Productivity and Industrial strategy

The green paper is arranged around ten strategic pillars, one of which is to ‘develop affordable energy and clean growth’. Within this, the green paper reiterates the Government’s commitment to shift towards a lower carbon economy, but stresses that his must be done in a way which ‘minimises the cost to UK businesses, taxpayers and consumers’. This echoes very similar statements in a previous Policy Exchange report, The Customer is Always Right, which argued that previous Governments had paid insufficient attention to the rising cost of energy and climate policies, and that going forward the Government should place consumers and affordability at the heart of its energy strategy.

There is significant focus in the green paper on how to manage or reduce the cost of energy through improvements in network efficiency, and also in energy efficiency. In addition, the document makes a passing reference to improving resource efficiency more generally. It notes that ‘increasing the efficiency of material use across the whole supply chain can deliver huge cost savings and improve the productivity of UK businesses.’ It is clear that the Government has the appetite to develop this idea further, indicating that it plans to ‘explore opportunities to reduce raw material demand and waste in our energy and resource systems, and to promote well-functioning markets for secondary materials, and new disruptive business models that challenge inefficient practice.’

Following the publication of the green paper, Policy Exchange hosted a roundtable last week, which considered the opportunity to embed resource productivity thinking in the Industrial Strategy. The roundtable was held jointly with SUEZ Recycling and Recovery UK (a waste management firm) and also involved a number of manufacturers across the automotive, metals, paper, and construction sectors. This blog provides a summary of the key points from the discussion.

Opportunity to Improve Resource Productivity

Improving resource productivity represents a significant economic opportunity for businesses. Research by Accenture has shown that there is potential to unlock $4.5 trillion of global growth through improvements in resource productivity. They suggest that this can be achieved by moving from traditional ‘linear’ business models, in which resources are extracted, consumed, and disposed, to more ‘circular’ business models in which businesses reduce their dependence on natural resources, and turn waste streams into new sources of revenue. Accenture has also done sector-specific analysis, for example showing that the automotive sector could reduce its cost base by 14 percent through improvements in resource efficiency, delivering $400-600 billion of additional profit globally by 2030.

Similar analysis by Oakdene Hollins for Defra in 2011, suggested that UK firms could realise resource efficiency savings of £55 billion per year (increasing gross profits by 5%), mainly through improvements in waste management practices. The bulk of these potential savings relate to the construction sector, and manufacturing (where an estimated 45 percent of costs relate to materials).

On face value, it appears that improving resource efficiency could make an important contribution to reducing the cost base and raising the productivity of UK firms, and it is right that this should be a focus of the Industrial Strategy.

In addition to the economic benefits, there are obviously significant environmental gains to be made by improving resource and energy efficiency. The Defra study mentioned above suggested that improvements in energy and resource efficiency could yield a reduction in carbon emissions of 90 million tonnes of CO2 equivalent per year (or 13 percent of the UK’s total greenhouse gas emissions). Increasing resource productivity can also reduce our ecological footprint, water use, and our reliance on material imports (see research by WRAP).

The Industrial Strategy green paper rightly recognises that improving energy and resource efficiency could contribute not only to the Industrial Strategy and the UK’s productivity problem, but also towards meeting our carbon targets under the Climate Change Act, and making environmental improvements in line with Defra’s forthcoming 25 Year Plan for the Environment.

Why and how should Government intervene?

The question then is what Government should do about it? If the economic opportunities to improve resource productivity are so great, then it should be in the interest of companies to realise these opportunities, and improve their competitiveness. What is the rationale for Government intervention?

Participants at the Policy Exchange roundtable indicated that whilst there are significant opportunities to improve resource productivity, they are not always realised by businesses. The main barriers can often be a shortage of internal capital, coupled with risk aversion or short-termist attitudes towards investing to improve future efficiency. Improvements in resource efficiency can yield long term savings, but still often require significant up front capital investment. Business investment horizons are often very short, with firms looking for a 2-3 year payback. This severely limits the scope of possible improvements in resource efficiency. Short investment horizons are compounded by the fact that resource efficiency investments have to compete against other demands on capital (potentially on a global basis if a multinational firm). It is often difficult to make the case to invest in resource efficiency – even within a resource-intensive business. Businesses could also look to external sources of finance, such as banks. But informational failures may impede the use of external finance, for example the cost of producing ‘investment grade’ analysis of efficiency opportunities can be prohibitive.

There may be a role for Government intervention to overcome these financing challenges and unlock projects. However, interventions to promote energy and resource efficiency need to be well thought through, and evidence led. There have been some notable failures of policy in the past, due to a lack of understanding of the underlying barriers to investment in efficiency – such as the Green Deal energy efficiency scheme. Government must explore in detail the underlying barriers to business investment in resource efficiency investment before it proceeds further.

Because of the difficulties in financing resource efficiency improvements, businesses rarely make significant transformational changes in the way they use resources, and instead tend to make relatively incremental improvements. There are of course exceptions. For example, over the last few years Jaguar LandRover has developed a completely new range of lightweight aluminium car bodies, driven by a need to reduce the weight of its vehicles in order to meet fuel efficiency and carbon standards. As part of this process, Jaguar LandRover made fundamental changes to its manufacturing process, to reduce overall material consumption, and increase the recycled content of the materials used. Central to this change was the development of a new aluminium alloy which can tolerate higher levels of impurities. This means that scrap castings and offcuts, which were previously discarded, can now be recycled back into the production process, thereby creating a closed-loop system. Overall, this has resulted in a 40 percent reduction in the weight of the cars, improvements in fuel efficiency, a reduction in the amount of virgin materials consumed, and the amount of waste generated.

This example highlights an important way in which Government can encourage resource efficiency improvements – through research funding and catalysing the rollout of new innovations. The project was delivered through a public-partnership between Jaguar LandRover and Novelis, facilitated by the University of Cambridge, and part-funded by Innovate UK.

Whilst this is an excellent example, in general the Government could do more to support research and innovation into resource efficiency. In 2015/16, Innovate UK allocated just £6 million of its £547 million annual budget to research into Resource Efficiency. Government has pledged to substantially increase R&D spending – with the Autumn Statement revealing an additional £4.7 billion of additional funding by 2020/21, including a new ‘Industrial Strategy Challenge Fund’. Given the size of the opportunity outlined above, and its relevance to both the Industrial Strategy and the Emissions Reduction Plan, resource efficiency should arguably be one of the areas of focus.

Tackling these issues will require some novel thinking from Government. Waste policy, resource efficiency, and productivity have historically been led by quite separate parts of Government (across Defra, what is now BEIS, and HM Treasury). There is a risk that work continues in silos, but roundtable participants thought that the process of developing a new Industrial Strategy could bring together these various parts of Government, and create a more joined up approach

Productivity and growth

What is productivity?

Productivity is a measure of the efficiency with which a country combines capital and labour to produce more with the same level of factor inputs

• We commonly focus on labour productivity measured by output per person employed or output per person hour.
• A better measure of productivity growth is total factor productivity which takes into account changes in the amount of capital to use and also changes in the size of the labour force.
• If the size of the capital stock grows by 3% and the employed workforce expands by 2% and output (GDP) increases by 8%, then total factor productivity has increased by 3%.

Productivity is an important determinant of living standards – it quantifies how an economy uses the resources it has available, by relating the quantity of inputs to output. As the adage goes, productivity isn't everything, but in the long run it's almost everything.

Higher productivity can lead to:

• Lower unit costs: These cost savings might be passed onto consumers in lower prices, encouraging higher demand, more output and an increase in employment.
• Improved competitiveness and trade performance: Productivity growth and lower unit costs are key determinants of the competitiveness of firms in global markets.
• Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested to support the long term growth of the business.
• Higher wages: Businesses can afford higher wages when their workers are more efficient.
• Economic growth: If an economy can raise the rate of growth of productivity then the trend growth of national output can pick up.
• Productivity improvements mean that labour can be released from one industry and be made available for another – for example, rising efficiency in farming will increase production yields and provide more food either to export or to supply a growing urban population.
• If the size of the economy is bigger, higher wages will boost consumption, generate more tax revenue to pay for public goods and perhaps give freedom for tax cuts on people and businesses.

What are the main determinants of productivity in a country?

• Access to Hard Technology
• Skills of Labour Force
• Quality of Management
• Training and Education Standards
• Competition within markets
• Cultural Factors such as attitudes and aspirations

Productivity improvements in China

China has achieved impressive gains in productivity in recent years and is catching up towards levels for the East Asian and Pacific region and middle income countries such as Malaysia.

What has driven these improvements in Chinese total factor productivity?

1. Resource shifts: There has been a huge shift of resources out of relatively low productivity agriculture into more productive work in manufacturing industry and construction. Over half of the Chinese population now lives in urban areas.
2. New technology and innovation: The willingness of Chinese businesses to adopt new production technologies and process innovations. Mobile telephony has expanded at a rapid rate
3. FDI effects: High levels of inward FDI have boosted productivity – new manufacturing capacity and technology has lifted efficiency and led to productivity spill over effects among supply-chain businesses. For example, in 2012, Samsung Electronics, the world's biggest memory chip maker, unveiled plans to invest $7bn to build its first chip factory in China.
4. Openness and global competition: The Chinese economy has become more open – trade is accounting for a rising share of national income – global competition is a stimulus for efficiency improvements
5. Better infrastructure: Heavy state spending on critical infrastructure has improved the overall efficiency of the economy for example in reducing transport delays and increasing communication speeds
6. Management: Restructuring of state-owned businesses has been a factor behind better productivity. The Economist magazine reported recently that “sophisticated methods of control, more productive use of assets and rapid globalisation have boosted productivity"
7. Improved wages: There is strong pressure for mean wages to rise in China especially as the latest Five Year Plan emphasises the need to boost domestic demand. Will a number of years of rapid wage acceleration provide a boost to worker productivity?

Read here for more ESPECIALLY the AD/AS diagram

Productivity and growth

Increased productivity creates economic growth

This page summarises evidence on the relationship between increased productivity of firms contributes and economic growth. It includes positive correlations between increased investment and economic growth, since increased productivity is one possible way of how investment affects economic growth.

Increases in productivity allow firms to produce greater output for the same level of input, and thus result in higher Gross Domestic Product.

A study of agriculture in Thailand and Indonesia by Warr (2006) shows that, between 1981 and 2002, productivity increases in the sector following the introduction of irrigation accounted for 5% of overall GDP growth in Thailand and 3.5% in Indonesia. Moreover, the productivity increases in agriculture freed up resources which could then be put to use in other sectors. This reallocation contributed 16% to overall GDP growth in Thailand and 24% in Indonesia.

A global review by ILO (2013) examines the impact of labour productivity on growth. It finds that increases in labour productivity within economic sectors is the main driver of economic growth (rather than sectoral re-allocation). In particular, growth in industry and services play an important role for aggregate economic growth.

Productivity and growth

The great gains in standard of living have come from higher output per hour. That was true of the United States and Europe during the industrial revolution, and it's true of  Asia in recent years . Gain could, theoretically, have come from a change in distribution: more income going to workers, and less to owners of capital. Despite recent talk about inequality, changes in income distribution have not driven rising living standards over long periods of time. Rising incomes result from rising productivity.

Note that when “productivity” is used alone, it usually refers to labor productivity, but the concept can be applied to other factors of production. We sometimes refer to energy productivity (output per unit of energy used), and factory managers look at the ratio of output produced to raw materials used. In this article we focus on labor productivity.

Labor productivity is not well measured. In manufacturing, it’s easy to compare the dollar value of goods produced to the person-hours of labor required to produce those goods. It’s much harder in services. Take banking, for example. Your checking account is clear as mud. The bank provides to you the service of processing checks, for which you don’t pay (aside from exorbitant fees for bounced checks and stop-payments). However, the bank does not pay you a market rate of interest on the money you keep in the your checking account. It’s a trade: free services in exchange for free account balances. Government statisticians estimate the dollar value of the trade, so that the productivity of bankers can be assessed, but the figures are not very precise. Health care is another area where data don’t allow very accurate estimates on productivity. So productivity statistics provide a general tone, not high-fidelity notes.