Policy Uncertainty Discourages Innovation and Hurts the Environment

Large-scale changes are anticipated for U.S. environmental policies heading into 2017. The new administration has promised a “comprehensive review of all federal regulations,” which include policies aimed at carbon dioxide emissions from power plants, fuel economy standards, oil and gas production, and tax credits for solar panels, wind turbines and electric cars.

Exactly what form these changes will take is unknown. Some believe that most of these policies will be dismantled, while others argue that most of the policies will remain in place. But this is all speculation.

Oklahoma Attorney General Scott Pruitt has been nominated to be the next EPA administrator, a move widely perceived to indicate large changes ahead. gageskidmore/flickr, CC BY

What the discussion over what may or may not happen has missed, however, is that this uncertainty in itself is costly. Not knowing what the future holds, companies are less likely to invest in new technologies. To address today’s environmental problems, we need breakthrough technologies that can be widely adopted and exported to the rest of the world. Economists have shown, using both theory and data, that policy uncertainty makes this type of innovation less likely to happen.

Automakers’ Dilemma

Perhaps in no other sector is there as much uncertainty as automobiles. U.S. fuel economy standards have been around since the 1970s, but new rules introduced in 2012 mandate a steep climb toward 50+ miles per gallon (mpg) in 2025. There are real questions, however, about whether these rules will be relaxed and, if so, by how much.

The sheer complexity of U.S. fuel economy standards leaves policymakers with lots of options for policy changes. In a new working paper, fellow economist Chris Knittel and I review the complicated requirements imposed on automakers. Different-sized vehicles are treated differently, trucks are treated differently than cars, and alternative-fuel vehicles receive special credits and exemptions. Any or all of these rules could change.

Innovation companies, including Tesla Motors, were founded during a time when federal policy placed a clear emphasis on fuel efficiency. Will that continue?  Wikipedia, CC BY

This uncertainty puts automakers in a difficult position. Do you assume that standards will remain in place, and invest in producing high-mpg vehicles? Do you assume standards will be relaxed, and move toward lower-mpg vehicles? Or do you lie back and make little new investment, waiting to see what will happen?

Irreversible Investments and ‘Option Value’

Economists have long written about exactly this type of decision-making under uncertainty. There is broad evidence, based on both theoretical models and empirical evidence, that companies invest less when they face uncertainty. Using data from the United States and 11 other countries, a new paper by economists Scott Baker, Nick Bloom and Steven Davis, for example, shows a robust negative impact of uncertainty on investment. Companies in the health care and financial sectors are particularly affected by uncertainty, and cut not only investment but also production and employment.

Economist Steven Davis, founder of the Economic Policy Uncertainty Index, presenting his work on the effect of uncertainty on investment earlier this month. Bosse Johansson, Author provided

Why? The idea is simple. When there is uncertainty, there is “option value” to delaying irreversible investments. In other words, it is often better to wait and see what happens, rather than to make a costly mistake. R&D investments are particularly affected by uncertainty, because the return on these investments is sensitive to what happens with policy.

This literature has clear implications for current U.S. environmental policy. By any measure, there is today an unusually large amount of policy uncertainty, which creates an incentive for companies to delay investments. Why invest today in a new alternative fuel vehicle if fuel economy standards are uncertain? Why invest today in a new technology for producing solar panels, if federal support for renewable energy is in flux?

The Aluminum F-150

Will Ford regret investing in the new aluminum F-150, for example?

Ford just spent US$1 billion over six years to develop a new F-150 truck, with a lighter aluminum-based body and smaller, more fuel-efficient engine. The new truck was built to meet the new fuel economy standards. But if the standards are substantially weakened, Ford could be stuck with a $1 billion mistake.

Ford has invested about $1 billion in making an aluminum truck to improve fuel efficiency based on the assumption that regulations will remain in place. Sarah Larson, CC BY

Investments like Ford’s new F-150 are particularly sensitive to uncertainty because of the long time horizon. It takes many years for an automaker to develop a new vehicle model, so companies must be particularly careful when pulling the trigger. Today’s policy uncertainty makes it less likely that other companies will follow Ford’s footsteps with large investments in innovative new technologies.

Breakthrough Technologies

Perhaps most at risk from policy uncertainty are breakthrough technologies. In energy, in particular, companies often need a long time and lot of money to develop their technologies before coming to market – the so-called valley of death – and uncertainty over government policies can be the difference between success and failure.

Trump’s administration and Congress plan to roll back environmental regulations with the goal of improving corporate profits but the questions around the changes – which regulations will be rescinded and how, for instance – will depress investment in clean energy innovations. Tony Webster/flickr, CC BY-SA

Imagine trying to convince a venture capital firm to invest in your clean-tech start-up given today’s uncertainty. Sure, you can point to state-level policies in California and elsewhere (although there is uncertainty here too), but the questions around federal policy looms large.

If you are concerned about climate change, like I am, then this delay in the pace of innovation is deeply troubling. With carbon dioxide concentrations continuing to climb, small incremental changes are not going to be enough to address global climate change. We need big, game-changing technologies that can be widely adopted and exported to the rest of the world. And, unfortunately, today’s uncertainty makes this type of innovation less likely to happen.

The Conversation

This blog post is available on The Conversation.

About Lucas Davis

Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.
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5 Responses to Policy Uncertainty Discourages Innovation and Hurts the Environment

  1. sidabma says:

    President elect Trump is a business man who is going to Make America Great Again. Once President Trump realizes that over 90% of the CO2 in the combusted exhaust at our natural gas and coal power plants can be captured with the technology of Carbon Capture Utilization and transformed into useful – saleable products, and that this will create many full time jobs, and he won’t have to fight the EPA’s CPP, he will do what is best for America’s economy.

  2. Anonymous says:

    The importance of uncertainty is sometimes overrated, especially when combined with implausible assumptions about risk-aversion (Rabin). Even w/ risk aversion, uncertainty in some models increases investment (which invites enhanced scrutiny of empirical results). Surely Ford understood “The Value of Waiting to Invest” just as they understood the costs. Ford’s investment in the F-150 was prudent ex ante and plausibly not that bad ex post. Some kind of public support for innovations facilitating renewable energy is warranted but not any kind of support.

    • mcubedecon says:

      A broad, uncertain statement about the overimportance of uncertainty? How are we to know when uncertainty is unimportant? I’ve seen too many errors in utility infrastructure investment decisions based on single point forecasts to be so sanguine about the unimportance of uncertainty.

      But perhaps the most important dimension of the impact of uncertainty derives from the concentration of decision making. If thousands of decisions are being made (e.g., whether to buy a fuel efficient car), the risk of uncertainty is greatly diversified, compared to a single decision across a wide swath of the economy (e.g., PG&E or SCE accepting renewable contract bids).

  3. Pingback: Revue des blogs – mardi 3 janvier 2017 – Veille énergie climat

  4. Pingback: 3 Reasons Why Undermining the Paris Climate Agreement Would Be Bad for Business – Center for American Progress

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