The New Era of Industrial Policy Is Here

Summary.    Governments around the world are increasingly intervening in the private sector through industrial policies designed to help domestic sectors reach goals that markets alone are unlikely to achieve. Companies in targeted...

Governments around the world are increasingly intervening in the private sector through industrial policies designed to help domestic sectors reach goals that markets alone are unlikely to achieve. As a result, companies in targeted sectors—such as automakers, energy companies, and semiconductor manufacturers—may experience dramatic changes in their operating environments. The policies could create new costs or deliver financial incentives to shift R&D or manufacturing investments. They may also incent firms to alter their supplier networks or change their trading partners. Managers who have grown up in markets without such interventions are now facing an unfamiliar environment. This article will provide an overview of policy approaches and give managers a framework for responding to them.

The Fall and Rise of Industrial Policy

Industrial policies are not new. Countries have long practiced them: Japan used gyōsei shidō, or “administrative guidance,” coupled with loans, grants, subsidies, and other financial tools, after the Second World War to foster the growth of its manufacturing sector. In 1986 China launched its 863 program to modernize technology. South Korea, Singapore, and Taiwan all used programs to stimulate modernization and development. In the United States the Apollo space program and the work of the Defense Advanced Research Projects Agency (DARPA) are examples of mission-oriented industrial policies that successfully stimulated innovation. Yet over the last few decades, critics have questioned whether such interventions were the most efficient way to allocate public resources. Failures to achieve objectives, perceived anticompetitive effects, concerns about crowding out private investments, and the view that programs often ended up serving special interests all fueled the skepticism. As did high-profile failures such as the U.S. investment in solar panel maker Solyndra, the Synthetic Fuels Corporation (established in 1980 and closed six years later), and the commercial failure of the British and French Concorde supersonic passenger jetliner. Consequently, the pendulum swung the other way; many governments intervened less.

During the past five years, the pendulum has been swinging quickly back, propelled in part by the need to respond to global societal challenges such as the Covid-19 crisis and climate change. In addition, many countries fear that their strategic technologies or sectors are weakening, which poses a threat to economic growth, national security, and innovation capacity. Some new industrial policies focus on creating jobs; others on influencing international trade. Notable examples include the European Green Deal, Horizon 2020, and the Strategic Forum for Important Projects of Common European Interest (IPCEI); the Infrastructure Investment and Jobs Act (IIJA), the Inflation Reduction Act (IRA), and the CHIPS and Science Act in the United States; and policies in China like Made in China 2025 and its Belt and Road Initiative, which some argue was designed to grow its export trading ecosystem.

Sometimes governments intervene because the private sector may not be willing to assume as much risk as governments when it comes to providing public goods. Operation Warp Speed in the United States is a case in point. It was highly successful in accelerating clinical trials and introducing new technologies like mRNA vaccines, diagnostics, and therapeutics to fight Covid-19 because the Biomedical Advanced Research and Development Authority (BARDA) was willing to absorb large financial risks by betting on a portfolio of different technologies, including ones that had never been deployed.

A more controversial, and increasingly common, type of intervention focuses on helping specific industries or sectors. European governments’ support for Airbus helped the consortium overcome the high fixed costs of entering the commercial aircraft industry; China offered the same kind of support to the Commercial Aircraft Corporation of China (COMAC) to design and produce passenger jets such as the C919. China, which has long relied on industrial policies to develop its economy, also intervened heavily with subsidies in solid-state lighting, wind energy, and solar panel manufacturing. And recognizing early on the strategic importance of transitioning its automotive industry to electric, China also provided incentives to buyers of domestically made electric vehicles. The country became the world’s largest manufacturer of electric vehicles, and Chinese companies such as Contemporary Amperex Technology Company (CATL) and BYD have become dominant suppliers of lithium batteries and their components. Such successes have encouraged governments everywhere to intervene more in technology-focused and mission-oriented industrial strategies.

The intensifying geopolitical competition between the United States and China is adding fuel to the fire. The U.S. government has tried to reverse the declines of strategic sectors in its manufacturing base by offering significant subsidies and loans, erecting tariffs, and providing extensive tax incentives coupled with domestic content rules, such as those provided in the Federal Advanced Manufacturing Production Tax Credit of the Inflation Reduction Act. It has issued new rules governing ownership of entities and export bans, such as those for advanced semiconductors and the equipment needed to make them. These policies have led to a big jump in manufacturing investment in the United States but have prompted other countries, including allies, to counter with their own interventions. The EU, for instance, responded with its Green Deal Industrial Plan and proposals to temporarily set aside state-aid rules that limited subsidies to companies in member countries. South Korea’s parliament approved the K-Chips Act in response to the U.S.’s CHIPS and Science Act.

Industrial policies have also begun to spill across national or supranational borders (like the EU) with the emergence of new alliances and concepts like friend-shoring, or the sourcing of materials and components from trusted trade partners. Examples include the Chip 4 Alliance proposed by the Biden administration, which would create a “democratic semiconductor supply chain” that spans Japan, South Korea, Taiwan, and the United States; the Group of 7 agreement to collectively manage risks in critical mineral supply chains; and the UK–Japan semiconductor partnership.

Christopher Payne photographed Annin Flagmakers, one of the oldest and largest flag manufacturers in the United States, exploring how a flag can at once be a piece of fabric and represent a nation’s identity and ambitions.

Friend-shoring and industry-specific trade alliances add another challenge for companies that operate across borders: Executives need to understand not only the competitive dynamics of potentially unfamiliar markets in other countries but also the possible impacts of policy decisions in countries with competing sectors. For example, the United States has no flat-panel-display industry and relies on China, Japan, South Korea, and Taiwan for its entire supply of computer monitors, TVs, and displays used in cars and other equipment. But Chinese policies that resulted in overinvestment in manufacturing capacity will likely drive U.S. “friends” such as South Korea, Japan, and Taiwan out of the business, which will eventually force U.S. companies to source exclusively in China.

Navigating the Changing Policy Environment

As new policies are formulated and implemented, business leaders can take steps to position themselves wisely:

Recognize the different forms of industrial policy.

Industrial policies fall into four broad categories: horizontal, vertical, supply-side, and demand-side. It is helpful for managers to recognize the distinctions because each impacts market behavior and competition differently.

Horizontal policies apply to all firms irrespective of their activities, their location, or the technologies they use. They include things like R&D tax credits and accelerated depreciation, which reduce the costs of capital investments. Vertical, or targeted, policies favor a specific sector or firm. They include renewable-energy tax credits like those provided for in the IRA: a $3 per kilogram credit for the manufacture of solar-grade polysilicon and a credit of $12 per square meter for making photovoltaic wafers.

Supply-side policies mainly impact the cost of R&D or production, and they can tilt the playing field in favor of certain locations or the use of particular materials or technologies. Governments use supply-side tools such as grants, subsidies, tax preferences, and tax credits most frequently. Economists argue that they may be justified when firms don’t have sufficient incentives to invest in risky projects or they underinvest because they will get only a partial share of the total return on their investment. For example, the European Battery Alliance is channeling billion of euros into research and innovation, while in the United States the IRA provides credit subsidies and loan guarantees for a range of clean energy projects.

Christopher Payne

Demand-side tools, by contrast, typically affect domestic consumption of targeted products or services. They work to increase the size of the market overall. Examples include tax credits for the purchase of an electric vehicle and guaranteed pricing for renewable power sold to the operator of an electrical grid. Government procurement is another demand-side tool, as are tax credits for the installation of renewable-energy generation. Demand-side tools have the advantage of preserving market competition among companies vying to sell to customers, but nonetheless they distort markets, at least temporarily. Many provisions in the Inflation Reduction Act that support clean energy are essentially demand-side tools that contain domestic content rules.

Many companies focus on supply-side tools when they are lobbying because supply-side policies can be narrowly targeted to give their business an advantage. They expect that demand-side policies will create more competition for them. But lobbying for a combination of supply- and demand-side policies would often be more effective, as demand-side tools increase the size of the market, which creates more incentives for firms to invest—and lowers the risk of those investments.

Understand competing priorities and government intent.

When policies are still being developed, it is important for executives to understand the multiple interests at play. For the CHIPS and Science Act, for instance, the government’s highest priority was securing domestic sourcing of semiconductors for defense and critical infrastructure needs. Semiconductor makers, for their part, wanted help competing against lower-cost foreign competition; chip customers like automakers wanted a dependable supply; and organized labor wanted high-paying union jobs. Most policies are compromises that draw political support from a wide spectrum of constituencies.

Engage and educate.

Before industrial policies are finalized, many organizations employ their government relations teams or lobbyists to try to shape them in ways that serve their interests. But executives often fail to appreciate the importance of educating not only political leaders and appointees but also career civil servants who write the legislation—such as congressional staffs in the United States or EU staff in Brussels. Many civil servants have minimal experience in the business world, and areas like green energy or semiconductors are technically complex. That gives CEOs a unique opportunity to offer meaningful input, especially when they can speak for an industry sector.

Focusing on educating government officials and staff members about competing interests and issues may be a more effective way to shape the thinking of the people developing the policies than simply advocating for a particular measure. It entails temporarily setting aside a firm’s specific interests and conveying the big picture: the industry’s structure, existing trade dynamics, and how all the pieces connect. For example, recent semiconductor trade policies were motivated by the supply chain crisis that arose during the Covid-19 pandemic, when multiple strategic vulnerabilities were exposed. Yet many people in government and business fell into the trap of looking only one step upstream or one step downstream from where shortages appeared, which led to intense and competing lobbying around potential solutions. Taking a bird’s-eye view of the highly interconnected network of chip designers, materials suppliers, chip manufacturers, and chip consumers would have been a better approach. Then policymakers would have recognized that some bottlenecks in the supply chain were connected to demand surges and stockpiling in the face of looming U.S. sanctions on Chinese companies, and that automakers shared their call on chip foundry capacity with other sectors experiencing high demand. It would also have helped them understand how U.S. sanctions on select Chinese companies had triggered the construction of excessive capacity in mature chip sectors in China and was likely to result in commoditization pressure on other global players.

In a similar vein, many people in government may not appreciate how investment levels and time horizons for earning returns vary across sectors and even within a sector. Pharmaceutical companies and semiconductor companies might spend 30% or more of their revenue on R&D, whereas consumer goods companies might spend 2% or less. As a policy tool, tax credits are beneficial only when a firm has income to apply those credits against. Capital-intensive industries such as semiconductor manufacturing and mining may not turn a profit for 10 years or more. In such cases, offering a tradable credit would allow those companies to sell the tax preference to another business. For example, U.S. energy policy between 1918 and 1970 focused on increasing domestic oil and gas reserves. It offered the industry a host of incentives, including tax tools such as the expensing of intangible drilling and dry hole costs; a percentage-depletion allowance to counter the exhaustion of underground reserves; favorable treatment of capital gains on the sale of successful properties; and special exemptions from rules for limitations on passive activity losses. Taken together, they reduced the marginal tax rate in the oil and gas industries and helped put U.S. firms at the forefront of upstream production for most of the 20th century. But those approaches were formulated long before many of today’s lawmakers were born. If corporate executives spend time educating them, they’ll be more likely to formulate more-nuanced policies.

Collaborate.

Working with upstream and downstream partners in your supply chain can lead to commercially successful outcomes that are aligned with industrial policy objectives. In Europe, many companies that are responding to mandates to reduce carbon emissions face a “chicken and egg” problem: Companies may hesitate to switch to a more sustainable fuel because sources of supply down the road are uncertain. At the same time, potential fuel suppliers cannot or will not invest in more capacity unless they are assured that there will be sufficient sustained demand to earn a return on their investment. A.P. Moller-Maersk, the Danish shipping and logistics giant, tried to address that dilemma by signing offtake agreements with biomethanol suppliers to get them to commit to investing in new production capacity. Similarly, General Motors is investing $650 million in Lithium Americas to help it develop its new Thacker Pass mine in Nevada, a deal that includes a 10-year offtake agreement and options to secure even more of the mine’s output.

Adapt.

The late Harvard Business School professor Bruce Scott described business as an activity conducted on a playing field that is operating under rules set by the government. From this perspective, new industrial policies are an attempt to change the rules of play in order to achieve specific goals.

Christopher Payne

Adaptability, therefore, is critical for business leaders. The RISC-V Foundation, an organization set up to foster the adoption of its open-source processor core technology (developed at the University of California, Berkeley), moved its headquarters from the United States to Switzerland, renaming itself RISC-V International in the process. It did so to ensure that its members, which include U.S., European, and Chinese companies, could continue to use RISC-V chip designs in the face of increasing trade restrictions.

Another example of adaption: Some Western companies that have large businesses in China are bifurcating their supply chains to serve the Chinese market separately from the rest of the world. And many Western firms that are dependent on China for most of their production needs but can’t move to other countries yet will need to develop road maps to diversify their production over the long term.

Decide whether to accept subsidies.

Demand-side subsidies are relatively straightforward. The seller’s task is to comply with requirements that enable a buyer of its product to collect the subsidy. When government programs offer supply-side subsidies, however, business leaders must decide whether to accept them. U.S. programs increasingly have strings attached, ranging from the traditional, such as meeting minimum investment or hiring levels, to the nonconventional, such as the government taking equity stakes, financial stakes, or shares in future earnings. During Operation Warp Speed, for instance, Moderna’s executives accepted funding from BARDA to accelerate development and scale up manufacturing. By contrast, Pfizer’s leaders took a more limited approach: The company received a government commitment to purchase 100 million doses of its vaccine after it successfully manufactured it and received the Food and Drug Administration’s emergency-use authorization. Both vaccines were commercially successful, but Moderna’s closer collaboration with the government probably contributed to subsequent disputes between the company and the National Institutes of Health over patent ownership and which companies had the right to license the technology.

Subsidies can bring other constraints. An extreme case in point is the U.S. government’s bailout of GM during the Great Recession. The 2008 financial crisis caused a precipitous drop in sales for domestic automakers, leaving them in financially precarious positions. Concerns about the collapse of a major industry prompted the federal government to step in. GM received more than $50 billion as part of the Troubled Asset Relief Program (TARP), but it had to grant 60.8% of shares in a New GM to the U.S. Treasury and the balance of shares to the United Auto Workers retiree health care trust fund, the governments of Canada and Ontario, and holders of the old GM’s bonds. The Obama administration pressured GM’s then-CEO Rick Wagoner to resign, and the company went through a restructuring directed by the administration’s Auto Task Force, effectively ceding management control to the government.

Plan to live without subsidies or preferences in the long term.

Once a firm accepts subsidies or tax preferences, managers need to plan for the time when that support ends. Construction subsidies offered under the CHIPS and Science Act, for example, will likely be onetime events, designed to help offset high construction costs. But these subsidies alone will not reduce operating costs except to the extent that they reduce the cost of capital and consequently lower amortization per wafer produced. Plus they come with strings attached—there may be restrictions on companies’ ability to invest in other countries in the future or other constraints on their future operations. The ultimate question for executives will be how to address higher costs for materials (much of which will still need to be imported), availability of skilled workers, and other ancillary costs.

One theory behind subsidies in the IRA and CHIPS and Science Act is that manufacturers will build scale and lower their costs by moving down the learning curve, and that may be true. But it is important for businesses leaders to understand that government objectives are not necessarily focused on company profitability. For example, the CHIPS and Science Act has as its highest priority ensuring domestic access to advanced semiconductor manufacturing capacity for military and essential commercial uses. It is not designed to ensure the profitability of manufacturers’ domestic operations. That’s up to the companies’ leadership. In a similar vein, some subsidies under the IRA or IIJA will require higher percentages of domestic content over time and will be phased out over time, so managers need a plan to be competitive when that happens.

We are moving into a new world order, where governments around the world are increasingly using industrial policy tools to shape where companies structure and locate their operations, which products they sell, and to whom they sell them. For companies that operate in multiple countries, navigating those policies won’t be easy. Managers need to understand the goals of the governments, work to educate government officials and staff to shape policies as they are being developed, and figure out how to optimally revamp their operations accordingly. Corporate strategies built during what we will probably look back on as a golden age of globalization will have to be recast for a more fragmented world, taking into account different country contexts and constraints and tailoring approaches that fit these markets. It will be much harder to have one size fit all.