Cutting carbon – could this solve the productivity puzzle?

Cutting carbon – could this solve the productivity puzzle?

Productivity in the UK has stalled since 2008. After decades of unabated increase, our output per hour has plateaued. Other developed economies have experienced similar slowdowns, but no western economy more than the UK. There’s not a simple answer, and economists refer to it as the ‘productivity puzzle.’

Meanwhile, after a world-leading start in cutting carbon emissions – UK emissions are down 43% on what they were in 1990 – we are now set to miss our next major carbon target.

Historically, environmental policy has taken a backseat when the economy has required attention. The assumption is that productivity suffers at the hands of regulation, as resources are redirected from output to compliance.

But we are entering a new phase of carbon reduction. Our major gains so far have been in the transition from fossil fuels to clean energy – the relatively low-hanging fruit on the path to zero carbon. The now and future are more challenging. And it appears we’re already faltering.

The government’s Industrial Policy – formulated in response to the productivity puzzle – places ‘clean growth’ admirably front and centre. But it doesn’t clearly articulate the links between carbon policy and productivity which is vital for shaping policy going forward if we are to achieve the twin goals of economic growth and carbon reduction, without one impinging on the other.

It is for that reason that Energy Systems Catapult (ESC) commissioned us for its latest report, examining the link between carbon policy and productivity.

Our report yielded two major findings:

  1. Carbon policy need not harm productivity.

  2. Carbon policy may even produce a small productivity boost.

The implication is that productivity growth and emissions reduction can go hand in hand. One need not come at the expense of the other. It all depends on how carbon policy is designed and implemented.

Why the productivity puzzle matters

The nation’s Gross Domestic Product (GDP) may be the headline figure in every budget announcement, but it’s rising productivity that actually implies rising living standards. As economist Paul Krugman once put it: “Productivity isn't everything, but, in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

In recent years, GDP has increased, but so has the number of hours worked. If we are any richer at all, it’s only because we are working more. Which is hardly a better life.

From 1971 until 2008, productivity increased at a broadly consistent 2% per year. Since 2008 it has sputtered to an average of 0.5% per year. A similar slowdown is visible in the other G7 economies, but the UK’s productivity plateau is particularly acute.

Solving the productivity puzzle is vital. The growth potential of the Green Economy is widely recognised – as much in the Industrial Strategy as anywhere else. But economic growth is only a worthy goal if it secures a better standard of living. For that, productivity is the mechanism.

The real value of productivity

As essential as it is for carbon policy not to undermine productivity, it is equally important that stimulating productivity doesn’t exacerbate our emissions problem.

Currently, productivity measurements do not account for the cost of carbon. The two are treated as related, but separate issues.

The raw output that defines productivity is routinely adjusted for externalities. On the face of it, producing ten violins in a day is more productive than one. But what if that one is a Stradivarius? Perhaps you can produce twenty violins in a day, but it costs three times as much.

Similarly, given the primacy – and urgency – of our goal to reduce CO2, can it really be described as more productive if your output doubles but so do your carbon emissions?

There are established methods for pricing externalities and Natural Capital. By our basic calculations the value of avoided carbon emissions is currently around £7.5bn, or 0.4% of GDP. Even this is an incomplete measurement. It would be impossible to account for every indirect effect of reducing emissions: transferrable skills, new technologies, the human effects of living in a better environment.

Still, even this relatively crude measurement allows us to account for carbon in a way that reveals the real value of productivity, in the context of a world suffocating from carbon dioxide.

Carbon policy needn’t harm productivity

Even using current measures of productivity, on a macro-level it’s not at all clear that carbon policies hurt aggregate productivity. While UK emissions have fallen 43% since 1990, the economy has grown by two-thirds. And productivity only began to slow with the financial crash.

If we zoom in to individual firms – vital in shaping future policy – we find a variable, dynamic effect of carbon policy on productivity, dependent on the policy itself, and the individual firm.

Yes, carbon regulation can produce a short-term productivity hit as compliance eats at output. But it doesn’t have to. And over time compliance costs can be outweighed by gains made in innovation.

We believe this should be the mantra of future policy design. Outweigh compliance costs through innovation.

How to cut carbon productively

Our own judgement is that carbon-policy-fuelled innovation could lead to a short-term aggregate productivity boost taken across the whole economy.

In general, market-based initiatives are more likely to achieve a boost in innovation. The EU Emissions Trading System (ETS) is a good example. It resulted in a 10% increase in low-carbon patents, without crowding out other innovation.

But there are good examples of successful direct regulation – especially when it comes as a balance of differing policies. The success of the sustainable energy market in Britain owes much to the Contract for Difference (CfD) policy – protecting renewables from fluctuations in wholesale energy prices – which was accompanied by significant direct R&D investment.

The key is to adapt policy to the sector in question. What works in one may not work in another. It requires a nuanced approach.

Policy implications

Our progress on carbon emissions is slowing, at the same time as our productivity has plateaued. If we are to stimulate productivity at the same time as cutting carbon, policy will require an extraordinary deftness of hand.

With its focus on clean growth, we believe the Industrial Strategy is at the heart of escaping the quagmire we find ourselves in and our work adds some subtlety to it. We have three broad policy recommendations, which we hope to be incorporated into the Industrial Strategy, as well as future carbon and productivity-related policy:

  1. Consider how to include carbon emissions in productivity measurements.

  2. Gear carbon policy interventions towards stimulating innovation.

  3. Adapt policy to the specific context – measures that work in one sector may be damaging to another and vice versa.

Taking such a nuanced approach to carbon and productivity policy will hopefully result in reductions in the former and gains in the latter. At the very least, it should help to reduce carbon emissions without harming the economy.

To read our full report including detailed analysis and methodology, take a further look here.