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Financial Innovation and The State: Lessons for 21st Century Climate Finance from the 19th Century Railways Era

Environnement & Ressources Naturelles 
Billet du 1er octobre 2015
Par Dipak Dasgupta
This paper seeks to bring a historical perspective to current global financial architecture issues on the speed and scale of climate finance needed to achieve a safer two degrees world. We look back in history to a similar episode for lessons: the financing and building of railroads in the 19th century.

This article is part of a special series discussing the economic dimensions of environmental issues ahead of the - COP 21 Climate change Conference held in Paris on 30 November-11 December 2015. Read more about it here.
Mr. Dasgupta is an international economist. He currently works and advises on climate finance, macroeconomics and financial markets. He is Alternate Board Member of the global Green Climate Fund, representing India. He is Member of Advisory Board of the Imperial College and LSE Grantham Institute (London) for a new M.Sc on climate finance and management. He is former Principal Economic Adviser, Ministry of Finance India. He established and headed the Climate Change Finance Unit at the Ministry. Mr. Dasgupta worked earlier at the World Bank for over 25 years. He was also adviser to the chairman and head of policy research at the Industrial Development Bank of India. He has taught and lectured at universities and think-tanks around the world. He is principal author or editor of twelve books and over 100 articles. He was educated at Kolkata, Delhi, and Cambridge. Mr Dasgupta received the Adam Smith Prize at Cambridge and the Amex Bank Review Awards in International Finance.

Every age generates it’s own challenges and opportunities. Right now, after nearly 300 years of rapid and enormous growth in incomes that came in the wake of global industrial revolution, trade and urbanization, one of the biggest challenges, and opportunities, facing the world is how to handle global warming by shifting to a much faster de-carbonized path of economic functioning. It’s not the only global challenge: creating jobs and incomes for the still vast numbers of poor, and reducing global hunger, lack of energy, lack of water, disease, conflict and war are equally enormous challenges. But the crux of development and solutions to many of the other problems is access to and use of cheaper and plentiful sustainable energy---without the old model of mining and using fossil-fuels. Some already rich countries will need to drastically alter their consumption patterns of energy. Others that are still at very low levels of income and catching up will need to be provided with the instruments of a shift to clean energy and avoid a carbon-intensive energy path of production.
This paper examines public policy and incentive pivots to speed up economy-wide de-carbonization with financial stability through a massive shift in private climate finance towards renewables and related infrastructure---in both developed and developing countries, and especially the latter. It seeks to bring a historical perspective to current global financial architecture issues on the speed and scale of climate finance needed to achieve a safer two degrees world. We look back in history to a similar episode for lessons: the financing and building of railroads in the 19th century.
Finance, as I argue, in this paper, is a crucial instrument of these shifts. We cannot do otherwise. Without finance fostering this technological shift, the pace of change will simply not be quick enough. The world is not short of savings, nor is it short of the needed technological investments and opportunities to redirect it to---if we are to avert a disastrous ongoing speed of global warming and its tipping points. Financial innovations and the role of the state in fostering these shifts worldwide is what the challenge is all about. In this short paper, I talk mainly about the lessons of history. 
A particularly important historical episode was in the 19th century, when throughout the world, massive investments in Railroads happened over a few decades. Railroads transformed the world, raising the speed and convenience and reducing the costs of transportation dramatically, without which the next stage in global economic growth, industrialization and urbanization as we know it could not have happened and spread inland. Motorization came later. Ocean shipping came earlier. In between was this period of massive building of gigantic arteries of land transport within a very short time that laid the engines of prosperity that we have become used to. What were the crucial financial innovations by which this happened? What was the role of the state vis-à-vis channeling private savings and investments towards this end? And what lessons might we draw from that episode for climate change finance in the 21st century?

The Nature of Technological Diffusion: Disruptive Technology
Before we look into the Railways era in some detail, it is important first that we start with understanding what technological disruption or the rapid diffusion of new technology is all about.
When we think about large technological shifts, we measure the pace of innovation by the number of years it takes for a given new technology to become the dominant one, as measured by the percentage of households or producers that have shifted to a new technology, replacing an earlier one. This is not a simple process. The standard theoretical and empirical argument is that technology shift occurs along a classic S-shaped curve (Figure 1). Initially, the process of adoption is slow, then gathers apace as more producers or consumers take up the new technology, then flattens out asymptotically as we approach the 100 percent take-up of new technology (attributed originally to Gabriele Tarde, 1905, French sociologist) [1].

Figure 1: Classic S-Shaped Technological Adoption Curve
Source: Ron Neumann, Innovation and the S-curve, November 2013.
Presentation at the LiFT Conference: “Driving Innovation-Based Growth”.
Here is what the S-shaped technological adoption curves look like in real cases in the United States (Figure 2 and 3). It took a long-time for automobiles, airplanes and land-line telephony to take dominance in the early 20th century. There were many ‘glitches’ along the way as technology adoption sometimes faltered. But electricity penetration was much faster, as was later 20th century adoption rates for mobile telephony, internet and personal computers.

Figure 2: S-Shaped curves of Technology Adoption in the United States
Source: Michael Mace, Map the Future, Google Talks.

Figure 3: Technology Consumer Adoption Rates in the USA
Source: op.cit.
A “disruptive technology” is one that drastically displaces an established technology and shakes up the industry or a ground-breaking product that creates a completely new industry. This is the holy grail for most inventors. Clayton Christensen, a Harvard Business School professor coined the term in 1997 [2], and described a process where incumbent firms fail to see the nature of a disruptive technology till it is too late, when new entrants have already demonstrated and seized the opportunity. The old behemoths die out. Their stock market capitalization and value of business falls. It is not that the large incumbents are unable to see the opportunity. But they settle for sustaining technology: slow, modest, incremental improvements. New start-ups have nothing to lose: they displace the old ones. In one example, the argument is that the invention of the automobile itself was not disruptive. It was simply a technological innovation. But the Model-T Ford was disruptive.
Why? Because a disruptive technology innovator does two things, brilliantly. She lowers costs, broadening the mass acceptance. And she improves the customer satisfaction from the product, intrinsically making it a superior product for the same task at hand. The Model-T Ford did both. It dramatically lowered costs of production to bring the personal automobile within the reach of mass customers. And it improved the idea of reliable, every-day transportation from point-to-point, especially shorter distance, far better than anything that had gone before---including the Railways. Between 1909 to 1924, some 15 million Model-T Fords rolled out. Ford neither invented the automobile, nor the mass production system. Ford changed the business model: lowering costs and improving the customer’s satisfaction over anything else at that price point.

What Role Does Finance Really Play?
We need to understand clearly the role of finance and its innovations play in enabling the acceleration of the speed of massive technological shifts that routinely have taken place—of which Railways is one important example. We are principally interested in two questions: (a) what role does financial innovation play in this acceleration in the speed of adoption of new technology? And (b) what are the crucial factors that explain how this shift in financial innovation happens?
Take the Model-T Ford success. The two innovations in technology that Ford brought about still does not explain fully why some technologies become truly dramatic ones---bringing about a wholesale change in products. A third factor is usually crucial: the massive shift in financial resources towards the new product and market, and away from the earlier ones that it displaces. This shift in financial innovation is a crucial hand-maiden, both on the production side and on the consumption side.
In the case of the Model-T, Ford was financed repeatedly, and his first two companies went bankrupt. But his partners invested repeatedly, till his success with the third venture. Ford was also extremely cash conscious: building up a pile of cash reserves, bankrolling a steel plant, paying no dividends, and buying out his other shareholders at crucial stages---financed again by the banking system taking large risks.
As for the consumption side, Barry Eichengreen and Kris Mitchener described well what happened in the 1920s: an unprecedented credit boom. [3] As they describe it: “Accounts of the twenties in the United States (such as Kindleberger, 1973) emphasize the ready availability of credit, reflecting the ample gold reserves accumulated by the country during World War I, the stance of Federal Reserve policies, and financial innovations ranging from the development of the modern investment trust to consumer credit tied to purchases of durable goods like automobiles. Credit fueled a real estate boom in 1925, a Wall Street boom in 1928-9, and a consumer durables spending spree spanning the second half of the 1920s. That these booms developed under the fixed exchange rates of the gold standard meant that they generated little inflationary pressure at home and that their effects were transmitted to the rest of the world. Absent overt signs of inflation, the Fed had no reason to raise the official short-term rate”.
The automobiles sector saw massive expansion of credit financed by new finance companies that extended credit for mass automobile purchases. By 1925, there were over 1500 such car finance companies, and even the auto majors had set up new subsidiaries to extend such consumer durables finance. This, in turn, was accommodated by the banking system in a massive way.

The Railways Era (1840-1870s): Financing Railroads Globally
The paper examines the lessons of Railways financing in the period 1840-1870s when much of the world rapidly shifted from older and inefficient transport modes such as canals and local roads to railways. It required a massive global financing shift---similar to climate financing needs of the present day. Financial innovations were crucial---in national and global bond and equity markets.
The scale and speed of innovation required would not have been possible without a clear supporting role of the state to reduce risks and uncertainty of long-term infrastructure financing. Pricing and cost issues were crucial. Risk mitigation measures were also widespread. Parliaments allocated land and other sweeteners to defray the costs of railways. The state often took over bankrupt railroads. Guarantees were provided. Banks were encouraged to lend. There were many bumps on the road---booms and busts---but the railways revolution did get built, transforming the world. There are several lessons from that experience for the new challenge of decarbonization and building large scale clean infrastructure shifts. We test four, in particular: (a) how did the state mitigate long-term investment risks? (b) what role did the state and fledgling financial institutions play in backing private investment? (c) how did the state influence the price, costs and incentives towards the shift to railways financing (as “nation-building” priorities)? And (d) when financial ‘over-reach’ happened, how did the state and fledgling financial regulatory agencies respond? These still have some relevance to inform our views on the 21st century architecture on climate finance.
History suggests that the speed of technological shift in economy-wide areas---measured say by the number of years it takes a new ‘disruptive’ technology to reach say more than two-thirds of the total population---follows the classic ‘S” curve of new technology adoption, and appears to depend principally on three factors.

The first is the overwhelming technological, consumer and economy-wide advantages of the new product and the obsolescence of the earlier. Examples: steamships over sailing ships in ocean-going transport, electric lighting over gas lighting, and railways over canals for long distance transport, to more recent examples of mobile over fixed line telephony and e-retailing over brick-and-mortar. There are many more recent examples.

Second, it depends on the price and/or cost superiority of the new technology. The faster the drop in relative price or cost, the faster is the pace of adoption.

Third and not the least is a critical role for a massive shift in institutional private finance: wherever there are large network and capital costs involved, financial innovation to speed the faster reallocation of capital from the older to the newer technologies is crucial. Global capital markets follow these innovations.
Building on this framework, our paper suggests that the speed of decarbonization in the 21st century, involving a rapid technological shift from fossil fuels to renewables faces similar binding challenges. The ‘technological superiority’ is clearer, but has not yet been possible for the market to capture. The price and cost issue is unresolved---because of the reluctance to price the negative externality of carbon-based energy, and allow alternative clean energy investors to capture that benefit. And this also deters private investment. Absent a massive shift in climate finance, backed by careful design of public policy support, the adoption of new technology is likely to be sub-optimal. This is especially so where cost and affordability issues are important and in a world where public finances are fragile and inadequate.
We turn to the specific example of Railways financing in the 19th century that had to deal with similar problems. The railways did get built. But it required a lot of innovations and changes in the role of the state. We look at key lessons, both successes and failures in pricing, incentives and institutions in financial markets. Different countries adopted different solutions and models: starting with then most advanced Britain, followed by Europe, the Americas, and finally the colonial economies (from India to Latin America). By analogy, we will examine some broader policy questions: (a) getting prices right and allowing private financing institutions to capture part of the externality benefits; (b) more than that: the state may also need to lay out an institutional response to mitigate long-term costs and risk of private financing; (c) while ensuring that market forces choose the best technologies, products and financing structures in specific investments; and (d) avoiding ‘booms and busts’ that are inevitable, and the role of the state in mitigating excessive exuberances from successes, and risk-aversion in case of failure. A concluding section traces the relevance of the lessons and takeaways from that episode to the evolving 21st century climate finance architecture.

Rolf Roth & Gunter Dinhobl, 2008. Across the Borders: Financing the World's Railways in the 19th and 20th Centuries. Ashworth.

Jacques Richard, 2006. Prussian Railway Accounting. CEREG.

Gareth Campbell & John Turner, 2006. Dispelling the Myth of the Naive Investor during British Railway Mania, 1845-46.

Barry Eichengreen. Financing infrastructure in Developing Countries: Lessons from the Railway Age. Background paper for World Development Report 1994.
Maury Klein. Financing the Transcontinental Railroad. The Gilder Lehrman Institute of American History.
Timothy Irwin, 2007. Government Guarantees. World Bank.
D. Bogart, 2008. A Historical Perspective of Indian Railways.
Ann Carlos & Frank Lewis. The Profitability of Early Canadian Railroads---Evidence.
State Guarantees in PPPs. European Investment Bank. EIB.org.
Warner Baer, 1956. “The Promoting and Financing of the Suez Canal”. The Business History Review, pp.361-381. Harvard.
Amar Bhattacharya, Jeremy Oppenheim and Nicholas Stern. 2015. Driving Sustainable Development Through Better Infrastructure: Key Elements of a Transformation Program'. Presented at the Addis Ababa Meetings, July 2015.
Dipak Dasgupta, 2013. “Fossil Fuel Subsidies: Three Questions, Evidence and the Way Forward”. Ministry of Finance, Working Paper, Delhi.
Ron Neumann, “Innovation and the S-curve”, November 2013. Presentation at the LiFT Conference: Driving Innovation-Based Growth.

[1] Faridah Djellal and Faïz Gallouj, 2014. The Laws of Imitation and Innovation, in Gabriel Tarde and the evolutionary economics of innovation.

[2] Clayton Christensen, 1997. The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Harvard Business School, Boston.
[3] Barry Eichengreen and Kris Mitchener, 2003. “The Great Depression as a Credit Boom Goine Wrong”. BIS Working Paper No. 137, Basel.
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