-in and path dependence (Aghion, 2019[13]). Government failures including preference for incumbents, lack of policy predictability and stability, and regulatory barriers may also act as barriers to low-carbon innovation. In particular, climate policy uncertainty is associated with significant decreases in investment, particularly in pollution-intensive sectors that are most exposed to climate policies and among capital-intensive companies (Berestycki et al., 2022[14]).

Science, technology and innovation (STI) policies are critical for climate action because technological progress – which originates from investments in R&D activities but also from learning-by-doing and knowledge spillovers – reduces the investment costs of emissions-reduction policies. This is demonstrated by sharp declines in the costs of batteries and solar, which have both experienced a 90% reduction over the past decade, as shown in Figure 7.6. As a result, many carbon-free technologies (especially renewable energy) are already cheaper than fossil fuels.

A consequence of the cost reductions brought about by technological progress is that STI policies reduce the social and economic cost of reaching climate objectives (Acemoglu et al., 2016[15]). Indeed, by reducing the costs of low-carbon technologies, innovation policies can increase the responsiveness of emissions to carbon prices (D’Arcangelo et al., 2022[16]). Including effective STI policies in the climate policy mix reduces the carbon price levels needed to reach a given climate target. STI policies can therefore partially substitute for low carbon prices (although not fully). As such, suboptimal carbon prices, as are in place today, support the case for even stronger STI policies.

There is also an important political argument for including STI policies in the overall climate policy mix. A nationally representative population survey recently implemented across 20 OECD and non-OECD countries shows that subsidies to low-carbon technologies are systematically the most favoured climate policy compared to carbon pricing, bans or regulations. Similarly, support for a carbon tax is largest if its revenues are used to fund green infrastructure or to subsidise low-carbon technologies (Dechezleprêtre et al., 2022[17]). From a public acceptability point of view, STI climate policies thus appear to be a highly attractive option.

Given the significant reallocations implied by the low-carbon transition (between activities, sectors, firms, workers, and technologies), the focus of climate policy is gradually shifting to transition costs and how to mitigate them. Bringing about the necessary cost reductions to make carbon-free technologies competitive with high-carbon options should therefore be a primary objective of climate policy. This would also help to accelerate the diffusion of available technologies, which is critical to reaching medium term carbon-emissions reductions.

For these reasons, innovation and industrial policies – focussed on both development and deployment of low-carbon technologies – should constitute a cornerstone of strategies to reach carbon neutrality. Given the large range of barriers and market failures discouraging low-carbon innovation, the theoretical justifications for these policies are sound and well established. Innovation and industrial policies can also complement, and partially substitute for, carbon prices, which are often difficult to implement politically. In addition, by reducing technology costs and boosting the growth of new carbon-efficient firms and sectors, such policies will facilitate the adoption of more ambitious climate policies, including – through international technology diffusion – among emerging economies, where the bulk of future emission growth is projected to take place.

An increase in public RD&D expenditures targeted at technologies that are still far from market but necessary to reach carbon neutrality by 2050 is urgent. All models of climate policy show that optimal policy relies heavily on research subsidies. For example, Acemoglu et al. (2016[15]) suggest that 90% of all R&D expenditures in clean technologies should be funded by government for a couple of decades until the productivity of clean technologies catches up with that of dirty technologies. Critical areas such as electrification, hydrogen, bioenergy and carbon capture, utilisation and storage (CCUS) today receive only around one‐third of the level of public R&D funding of the more established low‐carbon electricity generation and energy efficiency technologies (IEA, 2021[2]). Therefore, governments should consider rebalancing their STI policies, giving greater emphasis to the RD&D stages, particularly for technologies that are not mature yet.

This increase should be gradual, though, for the research system to experiment with multiple search paths and technologies and adapt to changing circumstances. Such commitments should provide a long-term and stable perspective as for other climate policies. Post-COVID-19 recovery programmes can help increase public RD&D budgets but such increases will need to be sustained in the long run rather than one-off increases.

Importantly, specific R&D support instruments are required. Governments can financially support the innovation activities of firms through direct and targeted instruments (e.g. research grants) or via horizontal and untargeted instruments (R&D tax credits). Empirical evidence suggests that R&D tax credits have positive effects on firms’ innovative activity, with the effect on experimental development about twice as large as the effect on basic and applied research, and heterogeneous effects across types of firms (OECD, 2020[18]) (Bloom, Van Reenen and Williams, 2019[19]). R&D grants also have positive effects on firms’ innovative activity but the effect seems concentrated on small firms that are likely to be more financially constrained and focused on incremental innovations to meet short-term market demands (Bronzini and Piselli, 2016[20]; Bronzini and Iachini, 2014[21]). For clean technologies specifically, Howell (2017[12]) shows that firms that received a grant from the US Department of Energy’s Small Business Innovation Research programme increased patenting, survival rate and the probability of subsequently receiving venture capital among recipients, with stronger effects for firms that were more financially constrained. No study has examined the impact of R&D tax credits specifically on clean technology innovation.

A critical part of the climate innovation policy package is to close the funding gap for large-scale demonstration projects in order to help breakthrough innovators escape the “valley of death” of clean technology venturing (between research and commercialisation). The amount of funding which needs to be made available for demonstration support on technologies that still have a low technology readiness level is very significant, particularly in the industry sector: for example, a single 100 MW electrolyser for green hydrogen production costs between EUR 50-75 million; the production of green hydrogen is still about three times more expensive than grey hydrogen (made out of natural gas through steam reforming) even under the most favourable conditions. Major cost reductions – and the rapid deployment that they would induce – crucially depend on massive improvements in the cost of electrolysers through research and development and large-scale demonstration projects.

Despite this, the amount of public funding available for demonstration projects appears to be small. For example, the European Union recently introduced a new Innovation Fund as a funding mechanism for the demonstration of innovative low-carbon technologies. The first call for large-scale projects attracted 311 applications for a total amount requested of EUR 21.7 billion, while only around EUR 1 billion is available. By comparison, a typical carbon capture and storage (CCS), demonstration projects currently cost around USD 1 billion, take five years or more to build, and have a market value of around one-tenth of their cost. The IEA recommends that USD 90 billion be mobilised as soon as possible to complete a portfolio of demonstration projects before 2030 in electrification of end-uses, CCUS, hydrogen and sustainable bioenergy (IEA, 2021[2]).

Fischer, Newell & Preonas (2017[22]) model the US energy system and determine the optimal distribution of public spending between R&D support and deployment under various scenarios. They find that the optimal ratio of deployment spending to R&D spending does not exceed one for wind energy in almost all scenarios. With extreme assumptions on the magnitude of learning-by-doing, this ratio goes to 6.5. The ratio of public spending on deployment to R&D exceeds one for solar energy but not by much. The ratio reaches 10-to-1 under the “high learning-by-doing” scenario. This is far from the ratios observed in Figure 7.5. Support for early-stage deployment of clean technologies should continue, as it is justified by barriers and market failures at this stage (e.g. learning spillovers, technology and market risks, second-mover advantage), but additional efforts should primarily be focused on RD&D.

As regards what sorts of technologies should be priority for funding, governments should focus their support on technologies that are central to any decarbonisation pathway and have a strong public- good component (and are therefore less likely to be provided by the market). The goal is to avoid providing public support for research that the private sector would otherwise do on their own. This could include projects supporting long-term research needs where the payoff occurs further into the future (such as hydrogen), as well as infrastructure that has a public- good dimension (including transportation networks and storage for carbon, smart grids, and infrastructure for electric vehicles). In the IEA’s Net Zero Emissions scenario, electrification, CCUS, hydrogen and sustainable bioenergy account for nearly half of the cumulative emissions reductions to 2050. Just three technologies are critical in enabling around 15% of the cumulative emissions reductions between 2030 and 2050: advanced high‐energy density batteries, hydrogen electrolysers and direct air capture (DAC). These technologies should be the focus of government support.

In general, there is a need to adopt a portfolio approach in order to diversify industrial and technology risks. Given the technological uncertainty inherent to the transition to a net-zero economy, countries should aim to support an array of technologies while still focusing on national technological strength. A focus on particular production process should be avoided in order to prevent lock-in and give all green technologies a fair chance.

Barriers to external funding should be reduced to help high-risk companies raise funds. Favourable tax schemes, low-interest or subsidised loans for young firms, and a greater mobilisation of government venture capital toward the green transition can help (Hepburn, Pless and Popp, 2018[23]).

Collaboration in low-carbon innovation should be strengthened, both nationally and internationally. There is ample room for improvement in collaborative R&D between firms, between firms and public research institutions, and between countries to capitalise on complementary skills and resources at the domestic and international levels. Strengthening international co-operation and technology transfer will be particularly important to accelerate the development and diffusion of low-carbon technologies. Co-ordinated action can accelerate innovation, enhance economies of scale, strengthen incentives for investment, and foster a level playing field where needed. Sharing experiences between countries and industries can reduce individual risks and accelerate progress towards viable solutions. Measures and commitments to deployment can accelerate economies of scale and corresponding cost reductions. International co-ordination of R&D funding across different technologies and stages of innovation will be critical to developing the next generation of clean technologies. A relevant model is the International Thermonuclear Experimental Reactor (ITER) nuclear fusion project, funded by the EU, India, Japan, China, the Russian Federation, Korea and the US.

Low-carbon innovation policies need to be embedded in a broader package. Although innovation and industrial policies should play a greater role in carbon neutrality strategies, they are insufficient on their own and need to be part of broader packages of climate policies. Although technology policy can help facilitate the creation of new environmentally friendly technologies, it provides little incentive to adopt these technologies unless R&D activities manage to make clean technologies competitive with high-carbon alternatives on economic grounds. Until then, incentives for adoption need to be provided by demand-side policies, which can make low-carbon options more attractive economically. However, demand-side policy cannot supplant the need for technology policy, given the presence of barriers and market failures at the R&D and demonstration stages.

In particular, carbon pricing is necessary to encourage the adoption of clean technologies that are closer to market and thus “redirect” innovation toward low-carbon activities. There is ample empirical evidence that by encouraging the diffusion of low-carbon technologies, carbon pricing affects innovation activity further up the technology supply chain, favouring R&D in clean technologies and discouraging it in conventional (polluting) technologies. For example, Figure 7.7 shows that the introduction of the European carbon market (EU ETS) led to a large and rapid increase in low-carbon innovation (as measured by patent filings) among regulated companies, compared to a carefully selected control group of unregulated but similar firms.

Carbon prices can serve as a necessary backstop against possible rebound effects following efficiency improvements brought about by technological progress. They can also provide a useful source of revenue that can be earmarked for technology support policy. The current limited take-up of carbon pricing reduces incentives to develop and adopt new low-carbon technologies. In 2018 (the last year for which comprehensive data is available), 60% of carbon emissions among 44 OECD and G20 countries were not priced at all, and only 10% were priced at or above EUR 60/tonne CO2 (OECD, 2021[24]).

Commitments to raising carbon prices in the future and clear carbon prices trajectories can already spur innovation even if current carbon prices are low. Carbon Contracts-for-Difference (CCfD), an experimental mechanism announced in Germany in 2022, may decrease uncertainty thanks to forward-contracts on the price of abated greenhouse gases. The Dutch carbon levy, a top-up on the EU ETS with an explicit carbon price trajectory, is another example of how policy instruments can reduce carbon price uncertainty for investors (Anderson et al., 2021[5]).

Standard-setting is also necessary to reduce uncertainty and support the deployment of particular technologies. For green hydrogen, this includes standardisation of guarantees of origin, hydrogen purity, the design of liquefaction/conversion and regasification/reconversion facilities, equipment specifications and blending hydrogen into the gas grid. Another example is standardisation of plugs for electric cars across vehicles and charging stations. Such standards are best set at the international level and call for international co-ordination of national standards in the context of standard-setting organisations (Vollebergh and van der Werf, 2014[25]). Co-ordination on standards across countries could help to overcome barriers to first deployment created by international competition. Standards can also be helpful in restricting or phasing out particularly undesirable high-emitting activities or technologies (D’Arcangelo et al., 2022[26]).

Beyond carbon pricing and climate-related standards, the low-carbon transition will involve a massive structural transformation that will require the alignment of policy frameworks beyond innovation and climate policies. Competition and entrepreneurship policies play a critical role in encouraging business dynamism, the creation of new innovative firms and the reallocation of resources toward the most resource-efficient firms. Government venture capital may serve as a resource to help entrepreneurs finance projects with high social value. Education and skills policies are necessary to make sure that the transformation can rely on the right set of skills and research. For example, it has been shown that green investment made through the American Recovery and Reinvestment Act adopted after the Global Financial Crisis was more effective in geographic areas where green skills were more prevalent (Popp et al., 2020[27]).

An efficient and cost-effective shift to a low-carbon economy requires the engagement of many parts of government beyond those traditionally mobilised in the development of climate-change policies. Developing such a package requires the development of mission-oriented strategies across all countries committed to carbon neutrality. Mission-oriented innovation approaches, which are increasingly adopted by countries to address a wide variety of societal challenges, can help to promote systemic change because of their integrated nature (Larrue, 2021[28]). They are expected to improve co-ordination over traditional innovation policies through the collective development of a strategic agenda, the setting of a dedicated governance structure, and the implementation of a tailor-made and integrated policy mix. However, recent analysis shows that, despite displaying some systemic features, existing net-zero missions remain for the most part focused on support to research and innovation, led by STI authorities and drawing almost exclusively on STI funds (Larrue, 2022[29]). To realise their transformative potential, missions for net-zero need to move beyond this “STI only trap”.

Innovation has an essential role in the net-zero transition yet current trends show that innovation in low carbon technologies is lagging. Governments should strengthen their science, technology and innovation (STI) policies with a focus on innovation. The scale and scope of the transformation needed will also require efforts beyond traditional STI policies, in education, labour markets, and infrastructure development, and extending beyond the remit of traditional climate policy making. Enhancing innovation efforts in this way will crucially depend on adequate forms of finance and investment (see Chapter 8).

The need to build systemic resilience into the net-zero transition further strengthens the call for a broad approach to supporting innovation. The mission-oriented approach outlined above offers clear synergies and follows many of the recommendations made throughout this report on needing to work across government institutions and systems components, taking interlinkages between systems into account and stress-testing mission-oriented strategies against future disruptions.

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