CHAPTER TWO 
How should the government play a constructive role in energy innovation?
ENHANCING THE FEDERAL GOVERNMENT'S ABILITY TO EFFECTIVELY INNOVATE
In this chapter we focus on how the government can effectively and efficiently support the development of new energy and technologies and systems.
The United States still holds a lead in many key energy technologies and can draw on an extraordinary depth of talent and experience. These advantages create a real opportunity for the U.S. to carry its global leadership position into the advanced energy technology marketplace of the 21st century. But America today is only partially equipped to meet this challenge.
To enhance U.S. leadership in energy technologies, the federal government must not only maintain a robust effort across the innovation continuum, but it must promote an environment that favors innovation throughout the energy economy. We know from history and from our own business experiences that great innovation successes can emerge from a strong public-private partnership in technology development. Similar successes are achievable in energy, but only if the country bolsters its energy innovation capacity and investments and the nation's political leaders and business community work together to make a clean and secure energy future a reality.
THE CURRENT LANDSCAPE
The U.S. energy sector is a massive enterprise of interconnected and interrelated systems. Direct energy expenditures comprise roughly 9 percent of U.S. gross domestic product (GDP), but the importance of energy to virtually all U.S. economic activity far exceeds that. The U.S. "energy enterprise" is predominantly managed by the private sector, though there are numerous federal and state policies and programs that affect private-sector decisions on nearly every aspect of energy investment, production, delivery and end use.
The U.S. is fortunate to have a network of celebrated national labs and universities, robust venture capital resources and proficient entrepreneurs, a sophisticated financial industry, a legal system that protects the sanctity of contracts, and large technology and energy companies with the skills to scale technologies. What America arguably lacks compared to countries like China, Germany, Japan, Korea and others, however, is a collective sense of national purpose around this issue and a strategy for building innovative energy systems. The governments of our competitors, by contrast, are very clearly boosting their efforts to catalyze scientific and technological progress in the energy domain.
Furthermore, as pointed out in our initial report, total U.S. investment in energy innovation, by both the public and private sectors, pales in comparison to the levels of investment typical of other technology-dependent sectors such as pharmaceuticals, aerospace, computers, and electronics.
SIGNS OF PROGRESS
The good news is that solutions to this problem of under-investment exist. To achieve them, however, great care must be taken to leverage the strengths of the private sector while strategically and efficiently managing specific public interventions. A government-funded, government-directed approach - reminiscent of the "Apollo" and "Manhattan" projects - is unlikely to be either effective or politically viable. In those historical examples, enormous federal resources were concentrated on a single, defined technological challenge. Government was the sole customer and was willing to pay essentially any price to achieve the desired outcome. By contrast, the effort going forward requires targeted, limited government interventions at appropriate points in an energy innovation value chain that culminates in new consumer choices based on competitive cost and performance.
Fortunately, there are some encouraging signs of progress.
First, the federal government has provided clear and consistent support for basic science research for at least a decade now. Recent administrations have endeavored to increase federal expenditures for basic research even in the face of pressure to reduce spending.
Second, the current administration is taking specific steps to focus the DOE's basic science programs on technology challenges with high economic and environmental returns, while simultaneously improving links with the engineering community. These steps can improve the likelihood of achieving transformative scientific breakthroughs.
Third, Congress has recently authorized new efforts, such as the Advanced Research Projects Agency-Energy (ARPA-E), to translate early-stage science and engineering work into products with commercial potential. The federal loan guarantee program enacted in the bipartisan Energy Policy Act of 2005 issues loan guarantees to energy projects and advanced manufacturing facilities that could not otherwise secure financing. In our view, both programs face challenges but are directionally correct.
A common feature of these programs is that they attempt to address specific hurdles or "pinch points" in the energy innovation chain. Going forward, the government's key role should be to help fill gaps and address missing links along this chain.
THREE PRINCIPLES TO GUIDE FEDERAL INNOVATION ACTIVITIES
Building on our own private-sector experience and looking across the many examples where government has succeeded - and failed - in its efforts to support energy innovation, three simple principles emerge:
First, the federal government needs to focus its efforts on specific market failures in areas that can make a significant impact on strategic priorities.
The most significant market failures for energy technology center on the difficulty of finding adequate private-sector support for basic research, early pilot demonstrations (in the case of capital-intensive projects), and first-of-a-kind commercial deployment for new technologies. Private companies are deterred from basic research and early pilot demonstrations because they don't quickly earn adequate returns and can't prevent their competitors from also capturing some of the commercially valuable knowledge gained through these investments. When financing first-of-a-kind technologies, the risks are too great for traditional infrastructure investors to bear while the costs are too large for technology investors.
The federal government should intervene in those areas where a significant gap exists between national priorities and unaided private-sector outcomes. Focusing on specific steps in the value chain where the market falls short is likely to be more successful than trying to develop solutions from beginning to end. This kind of staged approach to investment demands private-sector involvement to (1) provide important market discipline, (2) reduce the potential waste of taxpayer resources, and (3) ensure that the government plays a constructive role at each stage.
A focused approach also means pulling back from technologies that do not show the same rate of improvement or promise, or where existing markets are already delivering continued progress.12
Second, the federal government should catalyze private-sector competition by providing incentives aligned with strategic goals.
Having identified targeted, strategic investment areas, government should then invest in these areas with the primary goal of fostering increased competition among energy innovators and technologies. The goal should be to correct market failures, but to do so by investing in multiple technologies and multiple competing approaches that show real and meaningful potential. This will create competition on multiple levels and maximize the likelihood of ultimate technical success.
Government should also base its investment goals on long-term, strategic - and potentially high-payoff - priorities, recognizing that some short-term technology gains can have significant positive impacts over time. This approach will both stimulate competition and leave room for multiple types of innovation.
To facilitate competition among technology, the federal government should take a portfolio approach to energy innovation investments - one that balances technology pathways and risks. Within its investment portfolio, DOE should also strive to institutionalize the ability to take risks. Incentives to "lowball" goals and metrics for fear of missing a target or losing funding should be minimized; some failure is required to achieve significant technology gains. Moreover, the federal government should be technology-agnostic as long as one or more innovations achieve the price and performance goals required to meet national objectives.
Third, the federal government should use the most cost-efficient actions to facilitate positive outcomes.
In the current restrictive budget environment there will likely be fewer funds for all technology areas, including energy. The federal government should seek maximum leverage in using its resources to achieve public objectives, ideally identifying those interventions where a small government action can significantly increase private market activity.
The most highly leveraged form of government support for innovation often focuses on fostering entrepreneurial activity and reducing barriers to innovation. Common examples include intellectual property protection, sound anti-monopoly policy, immigration policies that attract the best and brightest to the country, and structural market changes. For example, the reorganization of telecom markets in the 1990s led to massive innovation and investment in fiber and wireless networks. Similarly, energy markets could be restructured to encourage more advanced clean energy options.
Where direct government funding is required, federal agencies should strive to make their investments go as far as possible. To that end, they should focus on rigorous peer-review processes and competitive funding options that, when possible, attract private-sector participation and co-investment. As a general rule of thumb, the proportion of private-sector investment should increase as a technology approaches commercialization. DOE currently leverages its funding by requiring private-sector cost sharing but additional mechanisms should be explored and tailored to specific technology needs. 13
Predictable government regulations also create appropriate long-term incentives for innovation without requiring federal dollars. For instance, many state and national energy efficiency standards have systematically driven technology improvements without direct government funding. As a result of performance-based standards, new refrigerators sold in 2007 use approximately 70 percent less electricity than those sold 30 years earlier. 14 In general, performance-based regulations that set goals or rules and rely on private-sector firms operating in a competitive environment to find the best ways to meet them consistently drive innovation.
In sum, programs and policies that allow the country to make technological progress and meet national objectives with relatively small direct investments should be prioritized, improved and expanded.
RECOMMENDATIONS TO STRENGTHEN U.S. LEADERSHIP IN CLEAN ENERGY INNOVATION
Building on the recommendations we first outlined in A Business Plan for America's Energy Future, we have identified a suite of policies and programs that could strengthen our nation's energy innovation capabilities. As we have stated in the past, we strongly recommend making healthy investments in energy innovation activities across the continuum of science, engineering and early commercialization. More specifically, drawing on the three principles described above, the recommendations below are part of an overall approach that we believe is necessary to advance our country's innovation capacity.15
RECOMMENDATION 1:
Develop and implement a comprehensive, government-wide Quadrennial Energy Review (QER)
As we recommended previously, the nation needs a robust National Energy Plan to serve as a strategic technology and policy roadmap. As we noted then, DOE's strategic planning process and individual technology system roadmaps have only partially addressed the need for strategic clarity.
Importantly, such a plan should pinpoint key market failures and technology chokepoints in order to better orient federal programs and resources. 16 It should be based on rigorous analysis and should incorporate critical stakeholder input. With help from the private sector, the plan should identify critical gaps in the innovation chain and establish goals and effective partnerships to align the capacities of the public and private sectors and move technologies to market.
The President's Council on Science and Technology recently recommended developing a QER to provide a clear, integrated road map with short-, intermediate-, and long-term objectives for federal energy technology programs, along with a structured, time-bound plan to get there.17 DOE is already implementing a Quadrennial Technology Review (QTR) that, in addition to summarizing the current status of selected energy technologies, aims to describe program goals, engage private-sector stakeholders and identify important RD&D policies and levers. Such a road map has important precedents. In national security, the Quadrennial Defense Review lays out a long-term strategy that both the public and private sector can plan around. Elements of the QDR's success include providing clarity around long-term outcomes, driving alignment across multiple stakeholder groups, opening up Department of Defense (DOD) technology assumptions to outside scrutiny, and using a portfolio approach to balance investments.
We support DOE's QTR process, which we see as an important and meaningful first step toward developing a national energy strategy consistent with our own call for a National Energy Plan. The federal government should build on the QTR and move quickly toward a government-wide QER.
RECOMMENDATION 2:
Support "innovation hubs"
In our 2010 report we called for greater resources to be concentrated at "centers of excellence." We believe this concept has much in common with DOE's effort to establish "innovation hubs" and other collaborative innovation models.
Experience has shown that concentrated research centers can drive technologies down all three phases of the innovation "learning curve" by:
• Funding and organizing R&D projects that can lead to technology breakthroughs;
• Providing equipment and lab space to test the viability and scalability of new energy technologies; and
• Securing partnerships to collaborate and share intellectual property with the aim of bringing new technologies to market.
We believe ARPA-E represents one of the best investments the federal government can make.
The geographic concentration of highly technical companies - as occurred in Silicon Valley due to early federal spending on defense and space exploration - encourages concentrated talent, the exchange of ideas, and the creation of new technologies and ventures. To this end, we strongly support the direction of DOE's Innovation Hubs, Bioenergy Research Centers and Energy Frontier Research Centers and believe they should receive full funding.
RECOMMENDATION 3:
Support and expand ARPA-E
As we have noted previously, ARPA-E offers a stark contrast to the historic DOE structure in that it brings together experts from across the technology development spectrum. The creation of ARPA-E demonstrates a new commitment to working more flexibly within DOE to achieve technology goals. While it is too early to expect transformative technical successes from embryonic ARPA-E programs, the leadership team at ARPA-E has already marked several milestones:
• Investing in high potential projects;
• Successfully attracting talent from the private sector
and academia;
• Creating an "open architecture" organizational design that is well adapted to meeting current program needs; and
• Developing processes that support transparency and enhanced coordination with the private sector.
ARPA-E challenges and empowers innovators across a range of technology pathways. This has made it possible to leverage federal dollars with private-sector exposure and, in many cases, follow-on capital. By nearly all accounts, it appears that ARPA-E is being managed as a highly efficient, risk-taking, results-oriented organization. In short, ARPA-E exemplifies the principles laid out in this report.
We originally called for $1 billion in federal funding to support ARPA-E. We maintain that this funding level should be the goal over the coming decade and resources should move to this level as quickly as they can be efficiently and effectively expended. At a minimum we believe that ARPA-E should receive $300 million per year - its authorized budget - at the expense of other DOE programs, if necessary. Going forward, investments in ARPA-E should be prioritized and increased. We believe this new agency represents one of the best investments the federal government can make.
RECOMMENDATION 4:
Make DOE work smarter along the ARPA-E model.
Even with the best policy tools to promote innovation, government programs can fall flat without nimble, high-performing, risk-tolerant federal agencies. DOE has a critical role to play and will need to evolve beyond its current program structure and culture to be maximally effective.
DOE's oversight of energy is currently organized around specific technologies (e.g., renewable energy, fossil energy, nuclear energy) and functional aspects of the system (e.g., electricity delivery and reliability, energy efficiency). The result is a classic "stovepipe" organizational structure that suffers from well-understood challenges in terms of information sharing and internal budget competition. To be maximally effective in the current energy market, the federal government - particularly the national labs and the offices within DOE that fund and direct RD&D - must operate more nimbly and strategically.
DOE is making important strides in this area, but there is more to be done. We argue for "ARPA-izing" a larger portion of DOE and the national labs by expanding some of the new authorities, tools and processes embodied by ARPA-E.
Beyond "ARPA-izing" a larger portion of DOE, a number of steps should be taken to improve the overall effectiveness of the agency:
• Focus more on overall program success than on individual project success and emphasize the value in calculated risks. Such an approach would build in greater ability for DOE to accept and manage risks and allow some projects to fail even as others succeed.
To be maximally effective in the current energy market, the federal government must operate more nimbly and strategically.
• Focus on the role of program managers. While various organizational taxonomies could provide alternatives to the existing stovepipe program structure, we contend that talent management is ultimately more important than organizational structure. Outstanding employees can overcome suboptimal organizational arrangements, but even the perfect organizational structure - if it lacks talent - will still underperform. Hence, DOE's talent management system should focus on (a) recruiting world-class program managers from academia and the private sector and (b) establishing first-rate training and mentoring programs for existing employees. DOE should be empowered to implement fast-track hiring procedures and assiduously review both managers' and employees' performance and contribution to programmatic goals. The highest performers should be rewarded with both financial and non-financial incentives; poor performers must be dealt with appropriately and quickly.
• Align the internal structure. DOE is beginning to drive much greater alignment across its offices and programs. For instance, DOE's SunShot initiative aims to ensure that all DOE's solar innovation activities - from the Office of Science through ARPA-E, the Office of Energy Efficiency and Renewable Energy (EERE), and the loan guarantee program - are well aligned. While it is too soon to determine if these efforts will be effective, we believe they are directionally correct. DOE should continue to improve the alignment of cross-departmental efforts - from the national labs and Office of Science to the applied and commercialization programs - as a way to eliminate redundant projects and ensure a tight hand-off across the innovation value chain.
• Employ rigorous and transparent peer reviews. The need for rigorous program and project reviews may seem obvious, but tricky issues often arise in execution. For example, in an effort to prevent conflicts of interest or the appearance of conflicts, DOE will often exclude all professors from a particular university from participating in the outside review of proposals submitted in response to a DOE funding solicitation if even one professor from that same university has submitted a proposal. Carried to extremes, such policies can unnecessarily narrow the pool of qualified outside experts available to review proposals. While it is important to avoid conflicts of interest, that goal must be weighed against the benefits of seeking the most qualified individuals to participate in peer review. We believe rigorous disclosure and transparency requirements can provide adequate safeguards against potential conflicts of interest in most cases.
• Cancel non-performing projects. Projects that receive federal support must be continually monitored to assure that goals and deadlines are being met and that failing projects are not allowed to linger. Although DOE currently employs stage-gate assessments and has the ability to terminate projects, it has encountered difficulty in canceling failing projects. DOE must empower managers and provide the necessary leadership to make these critical decisions. Though it may be difficult to admit that a selected project is not going to succeed, doing so and then taking action to stop funding so that resources can be re-directed to more promising alternatives is critical, particularly given the current fiscal imperative to accomplish more with less.
RECOMMENDATION 5:
Develop a first-of-a-kind technology commercialization engine along the lines of the proposed Clean Energy Development Administration (CEDA).
Our previous report called for a new government-backed institution dedicated to overcoming financing hurdles for advanced energy technologies. Its specific mission would be to mobilize significant private-sector capital to buy down the risks of emerging technologies and fill financing gaps so that these technologies can bridge the transition from demonstration to commercialization (in the relevant literature, that transition is often referred to as the "valley of death"). Currently, our country's energy innovation system still lacks a successful, repeatable, technology-neutral mechanism to finance, build and demonstrate unproven, large-scale energy facilities.
To effectively accelerate the demonstration and subsequent deployment of competitive new technologies, a new government-backed financing institution should build off the successful elements of DOE's loan guarantee program and be carefully structured around the following principles and design features:
• Independence. The kinds of projects that will require financing support will typically involve complex technology and span multi-year construction periods, both of which increase project financing risks and costs. This means the new institution must have sufficient autonomy to take calculated risks, without political interference. Creating a culture that tolerates risk, and even some failures, is essential.
• Private-sector co-investment. Substantial private-sector participation is required to reduce the institution's capital requirements and help ensure that new technologies eventually meet the test of competing in real-world markets.
• Strong public- and private-sector expertise. The financing institution should have the authority to use scientific experts from government agencies to provide technical evaluation while seeking advice from business experts in the private sector concerning the commercial aspects of potential investments. Similarly, the financing institution should adopt flexible hiring practices to attract highly-skilled technical experts, investment professionals, and scientists.
• Flexibility to offer financing products based on market gaps. The institution should have broad flexibility in the types and terms of financial instruments it employs to address the specific market failures that apply to each target investment. It should also have strict, short deadlines for conditional acceptances or rejections to speed development and reduce bureaucracy so that its financial products are attractive to the private sector.
• Governance and oversight. A diverse board of directors should provide guidance on priorities and best practices, while ensuring that the institution adheres to its organizational mission, operating principles, and strategic objectives.
• Self-funded. The new institution should strive to be self-funding after an initial public capitalization, meaning that on an ongoing basis it should be funded to the extent possible by financing fees and by returns on profitable investments.
• Portfolio investment approach. The institution should strive to create a diversified investment portfolio, focused primarily on clean energy technologies with breakthrough potential. Additionally, the Office of Management and Budget (OMB) and the new institution should jointly develop a methodology to score investments at the portfolio level.18 This would allow the new institution to operate more nimbly and be evaluated on the overall performance of its investments - in contrast to DOE's Loan Guarantee Program, which is scored on a project-by-project basis.
• Transparency. Decision processes, selection criteria, and investment results should be published to provide feedback to the private sector and reduce the perception that projects are being selected on the basis of partisanship or favoritism.
A number of recent proposals have been introduced in Congress to create a "green bank" along these lines. Currently, there is some momentum in the Senate behind legislation to establish a new energy financing institution called the Clean Energy Deployment Agency (CEDA). We believe the CEDA legislation aligns with our original recommendation to create an institution to finance and build at-scale, advanced energy technologies and could be implemented in a way that encompasses the design elements enumerated above. We believe greater success in this area could have profound implications for energy markets over the coming decade and for U.S. competitiveness in the global market.
THE NEED FOR SMART FEDERAL PROGRAMS
We believe it is critical that the United States pursue a strong strategy to lead in the global race to develop new energy technologies. With China and other trading competitors poised to build more energy infrastructure in the next 15 years than the United States has built in the last 100, our nation faces a significant challenge in maintaining a place at the forefront of a multi-trillion dollar effort to transform the world's energy systems and develop new, high-value industries. Meeting this challenge will require smart government intervention to overcome specific technology hurdles and close specific market gaps.
While we continue to believe that the situation requires increased federal investment in energy RD&D, ramped up over an appropriate period of time and offset by spending cuts elsewhere in the federal budget, we understand that DOE and the rest of the federal government will need to demonstrate improved performance to justify a greater commitment of public resources. We are confident that applying the principles and recommendations outlined in this report will help establish credibility with Congress, the marketplace, and the public and earn the additional resources needed to advance the energy innovation enterprise.