Eyes on the Prize

A look to the final frontier and then back to energy

Picture from The Guardian

While evidence in favor of global warming piles up by the day, there seems little political motivation to try to address the issue. Both cap and trade and a carbon tax would be politically impossible in such a low growth environment, and subsidies for more clean energy research would be shouted down with cries of "Solyndra!" Moreover, these policies are likely to have little substantive effect either. Without an international governing body, trade would nullify cap and trade or carbon taxes, and research subsidies tend to increase the price of research without raising the quantity. With this in mind, Evan proposes an alternative funding mechanism: research prizes. Instead of having the government subsidize firms or directly do basic research, the Federal government could sponsor research competitions, allowing innovators from all over the world to pool their collective wisdom to solve the energy crisis. To get a better idea of this would mean, we should look at a current example in which prizes played a large role: NASA's development of private, low earth orbit vehicles.

First, some history. What is often left out of the public memory of the push into space is what happened after we made it to the moon. Optimism about U.S. space policy led people to make "conservative" predictions of Mars landings by 1988, with a Mars base by the end of the century. Pan-Am even started taking reservations for flights to the moon, as it was forecasted that trips to the moon would be a quickly realized affair. So what happened? As the geopolitical impetus for the space program started to fade, so did the funding. Instead of going back to the Moon and beyond, we settled with the Space Shuttle program, which functioned as a space taxi that would ferry astronauts from Earth to Low Earth Orbit (LEO) and the International Space Station.

In theory, the Space Shuttle was supposed to be a temporary affair, replaced by a vehicle capable of going to the moon and beyond. However, cost overruns and budget problems eventually ended the program, resulting in a problem: after the retirement of the Space Shuttle in 2011, there was no way for U.S. astronauts to get back to space. Instead, we had to buy seats on Russian Soyuz shuttles at a price of $51 million, round-trip. 

Enter Commercial Orbital Transportation Services (COTS), a program designed to spur private sector solutions to the space transport program. It was implemented through special arrangements known as Space Act Agreements (SAA) coordinating development between NASA and private sector firms. Firms submitted proposals, NASA gave initial approval, and as the firms met certain milestones NASA gave them more funding. The funding was capped though, so no matter how much the companies spent, NASA would not pay them extra. This forced the competing firms to cut costs and streamline projects. NASA promised to purchase resupply and crew transport services from the final successful companies.

The program has been a resounding success. About 26 companies submitted proposals for the first stage, CCdev-1. Another 11 propsals were submitted for the second stage, CCdev-2. Space-X, the private space company that docked with the ISS just a few months ago, was actually denied funding for CCdev-1, but was later granted funded for CCdev-2. This showcases the resiliency of the SAA funding structure. Even though SpaceX was passed over, it still pulled through and is now the front runner in the COTS race. There is even discussion on how SpaceX's Dragon and Dragon Heavy rockets may make a trip to Mars by 2017, nearly 15 years before the same projection for the NASA planned Space Launch Vehicle at less than one hundredth of the cost. Of course some of it is hype and overoptimism, but it nonetheless stands testament to how far SpaceX and commercial space ventures have come since the era of Apollo.

The development of commercial crew highlights a few lessons about prizes and innovation. First, prizes often save money. There are stories of Elon Musk, the founder of SpaceX, being so unsatisfied with the market price for a certain injector that goes into the Dragon rocket that he decides to build it in-house at less than half the price. This is a particular issues as politicians like to see results for their billions of dollars spent. Lower costs equal happier politicians, which is a plus for a research program.

Well, except if the politicians are hungry for the pork offered by the traditional Space program. In the commercial transition, Senator Hutchinson of Texas has been a notable offender, fighting hard for the traditional government programs such as the Space Launch System as their budgets are cut in favor of commercial crew. This is the second lesson on why prizes are useful; they guard against rent-seeking, as if a firm meets the requirements, they are eligible for funds. No backdoor deals are needed.

A third lesson is that when you give the private sector the chance to directly work with the technology in the hope of generating disruptive innovations, they are in a better position to develop the technology into further disruptive innovations. In the vocabulary of growth economics, prizes promote "learning-by-doing", and have domino effects in promoting further development down the line. The fact that many firms are all trying their own ideas means that the market learns at a much faster rate once the knowledge gained from the innovations diffuses outwards. You have decentralized tinkering, instead of a top-down solution, vastly increasing the probability that someone thinks of the golden idea.

So does this mean this kind of fixed-cost research prize system is always superior to government sponsored direct subsidies and research funds? If anything, just the opposite. SpaceX, United Launch Alliance, Sierra Nevada, and all the other commercial space companies would not have gotten off the ground without the initial investment from NASA. Imagine Kennedy delcaring "We choose to pay the private sector to bring us to the moon in this decade and do the other things, not because they are easy, but because they are hard" There would have been no gravitas, no national pride, and importantly, no technology. At that point, the technology had not been developed. Somebody needed to go do the basic science to get us up there. 

To give an example of the wide range of science involved, think about the "simple" task of linking two orbiting objects together. It requires a firm understanding of the science of orbital rendezvous to build the correct equipment and to pilot correctly. Buzz Aldrin actually wrote a dissertation on this issue, and although it seemed useless at the time it was critical in the development of the space program. Buzz also spent time solving other physics problems such as the differential effects of gravity on large objects in space and the implications for navigation. If that science seems like something the private sector would be willing to fund, recall that the initial analyses of rocketry were conducted by a German Nazi* that was working on military rockets. None of this was easy; this was part of the reason why there were so many failures. Without the military impetus and government support, there would have been no space program. If the SpaceX Falcon rockets are able to fly so far now, it is because they launch off of the shoulders of giants. This is true figuratively as well as literally. The Falcon rockets launch from Cape Canaveral, the former launch site of the rocket that took us to the moon: the Saturn V.

In short, government directed research and prizes are complements. First, government R+D and subsidies are best for discovering fundamental disruptive technologies and sciences, whereas prizes are an effective way to further organize and commercialize that existing knowledge. Without DARPA, there would have been no Internet. But without subsequent innovations from companies such as Google or Facebook, the Internet would not be as vibrant as it is today. Second, it is important the government is to be a consumer, or an anchor tenant, of the innovation. For commercial space, NASA has committed to buy launches from whichever company that ends up developing the rocket. For energy, this would mean a guarantee from the government to purchase the electricity or fuel cells produced by a revolutionary firm. Third, private sector innovations from prizes can be used by the government. Government investments that fed into the private sector may feed back to the government again. NASA may end up using the improved rockets from COTS instead of the current United Launch Alliance Atlas V rocket for future Mars missions. The military may extensively deploy improved private sector solar panels to increase readiness in times of energy price volatility. So by all means, use prizes to spur innovation. But don't neglect the foundational role of the government in other dimensions.

*The rocket scientist in question was Wernher von Braun, and Tom Leher once wrote the following poem making fun of his political history:

Once the rockets are up,
Who cares where they come down?
'That's not my department',
Says Wernher von Braun.

(International Trade) Walking on Sunshine

Unleashing the power of the sun international trade in clean energy production

(Photo credit: http://seidmaninstitute.com/wp-content/uploads/2011/01/solar-panels.jpg)

International trade has been one of the most powerful forces in promoting technology development and diffusion. Why should this be any different for the clean energy industry? Without a doubt, one of the largest crises modern economies face in the medium-term is that of energy. Modern production depends on high-density energy sources; without them, many cornerstones of society, such as transportation, manufacturing, and agriculture would be impossible.

To begin the discussion, it's useful to describe some stylized facts about clean energy production. On a whole, it's an industry that exhibits increasing returns to scale. While current costs are relatively high, it's hoped that by increasing the scale of production, costs will be lowered in the future. I can think of at least three mechanisms that make this the case.

First: research and development. Much of the current knowledge about clean energy is quite limited and is not enough to create sources of energy competitive with fossil fuels. Thus, small amounts of investment are unlikely to create enough of a critical mass to make clean energy competitive. Instead, large increases in investment may result in a breakthrough which can then diffuse through the market. As firms compete with each other, this may result in more knowledge spillovers, creating ever more efficient sources of energy.

Second: scale of production. The average businessman can't produce solar panels; large scale production requires at least a year of developing infrastructure, and the complex chemical knowledge behind creating the solar panels entails a large amount of fixed costs as well. Panel production only becomes profitable at a certain critical threshold of demand, making the industry subject to strong increasing returns.

Third: scale of distribution. A major problem with popular clean energy sources such as solar or wind is that they can be intermittent. Solar cells can't power a house when the sun doesn't shine; windmills can't power factories if the wind doesn't blow. Smart grids offer a solution by allowing utilities to dynamically allocate these volatile sources of energy. However, the service provided by smart grids is a public good. Companies can not opt out of using the grid, making the good non-excludable. Companies can use the information utilities offered by the grid without excluding other firms, making the good non-rivalrous. It's the classic example of a public good that a perfectly competitive market can't provide. Thus, if the panels are produced at a larger scale, this allows more efficient distribution of the energy through a smart grid: a critical component of clean energy development.

Scale economies make trade very important because the large international market provides the necessary demand for companies. However, scale economies can also justify industrial policy, Governments may want to promote domestic clean tech companies to carve out a larger share of the global market. Clean tech is an especially lucrative field for industrial policy as it also represents one of the "advanced manufacturing sectors with high technological and skills requirements"" that the US has dominated in the past. A recent Brookings report comments on the importance of manufacturing for the United States:

Manufacturing accounts for 12 percent of U.S. gross domestic product and less than 10 percent of national employment; alone, it cannot power the economic recovery. Yet manufacturing accounts for 70 percent of private-sector research and development in the United States. High levels of investment in R&D, the potential to reduce the trade deficit and the ability to produce good jobs for middle-skilled workers merit the increased attention the sector is receiving after decades of policy drift. The administration, for example, has included a manufacturing initiative of roughly $1 billion in its fiscal 2013 budget, and notable plans have been proposed in Massachusetts and in Chicago.

As a result, the government has implemented various production tax credits, direct loan guarantees (link to Solyndra), and, most recently, tariffs against solar panels produced in China.

This is where I depart from the stylized description and proceed to get incredibly angry at the tariff on solar panels.

While most of the other subsidies are based on solar power production, the tariff is unique in that it taxes international solar panel production to bolster domestic panel production, not domestic power production. It is as if the policy loses sight of the end-goal of power production in the pursuit of component production. But, in the end, we shouldn't care who's producing the nuts and bolts. Who harvests the energy is much more important. What we consume matters much more than what we produce. To provide an example, if one country, say "China", produces solar panels, while another country, say the "U.S.", consumes the solar panels, which country ends up producing more of its electricity from clean energy sources? Although "China" goes through all of the hard work of production, it is the "U.S" that reaps the benefits of solar power consumption.

Recent experience has shown us that cheap Chinese solar panels facilitated the low-cost installation of many rooftop panels, thereby strengthening the solar power industry in the United States. We need to face the fact that the Chinese can produce solar panels at a comparative advantage. They are willing to jeopardize their own environment to produce the panels; this is a cost that we refuse to bear.

US manufacturers of solar-grade silicon would never be able to replicate the actions of the Chinese. Porges stresses that “production in the United States is a highly, highly, highly regulated process” and McCue misses no opportunity to emphasize the extensive waste management efforts of his company. Shi categorically contrasts the US market with Chinese manufacturers, claiming that if silicon tetrachloride poisoning “happened in the United States, you'd probably be arrested."

The fact that solar panels can be produced so easily in China should actually be a good omen for solar power advocates. The technology has been developed and has diffused to such a degree that even a low productivity country such as China can produce them competitively.

Another argument for liberalizing solar panel production follows Richard Baldwin's recent works on "Globalization's Second Unbundling" and the role of supply chains in industrial policy. The old trick with using tariffs to create an entire domestic infant industry has lost its effectiveness. Nowadays, countries tend to integrate themselves into supply chains. Instead of mastering the entire production process, countries can now specialize in one component, and then gain a comparative advantage in producing that one component. Thus, the United States really should worry less about the production of solar panels and start worrying more about other high value-added activities involved in the development of clean energy.

On this topic, I'm thinking specifically of the development of smart grid technologies. This is something that Europe has been trying to develop as well, so the returns from an effective development of a smart grid would be massive. It would facilitate greater clean energy production in all countries, and would also allow us to reap the gains of cheaper clean energy components, no matter if they come from China or are produced domestically. The smart grid also has an uncertain right tail. From the UCLA Smart Grid Energy Research Center:

While every major media source today is talking about the Smart Grid due to its importance to the national energy policy agenda, it is still unclear to many as to what this grid of the future will look like. In-fact, it is like trying to predict what an iPhone would have looked like in the year 1984 (25 years ago), when a cell phone was simply a mobile telephone. There is tremendous opportunity for creativity, experimentation and research in the defining of the Future Smart Grid. Throwing open this opportunity to students in universities or entrepreneurs in industry could result in new and currently unimaginable possibilities for the grid of the future. Therefore, while the utility community is trying to determine this singular vision of the grid of the future, the eventual outcome is impossible to predict, but the community at large needs to ensure that those who want to experiment with meritorious ideas get the appropriate resources, opportunities and incentives to do so.

Industrial policy, by its virtues, tries to change comparative advantage. But it should be designed to create new comparative advantages in new fields, not to fight old comparative advantages in old fields. It should be used to find new value-add technologies, like smart grids, and not mess with old vanilla components, such as polysilicon solar panels. Global warming is, indeed, global, and well designed international trade policy will be an important component in that fight.

P.S. While the following is pure speculation, an extended version of Baldwin's "rebundling" of globalization and regional comparative advantage would seem to justify the U.S. working with Latin American countries to help promote component production for a smart grid. This would help cement the Western Hemisphere's regional comparative advantage in a critical technology for the future. Ideas like these would constitute a form of industrial policy that goes beyond one's borders in order to secure a domestic advantage. This seems like an exciting route for future policy.

P.P.S. Funny quote from the NYT article on the solar tariff, can you figure out why?

“This is really a surprise,” he said in a telephone interview. “It’s really dangerous.” Mr. Li said that Chinese companies would “certainly” retaliate by filing a trade case at China’s commerce ministry accusing big American chemical companies of dumping polysilicon, the main ingredient in solar panels, on the Chinese market.