Chapter 5:Struggling to the market, version:5CO2NNECT
Pre-Imperial Review Meeting
Struggling to the market
‘Governments are bad at picking winners – but losers are sure good at picking governments’
-Anonymous cynic on technology policy
This chapter investigates the causes that prevent potentially successful low-carbon technology to be integrated in new products and commercialized. After a brief general introduction on the main issue (Section 5.1), it will describe the path pursued by new technologies towards wide diffusion (section 5.2) and the role that investors play in easing such process (Section 5.3). Then, it will present a detailed description of the reasons why in several cases developers are not able to get enough funding to successfully commercialize their applications (Section 5.4), and it will illustrate some case studies and policies implemented to address the problem both from the R&D side (Section 5.5) as well as from the market side (Section 5.6). After a brief resume of the four sizes of the challenge (Section 5.7), it will switch to the broader framework of investments, introducing the contents of the next chapter (Section 5.7).
Table of Contents
5.1Introduction
5.2The innovation chain
5.3Who invests, and why?
5.4The technology valley of death
5.4.1Uncertainties and information
5.4.2Private and public goals
5.4.3Sunk costs and long timescales
5.4.4Management skills
5.4.5Economies of scale and experience
Policy responses: overview
5.5Pushing further
5.5.1RD, D, D …
5.5.2Incubators and public-private partnerships
5.5.3 Market Engagement
5.6 Pulling deeper
5.6.1Strategic deployment
5.6.2Removing Barriers
5.7 Synthesis: the four journeys
5.8Conclusions
Bibliography
5.1Introduction
As seen in the previous chapter, innumerable technologies could help us achieve a secure, low-carbon energy system at reasonable cost. The diversity of energy uses, systems, and national contexts, means that there can be no ‘magic bullet’: contrary to the popular imagination, the core challenge is not to discover a new, revolutionary technology thatis going to solve all our energy problems. Indeed, a century of disappointments have caused even enthusiasts to lower their expectations for salvation from a single technology, be it nuclear/fusion power or hydrogen.
Rather we need a proliferation of smarter, cleaner technologies to be developed, commercialised and used at scale. The main technical options are already on the table, at various stages of development. Nor are the barriers economic – in the big picture, that is. Just think about renewables. We know that they are potentially able to produce clean energy, and because they need no fuel to function, they hold a promise of doing so cheaply, with enough development. Sure, they are at present more expensive; following on from what we know about learning processes, sketched at the end of Chapter 4, they and other technologies need some “learning investment” (R&D, prototype development and so on). Given a range of options, the costs of many, perhaps most, can reasonably be expected to come down.
The potential benefits are huge. Figure 5.1 sketches this – for any clean electricity technology, that starts with unit costs well above conventional power generation but with the prospect to decline with learning and scale economies. These accumulate over time and expansion of the technology. Sooner or later it will come to compete with established, fuel-based generators – particularly if the costs of environmental damage and climate risks are increasingly factored in. The additional cost of initial deployment applies only for a limited time and market - illustrated by the initial wedge. As the technology takes off at scale, the benefits – the volume on the right hand side, with mass deployment – holds the prospect to swamp the initial investment costs.
Figure 5.1: Immediate costs and future benefits of renewables
In one chart, that captures the economic case for technology policy. Unfortunately, it has the potential to be deeply misleading about what to expect – or do. If the world were like an ideal model characterized by omniscienceandrational behaviour, there would be no need for this book. It would just happen.
However,someone has to bear the cost – and later, maybe much later – they have to get the benefits, if they themselves are to profit from the investment.
For private investors, that would need deep pockets, patient financiers, total protection against others using your innovations (a constraint which could partly undermine public benefits) – and a good crystal ball about both your own technology and the whole system. If you’re hoping to profit from the environmental benefits, you would also need a deep conviction that governments would indeed make your powerful, entrenched high carbon competitors pay for their environmental damage.
Even policymakers would need technical expertise, clarity and great confidence – and a sense of national benefits. To most governments, reality looks more like an amateur cook trying to bake acake: the ingredients are (almost) all available, and we have a vague idea of what the final results should be, but we feel unsure about how many eggs to put in the bowl or at which temperature to set the oven. And if we succeed, others – businesses, and countries - may come and eat most of the cake anyway for free.
Aside from culinary metaphors, one of the major hindrances to the creation of a complete and successful product is the high uncertainty connected with implementing new technologies in a profitable business. The need for expensive prototypes, dedicated infrastructures, long term investments at stages where future revenues are far from guaranteed to prospective investors can freeze the innovation process, even when new technologies would theoretically be likely to provide great benefits to consumers.
Its not just risk, but more fundamental uncertainty, about the outcome of both technicalprogress and the capability of the entrepreneur.[1] Even the first man to drill an oil well – probably the most profitable innovation in history – was only saved by the US postal service: he finally struck oil after his last backer had posted the letter instructing him to quit.[2]
High sunk costs- that cannot be recovered even if one does quit – amplify the risks. Creating and commercialising a new product requires a long series of investments, potentially costly and time-consuming.Any possible return will take years, maybe decades, to materialise.
Governments have long accepted a role in research and development. But even when a basic technology has been researched and demonstrated, the next steps can be difficult. Its often easier for the innovator to continue seeking public support, than face the stiff winds of competition for private capital; and high sunk costs can scare away potential investors, stultifying innovation. The history of energy technologies is littered with the corpses of technologies that never made it across the “technology valley of death”, which we examine in section 5.4.
This is well known[3]; but the energy sector presents peculiar characteristics which exacerbate the phenomenon. In some sectors, the investments and returns work adequately to reward innovation: the IT sector, and pharmaceuticals, for example, spend typically 10-20% of their gross turnover on developing new products. In the energy sector, the typical figure is well under 1% - and in the UK’s liberalised electricity sector, it sank close to zero.[4] The construction sector is little better. In tackling our energy and environmental problems, we are seeking radical innovation in some of the least innovate sectors in our economy. The reasons for this, and the solutions, form the core of this chapter: why new energy technologies struggle to find the capital they need to develop and grow – and what to do about it.
5.2The innovation chain
Innovation involves a complex chain of processes. Not all the phases involve the same actors, face the same barriers, or require the same policies. Usually, when people think about technology innovation, they think about R&D. But R&D, frankly is easy compared to the rest of the process.
The innovation chaincovers the whole process that starts with a technical advancement and ends with the successful diffusion of a product based on such discovery. Following one of the fathers of innovation studies, Schumpeter, economists have got used to thinking about three main stages: invention, innovation and diffusion[5]. For useful policy, this is still far too coarse. This chapter sets out the innovation chain in six distinct stages, which can loosely be matched against the three more aggregate phases as set out in (Figure 5.2).[6]
Figure 5.2: The innovation chain
Innovation starts with basic research and development, that is, the discovery of the core technology and its main functioning. This is far from a product, since the focus is on theory and principles, more than applications. The photovoltaic effect was observed for the first time in 1839, the first photovoltaic cells were built in 1941, and it took the space race to turn them into a product delivering power for useful applications[7].
Technology-specific research, development and demonstration– yes, the whole lot – can be considered as the second step in the chain. In this, the main concern is applying the basic discoveries to produce a prototype which is able to work technically. The focus is finding the design, materials and techniques to make it work: economic considerations, about costs or market potential, are absent or secondary.
This may be a complete technology, but it is not yet a product. Why? Because what cames out from engineers cannot immediate be commercialized. After all, people do not want photovoltaic cells that just convert light to electricity.They want panels which can be easily installed on the roof of their buildings, trusted to produce a reasonable amount of electricity that can be connected and used. This requires market demonstration;after testing that the technology works, developers face a double challenge: showing to investors that what they have produced has potential to return profits, at least in the long run; and convincing potential customers that the product is really able to satisfy their needs and requirements.
From this point on, there is a product, not just a technology. In the commercialization phase, a firm must be created to manage whole financial process of making the product and seeking customers, and managing all the financial and other considerations in between. Usually at the beginning new products are sold in niches, small protected environment in which the new technology can start to diffuse without suffering too much from the presence of incumbents (we will talk in detail about market niches in Chapter 6).
Once the product makes the transition to being a commercial product, it can start enjoying scale and learning economies as well, reducing costs and increasing efficiency; step by step, this may also involve physical and/or infrastructure (like a “smart grid” system for renewable energies, and associated terms of access). With market accumulation, revenues start to grow and investors feels more and more attracted to put in capital.
The final phase of the innovation chain is the diffusion of the technology on a large scale: the product is moving to maturity phase, and it is not perceived as novelty anymore; potential improvements do not affect its main functioning, even if contribute to lower costs and increase efficiency.
Obviously, reality does not always follow such predefined, linear schemes.However, this description is a reasonable summaryof the story of most technical innovations, and will be usefulto identify the phases where the chain is more likely to “break”, thus undermining the diffusion of the new technology.
Of course, not all innovations are similar. We are concerned with energy innovation, in part of for public good. As noted, energy is not an innovative business. Academics have articulated several factors that impede innovation in energy – summarised later in this chapter – but amazingly, hardly any of them have noticed the most fundamental one. It generally does not involve making a different consumer product – merely a different way of making the same thing.
Consider the iPhone. But it is a unique device, and Apple knew that consumers would pay a high premium to get one; there was nothing like it. It cost a huge amount to develop – but that was trivial to the rewards from selling product that hundreds of millions of people would want, and no-one else could produce. In pharmaceuticals too, the drug companies know that a successful drug is a unique product, protected by patents, and they can charge health services and companies pretty much whatever it takes to recoup their investment. In both these sectors, therefore, the innovation chain is complete(Figure 5.3): technology push easily meets the pull of market profits.
Contrast that with energy. In our current systems, consumers buy electricity, or liquid fuels for their car. That’s it. Any new, better way of producing the stuff has to compete with all the other incumbents, producing and selling the same stuff. To get anywhere, the newcomer has to undercut the incumbents – unless there is market support or protection, they must sell at a lower price, against technologies that have a century of development behind them. The process for a newcomer is slow, not fast. The margins are small, not massive. The risks are high, the rewards are low; and the results to date, correspondingly limited. In a nutshell, technology push does not meet market pull, as illustrated in Figure 5.3.
Options for engaging consumers more directly, in ways that might start to make energy look more like IT or pharmaceuticals, are explored under Pillar 3 of this book. This rest of this chapter focuses upon the underlying processes and more established ways of trying to accelerate innovation in energy technologies.
Figure 5.3: Connected versus disconnected innovation chains
An additional problem concerns the need for innovation ‘in the public interest’ – for example, the environment. Pure energy innovation can and does extend the use of fossil fuels: a more efficient thermal processing technology, or a new method for extracting oil from bituminous sands can induce the market to delay the switchover towards a low emission energy system. Environmental innovation requires an added element – a driver, or benefit, associated with the environmental gain.
5.3Who invests, and why?
Who are investors, exactly? How do they decide whether to financially support one project or another? The most directly relevant distinction is between public and private investment. Public institutions are focused on the social (including economic) benefits of a technology, among which environmental concerns play an important role; private subjects tend obviously to look for profit, or more precisely, a return from investment which is proportional to the risk taken[8].
Being particularly interested in collective benefits rather than specific sales, public bodies tend to invest in the early phases of R&D, focusing more on the technical characteristics of the new discovery than the profitability of the product. This is not surprising, since it is broadly accepted that commercial activities - selling – is generally best done by private actors in a market. Public institutions are accountable towards taxpayers, and resources provided for investment justified on the basis that the outcomes are likely to produce beneficial spillovers, such as lower emissions or lower energy prices.
Private investors may fund risky ventures, but they exact a price – in terms of the interestrate, or investment returns,which investors seek on their funding: the higher the risk, the more that borrowers will have to pay.Different types of investors play at different stages of the process. As is well known in economics, capital markets are far from perfect and do not adapt to all possible needs – they do not operate well across all stages of the innovation chain. As a result, certain phasesare characterized byfewerresources, and more costly capital.
In the market demonstration and early commercialization phases, the most common investors are the so called “angel investors” and “venture capitalists”[9]: angel investors are wealthy, individual informal investors from diverse backgrounds, while venture capitalists usually represent organizations which are willing to finance the development of start-up projects. A feature is the high return on investment they require, due to the high uncertainty connected to such operations.
Later in the innovation chain, when products start to be adopted by consumers, uncertainty decreases and learning economies bring down costs,more market instruments become available: project financing, investment banking, and, in general, public and private equity.The path becomes smoother and it is easier to carry on the latest phases of the innovation chain. The technology has scrambled ashore, into the forests of mainstream commercial activity. Alas, most never make it; and plenty still struggle once ashore.
5.4The technology valley of death
During the first stages of the chain, in particular R&D, funding is provided by public institutions, which typically focus on collective benefits, as written before; at the end of the process, scale and experience economies allow to reduce costs, while diffusion of the product contribute to reduce uncertainty and, therefore, attracts more capital towards the project.Consequently, the intermediate phase, when public financing starts to fall but the degree of uncertainty is still high, is the most delicate, and it generally correspond to the market demonstration and the commercialization stages, where huge investments are needed as well for the setting up of the market for products derived from the just-discovered technology; the plummet of cash flows which occurs in this step is a well known phenomenon[10], but it would be not a critical issue if there were early investors willing to finance the new business.