Guest Column: The Benefits of Investing in Energy Research and Development

By C.-Y. Cynthia Lin

Owing to mounting geopolitical, environmental and economic concerns, investment in research and development (R&D) in the energy sector has become increasingly crucial for sustainability, security and environmental protection.  A 1997 report from the President’s Committee of Advisors on Science and Technology and a 2004 report from the bipartisan National Commission on Energy Policy each recommended that federal R&D spending be doubled. Several groups have called for even larger commitments, on the scale of the Manhattan Project of the 1940s. In his remarks to the U.S. Senate Committee on Agriculture, Nutrition and Forestry in 2004, Professor Lee Lynd of Dartmouth College recommended a several-fold increase in the amount of funding for biomass energy R&D, with clearly demarcated support for both pre-commercial research devoted to innovation and applied fundamentals as well as cost sharing for first-of-a-kind pioneer plants.

Since the mid-1990s, however, both public and private sector investment in R&D in the United States has stagnated for renewable energy and energy efficiency, and has declined for fossil fuel and nuclear technology. The 2005 federal budget reduced energy R&D by 11 percent from 2004; the American Association for the Advancement of Science projects that federal energy R&D will decline 5.6 percent by 2011. In addition, investment in energy R&D by U.S. companies fell by 50 percent between 1991 and 2003. Moreover, funding after earmarks for bioenergy R&D by the Department of Energy has declined yearly for the last several years. These declines are neither new nor unique to the United States: Between 1980 and 1995, international R&D fell 39 percent for energy and 56 percent for renewable energy.

According to economic theory, there are several reasons why the private rate of R&D may diverge from the socially optimal rate of R&D. First, firms may under-invest in R&D because there are positive spillovers involved: When a firm makes a discovery, other firms can free ride on the invention and may even imitate the invention without having paid for the R&D efforts. Even with patent protection, these spillovers reduce the payoff to investing in R&D. A second reason why the private rate of R&D is lower than the optimal rate is the appropriability effect: In the absence of perfect price discrimination, the private surplus from innovation is lower than the social surplus. A countervailing effect that leads firms to over-invest in R&D is the business-stealing effect: A firm that introduces a new product does not internalize the loss of profit suffered by its rivals on the product market. Thus, market imperfections may lead to either overinvestment or underinvestment in R&D relative to its socially optimal level.

A crucial parameter needed in order to determine the optimal level of R&D investment is the rate of return to R&D investment. This rate of return measures how much productivity increases as a result of investment in R&D. In principle, we would want to estimate the social rate of return as opposed to the private rate of return since the former is a more general measure that accounts for R&D spillovers. Furthermore, findings in the empirical productivity literature emphasize that social rates of return remain significantly above private rates.

In ongoing work1, my former Ph.D. student David Corderi and I are estimating the social rate of return of R&D in energy-related industries for a number of Organisation for Economic Co-operation and Development countries. By analyzing the productivity effects of intra-industry spillovers from R&D expenditures, our estimates provide a lower bound on the social rate of return to energy R&D. Our results suggest that research and development has a positive and significant social rate of return in France, Finland and the Netherlands. As our estimates provide a lower bound, the actual social rate of return to energy R&D may be even higher. We also find evidence again diminishing returns to energy R&D. There are thus positive and significant benefits to investing in energy R&D.

C.-Y. Cynthia Lin, an associate professor with a joint appointment in the Agricultural and Resource Economics Department and the Environmental Science and Policy Department at the University of California at Davis, is a member of the Controller's Council of Economic Advisors. The opinions in this article are presented in the spirit of spurring discussion and reflect those of the authors and not necessarily the Controller or his office.

1 David Corderi and C.-Y. Cynthia Lin, "The Social Rate of Return to R&D in Energy"