Free markets are extremely useful tools, but they have their limits as well, as they rely on price signals that provide incentives on which economic actors take decisions, but at times, these price signals do not contain all relevant information. Supporters of free markets see no role for the state in meddling in the market mechanism (bar enforcement of property rights), and hence they see no role for industrial policy, but we think it can be useful, as the solar sector testifies.

The solar sector is almost a laboratory case in the value of industrial policy, as sometimes, not all of the benefits of an industry are reflected in the price. The main benefits of solar energy are (here more):

• clean energy
• reducing greenhouse emissions
• contributing to energy independence and security

These benefits are considerations that play no role in the price formation of solar energy. These are all external effects, benefits that accrue to society at large. On price alone, solar energy cannot compete with fossil fuel.

In fact, it’s even worse, as fossil fuel contains negative external effects, that is, its production engender cost to society at large that are not reflected in its price formation (these costs are a mirror of the benefits of solar energy: pollution, greenhouse emissions, dependence on foreign sources). Also, surprisingly, fossil fuel production gets a lot of subsidies (at least in the US).

Since both positive and negative external effects have no bearing on the market parties making supply and demand decisions (hence the term ‘external’ effects), so goods that produce positive external effects tend to be under-supplied, those with negative external effects get oversupplied from the point of society at large.

Taxation, regulation, or trading rights can address the negative external effects problems, some form of industrial policy can foster sectors with positive externalities.

The benefits of solar energy are especially important for the US, consider alternative policies to secure energy supplies. These have not only been terribly expensive, their efficiency is rather questionable. The US has engaged in various geo-political policies, including war, to secure energy supplies and the effectiveness of these is in serious doubt.

For instance, in a recent book, Nobel prize winner George Stiglitz has argued that the cost of the Irak war will amount to the staggering figure of $3 Trillion, and, in terms of energy independence, it has been rather counterproductive, although one could argue that energy security surely was not it’s only, or perhaps not even it’s main objective.

Meanwhile, countries like Japan and Germany spend a negligible fraction of these sums to establish a viable market for solar energy through industrial policy, as a quote from a US publication laments:

“Unfortunately, the United States has lost its lead in solar power development. In 2003, shipments from U.S. solar power manufacturers fell by over 10% and our overall share of the world market dropped to 14%—the lowest level ever…. In 1997, U.S. solar power manufacturers captured 100% of the domestic market; in 2003, they captured only 73%. In 1997, U.S. manufacturers captured more than 40% of the world market; in 2003, they captured a mere 14%.”

The publication dates from 2004, and things have improved somewhat due to renewed policy efforts at the state and federal levels. However, this didn’t prevent that:

“Despite the new CSI program in California, state renewable portfolio standards and federal tax credits from 2006, the U.S. fell behind Spain to become the fourth largest global market for PV due to disparity levels in domestic government support for solar.”

And:

In 1997, said Resch, America was the leader in solar energy technology, with 40 percent of global solar production. “Last year, we were less than 8 percent, and even most of that was manufacturing for overseas markets.” (From Friedman in NYT 30 April 2008)

One has to conclude that:

“U.S. solar insolation (the amount of usable solar resources) far exceeds that of Germany. Yet Germany is the top market for installed solar energy in the world due to far greater policy support, and Germany installs 8 times as much PV as the U.S. because Germany has provided generous incentives that stimulate demand for solar energy.” (US solar year in review 2007)

Left to the free market, solar industry would hardly exist (with the exception perhaps of some remote areas where due to particular circumstances electricity from competing sources is very expensive, but even this can be seriously questioned, because without some form of government support, research incentives to produce solar technologies would also be a lot weaker).

Thomas Friedman, author of “The World is Flat” had a few comments to make about US energy policy recently:

“Few Americans know it, but for almost a year now, Congress has been bickering over whether and how to renew the investment tax credit to stimulate investment in solar energy and the production tax credit to encourage investment in wind energy. The bickering has been so poisonous that when Congress passed the 2007 energy bill last December, it failed to extend any stimulus for wind and solar energy production. Oil and gas kept all their credits, but those for wind and solar have been left to expire this December. I am not making this up. At a time when we should be throwing everything into clean power innovation, we are squabbling over pennies.”

It is also alarming, says Rhone Resch, the president of the Solar Energy Industries Association, that the U.S. has reached a point “where the priorities of Congress could become so distorted by politics” that it would turn its back on the next great global industry — clean power — “but that’s exactly what is happening.” If the wind and solar credits expire, said Resch, the impact in just 2009 would be more than 100,000 jobs either lost or not created in these industries, and $20 billion worth of investments that won’t be made.

While all the presidential candidates were railing about lost manufacturing jobs in Ohio, no one noticed that America’s premier solar company, First Solar, from Toledo, Ohio, was opening its newest factory in the former East Germany — 540 high-paying engineering jobs — because Germany has created a booming solar market and America has not.

One might wonder why this last jobs argument has not been more prominent in the current presidential debates, but there is a sound logic from political economy for that. Politicians respond to votes and lobbies. Old declining industries have a crucial advantage over new promising ones. The old industry have people who’s jobs are under threat, and an incentive to mobilize to lobby politicians for protection. New industries have no jobs and therefore little in the way of voter concern or powerful lobbies.

Instead, The US subsidizes traditional energy to the hilt, providing it with an unfair competitive advantage vis-à-vis renewable sources (apart from violating economic logic that sectors producing negative externalities should be taxed, not subsidized). This does suggest that the US is not averse to industrial policy in principle, but that it’s workings does not obey basic rationality, but rather to political incentives and powerful lobbies behind the curtains.

There are other examples of US industrial policy, more successful ones. One could argue that the whole advantage the US holds in large parts of the IT sector would not have materialized without programs from the Ministry of Defense, like DAPRA being responsible for the early versions of the internet. And faced with mounting competition from Japan, US policy makers clobbered together an industry pact for semiconductors in the late 1980s which has been successful in reversing it’s decline.

What would happen if the tax credits for alternative energy are not renewed in 2008?

An economic analysis by Navigant Consulting Inc., in Washington, D.C., found that more than 116,000 U.S. jobs and nearly $19 billion in U.S. investment for solar and wind could be lost in 2009 if renewable energy tax credits are not extended by Congress. Specifically, Navigant found that 39,400 jobs are put at risk in the solar industry. The Feb. 13 study also noted the losses would begin in 2008 and accelerate as businesses anticipate an expiring ITC. (US Solar industry year in review 2007)

Having made the case for industrial policy to help the solar sector, we do recognize that markets and the price mechanism do play an important role. Incentives for alternative energy now also come from the skyrocketing energy prices, and these incentives, although rather simple in nature (they can be contained in something binary as a price) produce a myriad of reactions. Everywhere in the world clever people are trying to figure out ways to come up with improvements of alternative sources, discovering more traditional ones, or ways to make our energy use more efficient.

Markets are wonderful things, but sometimes they need a little help from a friend..