Addressing local content requirements: Current challenges and future opportunities
Local content requirements (LCRs) are policy measures that typically require a certain percentage of intermediate goods used in the production processes to be sourced from domestic manufacturers.4 Local content requirements in renewable energy policy serve as either a precondition to receive government support or an eligibility requirement for government procurement in renewable energy projects.5 LCRs are usually coupled with other policy measures to encourage green growth.
The great majority of LCRs are aimed at sectors other than renewable energy. Collectively, LCRs in the renewable energy space probably impact over USD 100billion of trade annually, but the available data do not permit an estimate of trade impacted by LCRs.
Moerenhout and Kuntze (2013) find that LCRs in green industrial policies are generally promulgated for four reasons. First, LCRs augment public support for renewable energy projects. Second, proponents point to the classic case for protecting infant industries, especially in developing countries, until they can compete on the international market. Third, the creation of "green" jobs, especially in developed countries, is put forward as a justification for the use of LCRs. Proponents also point to the potential environmental benefits of greater competition between renewable energy firms over the medium-term.
On this first point, renewable energy generally costs more than coal-fired power. Thus, one way to enlist public support for the extra cost is to tie renewable energy projects to domestic innovation and job creation through LCRs.
Local content requirements can also present an attractive solution to allow infant industries to become internationally competitive in their renewable technology and manufacturing capability. In addition LCRs may counteract government subsidies in other countries. According to this line of argument, LCRs provide incentives for local firms to produce and eventually innovate in the most promising green energy sectors and to lower their production costs over time.
By requiring firms to use a certain percentage of local inputs, demand for domestic cleaner industries will increase, spurring green job creation in the short-term. In the long term, there are economic benefits to be gained from "learning by doing" and from increasing the supply of renewable energy. Countries implement LCRs with the two-pronged goal of achieving a robust renewable energy industry that will be competitive in international markets, and securing associated local job creation.
Proponents of LCRs point to the positive spill-over effects for the environment in the medium term. By increasing the number of players in the international market, proponents of LCRs contend that, in the medium term, greater competition will spur innovation in the renewable energy sector and consequently lower green technology costs. Following this line of argument, the medium- term benefits will compensate the short-term disadvantages in terms of greater production costs. In addition, proponents claim that, by promoting the transfer of technology, LCRs foster sustainable practices worldwide.
Arguments against LCRs
Opponents to local content requirements in renewable energy policies point to the economic costs - inefficient allocation of resources, higher retail power prices, negligible employment gains and a negative impact on trade - and question the environmental gains in the medium-term.
Critics hold that LCRs lead to an inefficient allocation of resources by distorting the operation of comparative advantage. Enterprises inefficiently invest their resources in local inputs to artificially improve the competitiveness of local products, making foreign products less attractive to potential buyers.
While proponents argue that LCRs are a short-term policy, put in place to protect infant industries and businesses, opponents point out that once LCRs become a mainstay, withdrawal of government support will often be met with fierce resistance. It is also possible that the relevant manufacturing sectors will never attain the level of efficiency necessary to operate without government support, and instead require continuous government support.
In the short term, since firms are required to purchase local inputs that are likely to be more costly than foreign ones, their manufacturing costs are increased. Producers pass the higher manufacturing costs on in the form of increased power prices to domestic consumers. LCR proponents contend that in the medium and long-term, greater competition and innovation will eventually lower manufacturing costs, and hence consumer power prices, but this seems far from certain.
It is also worth noting that creating additional jobs through LCRs is not a certainty. LCRs increase the cost of renewable energy production through higher input prices. As such, less renewable energy is produced, resulting in zero job creation and possibly job losses in the green industrial sector. It is also possible that there is job creation but lower returns to other factors. Since LCRs require firms to source components locally, employment will increase in the component industry. The net effect for job creation of higher input prices and hence less renewable energy production combined with greater demand for component manufacturing is difficult to pinpoint.
Countering the output effect is the substitution effect, which assumes that labour can serve as a substitute for the local material. If the percentage of local content required is very high, then renewable energy production will be reduced, accompanied with net job losses. However if the amount of local content required is not very high, then firms might increase their employment to offset higher prices for local material.
Negative impact on trade
The effect of LCRs on trade is to discourage foreign imports and to stifle competition between domestic and foreign firms. The impact on trade of LCRs depends on the percentage of local content required and the efficiency of existing firms. In an economy with inefficient firms, a high degree of required local content thwarts competition.
In addition, LCRs might hamper innovation and quality in the renewable energy sector. With a restrictive LCR in place, investors might be deterred from investing in the renewable energy sector owing to higher input prices. Meanwhile, the higher the LCR, the more the renewable energy sector will be protected from foreign competition, resulting in lower quality and higher prices. Over time, this may impact the quality of foreign direct investment (FDI) attracted to the sector and encourage rent seeking, and less efficient FDI.
The effectiveness of LCRs
Kuntze and Moerenhout outline five agreed-upon preconditions for LCRs in renewable energy production to have a beneficial impact for the domestic economy: stability and large market size, a small degree of restrictiveness, cooperation between government and firms, accompanying subsidies, and technology and knowledge transfers.
LCRs in renewable energy must be introduced in a stable and sizable market that has potential for growth. Ultimately, investors are concerned with whether the higher costs incurred to produce local material will be more than compensated for through stable demand and industry growth. The larger the market, the more chance there is that welfare gains can be reached through LCRs. In addition, a large and stable market encourages transfers of knowledge and technology through learning by doing.
Second, the impact of LCRs depends largely on the percentage of local products required. To add value to the host economy, the LCR should be phased-in gradually, and the percentage of local content required should be tailored to the size of the green industrial sector and the opportunity cost of capital.
Third, in setting the LCR rate, governments have much to gain from cooperating with local businesses. Cooperation between governments and businesses increases information on both sides.
Fourth, the subsidy to which the LCRs are to be coupled must be sufficient to maintain market attractiveness.
Finally, LCRs will be more valuable if there is a high learning-by-doing potential, or if they do not overemphasize manufacturing portions of the value chain, but also target training-by-doing to establish high-skilled workers.
Despite these five identified preconditions, there remain questions about the terms of the best subsidy - type, targeted value chain, duration, and size. An additional precondition is a clear timeframe for the term of the LCR, beyond which it would not be renewed.
Wind energy in Ontario
In 2009, the Canadian province of Ontario passed the Green Energy and Green Economy Act, aiming to expand the renewable energy sector and create green jobs.
As part of the Act, Ontario introduced a feed-in-tariff (FIT) program to encourage investment in renewable energy, coupled with an LCR. Under the LCR, firms are required to use a certain percentage of locally manufactured material for wind and solar projects in order to receive government support.
The LCR was not phased in gradually. As a result, retail electricity prices increased by more than 17 percent in 2010 and are expected to continue to increase. The higher cost of renewable energy production from wind turbines will in all likelihood be passed on to consumers through higher electricity prices. While Ontario's government has stated that the Green Energy Act has led to the creation of 20,000 jobs, it is not clear that the FIT scheme pays enough attention to investment in training to increase workers' skills or sets renewable energy targets, which would serve to encourage new investors based on perceived guaranteed demand. In this case LCRs have increased the cost of producing renewable energy in Ontario.
Solar energy in India
In 2010 India launched the Jawaharlal Nehru National Solar Mission (JNNSM), which aims to increase solar power by installing 20GW of grid capacity by 2022 in three phases. As part of the Indian government's policy in the area of solar energy, an LCR was introduced in 2010. In response to the LCR, the majority of solar developers in India have turned to cheaper imported thin film technology, which also have better international financing options for such solar energy projects.
The LCR has slightly increased the cost of photovoltaic systems. In response to the measure, domestic manufacturers have scaled back the operations of their solar plants, operating below capacity or closing down altogether. In addition, the shift to thin film deployment has undermined anticipated economic and job growth from the JNNSM.
Thin film modules have a lower efficiency, which translates to added costs for the developer. As such, the overall cost might be higher once efficiency differences are taken into account. It has been suggested that an additional reason for the thin film preference of Indian solar developers is that the hot climate provides ideal conditions to maximise thin film efficiency.
Although global prices for crystalline silicon modules and cells continue to fall, owing to improved technology, Indian manufacturing competitiveness for crystalline silicon technology has not kept pace. The LCR is likely to discourage innovation in the solar energy industry and impede manufacturing competitiveness. The LCR might boomerang India's solar manufacturing and electricity goals.
As well, LCRs in India's solar technology area have resulted in higher costs for renewable energy products, in this case photovoltaic modules and cells, which have been passed on to the consumer.
Options and alternatives
Although LCRs are prohibited under the WTO, countries have nonetheless turned to LCRs as part of their renewable energy policies. There are, however, alternatives that could be considered as options to the recourse to LCRs. As technological innovation for renewable energy is costly, considerable government support may be required for these efforts. To sustain a permanent shift towards green industry and renewable energy, positive and well-directed incentives are needed.
Addressing conditions that are hindering the development of competitiveness in renewable energy manufacturing and services should be a high priority for governments, together with providing a better enabling environment for firms to operate.
To achieve economies of scale, governments should prioritise infrastructure investment. Developing countries often lack the financial capacity to subsidise renewable energy or the political capacity to impose carbon taxes - arguably the best policies to foster renewable energy. Therefore, they resort to LCRs. To address this constraint, government-sponsored financing should be promoted, such as loan guarantees for developers of alternative, green energy.
The advent of new technology and the rapid increase in production capacity in renewable energy resources have made them more competitive against conventional technology in energy. Policies such as FITs and other incentive mechanisms to stimulate investments in renewable energy may be continued and enhanced as long as they are also required to ensure a healthy growth of renewable deployment that will further provide attractive returns to investors.
Focusing on innovation in green energy requires adapted training programmes for domestic workers. These should be integrated with green industry needs, and periods of on- site training should be incorporated into the university curriculum or training programmes. Targeting all portions of the energy value chain rather than imposing an LCR aimed at domestic manufacturers should prove to be a better and less distorting way of expanding output in the green energy sector and would have the added benefit of creating associated green jobs.
Additionally, since many LCRs have nothing to do with renewable energy, countries that are rightly concerned with the use of this policy tool might focus their WTO disputes on LCRs outside the renewable energy space.
Addressing LCRs within a SETA
A Sustainable Energy Trade Agreement (SETA) presents an attractive solution to coordinate national policies with the aim of lowering the cost of renewable energy policies.
Negotiating a SETA could provide a way to address renewable energy concerns in a trade-friendly manner. To avoid the cost of permanent protection, countries might agree within a SETA a non-renewable time limit for their existing LCRs and agree on a "peace clause."
Governments might also consider agreement on a moratorium or standstill on the adoption of future LCRs within a SETA. To backstop such commitments, concerned countries might call upon the WTO Secretariat to launch a surveillance programme of LCRs in the renewable energy space. The programme would report on instances of adoption of LCRs and, where possible, assess their effectiveness.
Under a SETA, countries might agree to instead include their partners in a "regional content requirement" (RCR) for scheduled projects during the agreed phase-out period in the renewable space. This effective "cumulation" of the LCR within the region constituted by the members to the SETA would effectively dilute the restrictive impact of the measure.
Finally, countries might agree within a SETA to cap their LCR percentages at a level appropriate for the sector in question. This limit might be best negotiated in the context of a SETA, against other trade- offs in the environmental area. The SETA would provide a vehicle to specifically address the cost-benefit analysis of the recourse to LCRs.
This article has been adapted from a longer study, which can be accessed at http://bit.ly/14dtpen.
Sherry M. Stephenson
Senior Fellow, International Centre for Trade and Sustainable Development (ICTSD)