In economics, everything is connected to everything else. This is a sobering thought from a sustainability perspective: to become “green,” multiple parts of the world’s economies will somehow have to move together.

That challenge seems all the more formidable in the wake of last week’s landmark report from the Intergovernmental Panel on Climate Change. Scientists now say that keeping global warming to 1.5°C will require an unprecedented transformation of the world’s economy.

Luckily, economists have long grappled with the question of coordination, leaving us with theories and ideas that can help guide policy-making for a smooth transition. One of those ideas is “unbalanced growth,” where each new industry creates “forward and backward linkages” that push downstream demand for the industry’s output and pull upstream supply for needed inputs.

This concept is very relevant when thinking about a green economy. I used it to create a model of an economy transitioning from “brown” to “green” and tested out policy options for a transition to a more sustainable economy. The results provide insight into how a transition might happen, when firms and investors are influenced by policies but pursuing their own interests.

The unbalanced growth of renewables

First consider a low-carbon future in terms of the “unbalanced growth” theory. Electric cars currently rely on an electricity mix that includes high-emitting fuels like coal; an electric car bought today might thus increase emissions. But the more electric cars adopted, the more demand for electricity – and new electricity is mostly renewables. So the emissions from new electricity generation are likely to be lower.

Here, rising electricity demand “pulls” the expansion of renewables. That pull is needed, because adding renewables to the grid is challenging. As the share of renewables increases, it then creates a demand for the technologies that address that challenge and make the grid more robust. Some of those technologies, such as “smart grids”, are likely to open up new and currently unforeseen opportunities, creating a “push” for innovation.

The model I created envisions how this kind of relationship plays out in the aggregate in a two-sector economy that is closed to trade. This is a considerable simplification when compared to the real world; you might think of it as an elaborate “thought experiment.”

In the model, the economy starts on a brown-balanced growth path, with two types of industry. One, the “unaffected” industry, is indifferent to whether it uses green or brown technology – for example, a diesel truck switching to biodiesel. The success of the other, “affected,” industry depends on how much green or brown technology is in the economy – for example, a renewable electricity supplier needs a suitable grid.

In model runs, the affected industries switch to green technology later than the unaffected industries. The affected industries have little incentive to change, because they rely on the current structure of the economy to be profitable. Instead, they must be pulled by increasing use of green technology in the unaffected industries. For example, rising demand for biodiesel encourages the biodiesel industry to expand.

The model includes three different policy options for making green technologies more attractive. In one, it assumes that emissions reduction targets for a particular year (such as “fossil fuel free by 2050”) are backed by credible policy commitments. In the target year, it assumes that all brown production will halt, and brown assets will become stranded. This leads to a particularly abrupt and delayed transition. Without a positive incentive to invest in green technologies, investors and firms continue to make brown investments as long as they can.

A second policy option is an emissions fee, such as by putting a price on carbon and rebating the proceeds to households. In the model, this policy can lead to a comparatively smooth transition, giving people and firms time to adjust their expectations and revise their plans. But that only occurs if the emissions fee rises gradually over time. If it doesn’t increase, then there is no transition, and if it rises too abruptly, then there isn’t enough time to turn over the capital stock.

Finally, the model simulates some actions that a central bank might take. Regardless of the specific policy adopted, the effect in the model is to create a wedge between lending rates for green and brown investment: loans for green investment are less expensive than loans for brown investment. If the wedge is large enough, this policy successfully drives a transition, and with the least disruption.

The above graph shows the mix of green and brown capital over time, when brown capital investment is charged higher interest rates than green investment. The model output is based on a two-sector economy made up of “unaffected” and “affected” industry. The “unaffected” sector – or industry that is indifferent to whether it uses green or brown technology – pulls the “affected” sector in a green direction. Figure: Eric Kemp-Benedict / SEI.

How to navigate from brown to green technology

Green technology is already expanding. Most new electricity production is from renewables, and costs have been dropping sharply for solar, wind, and batteries. Electric vehicles and charging stations are proliferating as they drop in price. From this evidence, we might be tempted so say, “The sustainability transition is happening!”

Yet, at the same time, technologies are overwhelmingly fossil-fuel based, and fossil fuel exploration and extraction is booming. Seeing this, we might say, “We’re not going anywhere – green investment is too little and too late.”

The model can provide some insight to help navigate between these extremes.

In the absence of active policy, brown technology becomes locked in. So while continued extraction of fossil fuels is indeed a worrying sign, we can see why it is resistant to change. The key is whether green technologies, as they gain traction, are exerting a push or a pull on further green investment.

To take one example, if demand for electric cars is rising, while new capacity is from renewable sources, then it will spur innovation in renewables and associated technologies. For another example, if “biorefineries” begin to appear, then they will produce a variety of chemicals at low cost that are not widely used now, encouraging firms to invent new ways to make use of those chemicals.

What policies should be pursued? Of the three simulated in the model, my suggestion would be: all of them. A credible goal to be fossil-fuel free by 2050 is not only inspiring, but it helps firms and individuals plan for the future. An emissions fee can spur a transition among industries (and drive consumers to buy greener products, an important effect that is not simulated in the model). Finally, for transforming production, the model suggests that central bank policies affecting lending rates might be particularly effective.

In our highly interconnected and complex economies, each of these policies – and others – can help us to push and pull our way to a greener future.