Innovation has pushed down costs in excess of our expectations in many areas to date.

For example, the charts below, based on UK data, depict the projected levelised costs of electricity (LCOE) from various BEIS forecasts over time, and the auction clearing result. The LCOE is an estimate of the per unit cost of electricity production for a generator over its lifetime. Data reflects the date of the planned delivery of the asset.

It is clear that analysts have systematically underestimated the potential for cost reductions in solar PV and offshore wind (the same pattern has also been observed for batteries). Even though the Government’s cost forecasts have been repeatedly revised downwards, and despite the fact that forecasters include ‘learning rates’ in their projections, observed prices have been dramatically lower than expected.

This may be particularly the case for certain types of technologies that can be rolled out incrementally (as shown in the figure, cost savings have been much more substantial for solar and wind than for nuclear). With new increment, new learning on how to build and install these technologies is delivered, and major economies of scale can be realised in production. Our analysis suggests that at least in the UK, governments have underestimated how this can drive down costs, to the benefit of consumers and taxpayers alike.

Encouraging innovation can therefore yield large benefits. But it may require taking a short term hit on efficiency.

Carbon prices efficiently internalise the emissions externality, and are a key policy tool on a path to net zero. However, they do not allow firms to internalise “learning spillovers” directly (Private investment may not be optimal from an overall societal point of view because the benefits from R&D efforts by individual firms cascade down to other firms or countries. This effect is often referred to as “learning spillovers). And where innovative technologies are expensive, the distributional consequences of relying on a carbon price alone can be damaging (figure).

This has been part of the rationale for introducing subsidies for renewables and low carbon hydrogen across Europe, instead of relying on emissions trading systems alone. Much of the cost reductions shown above have been driven by the introduction of such subsidies.

At the same time, there is undeniably a risk of creating new distortions when applying subsidies. Designing support schemes targeted at certain solutions inevitably involves some degree of “picking winners.” This can mean diverting funding away from other solutions which could have come through as cost-effective solutions, and distorting firms investment decisions. It can also divert firms’ attention towards lobbying for funding.

Despite these challenges, delivering on innovation is still our best hope for net zero. Achieving net zero by 2050 requires nothing short of a transformation of the energy system. This transformation will require contributions from a range of innovative technologies and fuels, including new applications of electrification of, carbon capture and storage and low carbon hydrogen.