KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

KDI FOCUS Approaches to Enhance the Market Functionality of the K-ETS

South Korea has set ambitious greenhouse gas (GHG) emission reduction targets. However, the country currently confronts a decline in the price of emission permits. This downward trend could obstruct the successful realization of GHG objectives through market mechanisms. The current emissions trading scheme (ETS) restricts banking of excess emission allowances, which has been identified as the main reason of the ongoing price decline. Consequently, this restriction hinders the adequate reflection of updated targets within the emissions trading market. To address this issue and avert potential shocks from a substantial reduction in emission allowance supply during Phase IV, it is necessary to relax the banking restrictions. At the same time, to proactively manage potential price escalations resulting from eased restrictions on permit banking, supplementary measures are required. These measures could include the introduction of explicit market stability mechanisms utilizing allowance reserves and the expansion of allowance supply channels.

- South Korea has ambitious GHG reduction targets, but the demand and prices for emission permits are lagging, both displaying a decline.

- The pricing mechanism of the K-ETS is currently underperforming, consequently compromising market efficiency.

- In its current framework, the K-ETS imposes restrictions on the banking of unused emission permit in order to stimulate the trading market.

- The banking restrictions impede the price function and overall efficiency of the scheme.

- To brace for potential reductions in allowance supply in the future, it is crucial to relax the banking restrictions.

- Relaxing the banking restrictions could result in a short-term surge in demand and prices for emission permits. Therefore, alongside a gradual relaxation of banking restrictions, complementary measures should be implemented.

- By implementing an explicit market stabilization scheme utilizing reserves, emissions prices can be stabilized and market efficiency can be enhanced.

- As for the price tiers in the market stabilization scheme, they should ideally consist of two straightforward tiers with a considerable disparity between them.

- Eligibility for participation in emissions auctions, currently confined to entities subject to auctioned allocation, must be expanded to secure a consistent supply of emission permits.

- Given the long-term nature of decisions to reduce GHG emissions, it’s crucial to improve the predictability of the emissions trading market.

Summary

Research Monograph KOR Green Transition Strategy and Implementation

It is imperative for the Republic of Korea to prioritize the development of elaborate green transition strategies and implementation plans. In light of this urgency, this study offers ten chapters addressing select issues on green transition, which provide policy recommendations drawn from identification of problems, assessment of current policies, and empirical analysis.

Chapter 2 (Dr. Yong Hyeon Yang) assesses the national greenhouse gas emission reduction plan the Korean government announced in Oct. 2021. It finds the sectoral strategies to be insufficient for the stated targets and suggests that an energy transition ambition has to be increased as either targets have to be decreased in other sectors or there could be a need for more extensive electrification. Chapter 3 (Prof. Wonhyuk Lim) offers insights on energy transition strategies and their implication for the electricity industry. Periodical simulations should be conducted for multiple scenarios, and the overall cost of transition, including the expenses for networks and standby facilities as well as the levelized cost of energy, should be minimized. Accordingly, transition and phase-out of fossil fuel plants should be systematically planned in stages.

Chapter 4 (Dr. Yeochang Yoon) points out the limitations of the Korean emission trading system (ETS) and presents potential solutions. The current restrictions on banking need to be relaxed to keep the ETS allowance prices from dropping, but such adjustments should be introduced gradually to prevent a sudden decline in supply. Chapter 5 (Prof. Hyungna Oh) raises a possibility of insufficient investment in decarbonization technologies due to first-mover disadvantages. It advocates introduction of carbon contracts for difference to incentivize R&D in green technologies, especially when carbon prices are low or uncertain. Chapter 6 (Dr. Karam Jo) presents the empirical result that patents in some digital transformation technologies can increase patents in climate technologies by an average of 17.3% and underscores the need to promote such digital transformation technologies.

Chapter 7 (Dr. Junghyun Kwon and Dr. Joseph Han) reveals that elevated outdoor temperatures decrease working hours in an inequitable manner and deteriorate workers’ health. These observations imply that climate change could magnify income inequality. As such, protective measures for outdoor workers against high temperatures and support for their job transitions are crucial. Chapter 8 (Dr. Hyunseok Kim) proposes selective subsidies for regions heavily impacted by climate change and green transition, and highlights the necessity of assessing those impacts objectively. Most importantly, local governments should formulate transition plans in line with central government guidelines.

Chapter 9 (Prof. WooRam Park) indicates that a large portion of greenhouse gas comes from establishments with more than 300 workers, and in such industries as petrochemical and steel. It also shows higher carbon productivity in industries with lower greenhouse gas emissions and establishments using less energy. Chapter 10 (Dr. Joseph Han) reveals the empirical result that firms who entered in the first stage of ETS had significantly lower greenhouse gas emissions, energy usage, annual turnover, and employment than those who did in the second stage. The performance of these firms was influenced by the design of the ETS, for example, on what basis the allowances were assigned free of charge or for a fee. Hence, policy design for green transition should pay particular attention to its effects on businesses and employment. Lastly, Chapter 11 (Dr. Sora Chon) observes that the global green transition might trigger both green and energy inflation. Analyzing the effect of inflation factors on the Korean economy finds that such impacts vary based on whether inflation arises from a demand or a supply shock. Consequently, the Korean government's responses should differentiate between inflation factors that are demand-side and supply-side.

Summary

KDI Policy Forum Impacts of Climate Policies on Industrial Competitiveness in Korea

■ As carbon reduction targets are being strengthened globally, it is increasingly important in Korea to comprehend the impact of two major greenhouse gas (GHG) reduction policies, Target Management System (TMS) and Emissions Trading System (ETS), on industrial competitiveness.

- ETS relies more on individual firms’ economic incentives compared to TMS, which is a command-andcontrol regulation.

■ While the transition from TMS to ETS in 2015 is found to have partially alleviated the burden for manufacturing firms, there is a need to enhance policy effectiveness by acknowledging their limited performance in reducing carbon emissions thus far.

- While TMS was introduced in 2011 with the aim of enforcing emissions reduction and enhancing energy efficiency across different sectors, heavy emitters have been managed separately through ETS since 2015.

- Knowing the low abatement performance in the manufacturing industry after mid-2010, the reduced burden can be attributed to two factors: i) improvement in efficiency resulting from the transition, and ii) alleviation of the burden through the provision of free allocations.

- The policy efforts should aim for a greater reduction by strengthening the targets for the regulated firms, which is in line with the reinforced policy goals announced in October 2021.

■ Stricter goals are inevitable in the future, and therefore, policymakers must endeavor to bolster the sustainability of the manufacturing sectors by developing a detailed roadmap based on multiple indicators.

- Taking into account the varying impacts of GHG reduction policies on the competitiveness based on the energy intensity and emission intensity of each sector, the roadmap needs to be carefully crafted in order to impose a feasible burden on the regulated firms.

Summary

KDI Policy Forum The SME-Suitable Industry Reservation Policy: Economic Effects and Policy Direction

■ After marking the ten-year milestone since the adoption of the SME-suitable industry reservation policy, this study investigates whether the policy has enhanced the competitiveness of SMEs by safeguarding them as intended and offers implications for its future implementation.

- This SME policy involves the selection of specific products to protect the business territories of SMEs and limit the entry or expansion of large enterprises; however, evidence-based discussions on its effectiveness have been limited.

- While the production and employment of large businesses decreased after the adoption, the business activities of SMEs did not change much.

■ This reservation policy aimed to "ensure the competitiveness of SMEs through their protection." It successfully fulfilled its protective role by reducing the likelihood of SMEs exiting the market. However, the reservation policy had limited impact in terms of improving their performance or competitiveness.

- Following the designation of a set of industries (products) reserved for SMEs, the probability of exit for SMEs engaged in the production of those specific products significantly decreased. However, these SMEs did not show significant differences compared to other product producers in terms of most performance and input indicators.

- The industry-level analysis shows that the policy contributed little to the performance of overall industries to which the designated products belong.

■ The disappointing outcomes of the policy’s stringent measures highlight its limited effectiveness, as the restrictions on the expansion or entry of large enterprises did not lead to significant improvements in the performance of SMEs.

■ Based on the findings, it is recommended to suspend new applications for the designation of SME-suitable industries and gradually phase out the already designated reserved industries.

- In any business field, when there is greater uncertainty about future market restrictions, firms are less incentivized to engage in that market and invest in domestic production facilities.

- A policy that restricts production activity in a specific business area solely based on firm size may inadvertently undermine the efficiency of resource allocation in the broader economy.

■ Instead of protecting specific business areas, a win-win policy between SMEs and large firms should prioritize providing effective support for the growth of capable SMEs through appropriate regulatory measures to address anti-competitive and unfair practices.

Summary

KDI Policy Forum Can Artificial Intelligence Improve the Effectiveness of Government Support Policies?

■ Despite high hopes for artificial intelligence (AI) to generate powerful innovations across the public sphere backed by its strong prediction skills, Korea has not fully brought the technologies into the public sector in tasks like identifying policy target groups and managing follow-up tasks in line with its policy objectives.

- Recent cases of AI-applied public services in Korea show limited usage, mainly replacing simple repetitive tasks.

- Few leading countries are trying to apply AI-based analysis to select promising policy target groups to effectively achieve policy goals and follow up on the performance of public projects.

- While the existing management system for policy performance is mostly about ex-post assessment of project outcomes, the application of AI technologies signifies a shift to data-driven decision-making that uses ex-ante forecasts of policy effects.

■ An analysis of AI-applied recipient selection of small and medium enterprise (SME) policy support programs demonstrated the efficiency of AI in predicting the performance of beneficiary firms after the program and AI's potential to significantly improve the effectiveness of public support by providing helpful information in screening out unfit SMEs.

- Using firm-level data, this study applies machine learning to various public financing programs (subsidies or loans for SMEs) funded by the Ministry of SMEs and Startups and finds that AI helps predict the growth of recipient firms in the years following policy support.

- The application of AI in identifying fitting recipients likely to achieve intended objectives may increase project effectiveness.

■ In a KDI survey in 2020, respondents pointed out that what hinders transitioning into a system of AI-applied, data-driven policymaking in the public sector are: 1) incomplete standardization and linkage of policy information between governmental ministries and 2) lack of expertise in technology utilization in the public sector.

■ By developing a strategy to propel a transition into data-driven policymaking in the public sector, coordinated national-level efforts must be made to heighten policy effectiveness across different public fields, including education, health care, public safety, national defense, and business support.

- One way to adopt AI technologies in the public sector is by designing a policy to support technology adoption for competent public institutions. Support measures may cover system, data platform, security, organizational consulting, training, etc.

- Detailed strategies are: 1) unifying existing data management systems into one single platform, 2) reorganizing the way government work gets done to enable efficient exchange of policy information, and 3) building a trust-based public-private partnership.

- By examining the policy cycle from planning and implementation to evaluation, it is important to clarify areas for AI to contribute to policy decision-making. Also, the government needs step-by-step strategies toward data-driven policymaking, such as setting clear project objectives, selecting and sharing data, establishing system and security, and promoting operational transparency.

Summary

Research Monograph KOR Designing the Criteria on the SME Support Policy: Focusing on the Definition of SME and Small-Scale Reservation Policy

Government support programs for small and medium enterprises (SMEs) and regulations for large firms are all size-dependent policies. The purpose of this study is to evaluate the effectiveness of the SME definition and the small-scale reservation policy on SMEs' performance. This study intends to provide policy implications when designing the criteria for the SME support policy.

Chapter 1 introduces the criteria for defining SMEs and presents the distribution of firms according to the SME size categories. In Korea, SMEs account for over 99% of the total number of business enterprises, meaning that the definition of SMEs is broad enough to include most firms. There are numerous policy programs and tax benefits for SMEs in Korea and this chapter lists those support policies according to various size categories.

Considering all SME policies are size-dependent, Chapter 2 examines the effect of size-dependent policies overall, not of individual and specific policy, by analyzing changes in firm performances and employment with a change in the criteria used to categorize SMEs. We exploit the changes in the SME status of each individual firm by the change in the criteria to measure the effects. The result shows that the criteria change from the employment size categories into the turnover size categories has little impact on achieving the intended growth in employment. However, newly designated SMEs show significantly increased sales. This finding can be interpreted as indirect evidence of positive effects from tax benefits and support programs targeting SMEs, but further research is needed to find direct evidence. We also found that there is a significant decrease in sales per employee for the firms whose SME status is withdrawn, suggesting that there exists an incentive to maintain the status.

Chapter 3 demonstrates the economic effects of reservation policy for SMEs. Among an array of size-dependent policies, the reservation policy is one of the most restrictive policies since it directly regulates the entry and production activities of large enterprises for specific goods. The analysis demonstrates that although reserving certain markets may temporarily safeguard the SMEs producing the products, this effect is temporal and not beneficial to the industry's overall growth. The reservation policy may be of little use in securing the competitiveness of SMEs and can potentially exacerbate the misallocation of the resources among the enterprises within the economy. This study also points out that even in the markets not reserved for SMEs, investment incentives may shrink on the uncertainty that their production activities could be restricted at any time.

The findings of this study are consistent with recent studies arguing that the diverse distribution of firm characteristics such as productivity and size should be considered when designing SME policies. The overall productivity of an economy can increase when resource allocation shifts from low-productive firms to high-productive ones. In turn, it shows the need to check whether a policy operates against efficient resource allocation when examining the impact of a specific policy on the economy as a whole. Furthermore, this study is relevant to the field of measuring the effectiveness of SME policy by providing empirical analysis at enterprise or establishment levels.

Summary

Research Monograph KOR Digital Transformation Strategy for Digital-Based Growth

COVID-19 has caused many changes socially and economically. While closing their workplaces and stopping face-to-face meetings, companies expanded non-face-to-face activities such as working from home, webinar. In addition, consumers switched activities such as education, daily necessities purchase, food delivery, and fitness to online or mobile methods. COVID-19 caused a rapid change in the existing supply and demand system, and the changed pattern of economic activity is more likely to continue in the future.

The rapid transformation of lifestyle in the global pandemic situation was possible thanks to digital technology that has continued to develop over the past 30 years since the spread of the Internet in the 1990s. Digital technology has become a general-purpose technology that causes fundamental changes in economic, industrial, and social environment, including education, jobs, and lifestyles, beyond the level of limited use for specific products or services.

In particular, digital technology has undergone a rapid commercialization due to the expansion of infrastructure for high-speed transmission and computation of large amounts of data, the emergence of data-based applications, and the simultaneous development of hardware technology. The demand for digital technology has soared due to COVID-19, and it has emerged at the forefront of our society.

This phenomenon, also called digital transformation, is felt as a rapid and overall change in society. However, Companies has been feeing the impact of digital transformation before Covid-19. Advances in digital technologies such as the Internet of Things, Cloud, Big Data, and Mobile have provided companies with opportunities to innovate through new business models, while causing fundamental changes in the way companies work.

Digital transformation is expected to be positive for productivity improvement and economic growth by promoting the emergence of new products and services and enhancing work efficiency. In addition, digital transformation will promote the expansion of digital trade, thereby expanding export opportunities for products and services through digital. On the other hand, while the risk of cyber security is expected to increase due to high dependence on digital technology, there are also concerns that automation and digitalization of work may have a negative impact on employment.

Accordingly, this study examines tasks for digital transformation and policy directions for stable transition to a digital society in six dimensions: corporate, government policy, regulation, job, education, and global environment.

Chapter 1 identifies the key elements and expected effects of a company's digital transformation, and presents the patterns and levels of digital transformation of domestic companies. Chapter 2 examines policy challenges for digital transformation of SMEs so that SMEs can grow into small and medium-sized enterprises by using digital to increase productivity and strengthening innovation capabilities. Chapter 3 preemptively examines all problems related to the emergence of new industries using digital technology to seek ways to improve regulations that help the smooth growth of new industries. Chapter 4 quantitatively analyzes whether industrial robots, a specific form of automation, replace domestic jobs. Chapter 5 discusses the transition to digital education using artificial intelligence and its tasks as an alternative to solving the problems of our public education. Chapter 6 analyzes the current situation centering on digital trade, a new economic opportunity in the digital era, and examines recent trade issues.

This report summarizes the policy directions that can minimize the side effects that may be caused by digital tansformation while using digital transformation as a stepping stone for the growth of the Korean economy.

First of all, in order to produce a good performance for digital transformation of domestic SMEs, it is necessary to diagnose the readiness of SMEs for digital transformation and provide necessary policy support to SMEs while conducting consulting on what digital technologies and capabilities to be equipped with. In addition, policy integration and coordination is needed so that the government's various digital transformation policies for SMEs can be linked to each other.

Second, it is necessary to clarify regulations in order to harmonize newly emerging technologies and industries with the existing system in the process of transition to a digital society. Regulatory reform has been recognized as deregulation, but the current rapid digitization requires clarification of regulations, preemptive modification and timely provision of regulations, and advancement of regulatory quality.

Third, the trend of robot increase is expected to continue due to continuous digital transformation and industrial structure reorganization, so it is necessary to protect the vulnerable, centering on mid-skilled jobs in the manufacturing industry. It is necessary to expand vocational education so that workers can move smoothly to areas where labor demand is expanding, and to help higher education acquire robot utilization skills and complementary skills.

Fourth, the educational gap should be narrowed by using artificial intelligence. It is analyzed that non-face-to-face education due to COVID-19 has decreased academic ability and widened the educational gap. In order to solve this problem, policy efforts to improve the quality of education, such as strengthening learning feedback, spreading customized education at each student level, and introducing a continuous academic diagnosis system, are considered to be feasible through transition to digital education using artificial intelligence.

Finally, in order to expand the market through digital trade, digital trade statistics should be advanced, digital trade agreements should be expanded, systems should be established to preemptively respond to overseas data regulations, and support measures should be prepared to resolve digital trade disputes for SMEs.

Summary

Policy Study KOR Causes of self-employment management difficulties and policy directions

This study analyzes the factors affecting the sales, operating profits, and expenses of the domestic self-employed by using the MDIS data of the wholesale and retail industry for the last 20 years.

First, the operating profit of the self-employed has been on a downward trend since the 2010s. As of 2019, the average operating profit fell to 16.87 million won in the wholesale and retail business and 12.89 million won in the lodging and restaurant business. This was significantly lower than the operating profit of 20 years ago (on a real value basis).

Second, the decline in operating profit was attributed to cost increases while sales growth was limited due to market competition. In particular, the biggest increase among expenses was ‘other expenses’. The proportion of other expenses to sales more than doubled from 4.6% in 2000 to 9.5% in 2019 in the wholesale and retail industry, and in the lodging and restaurant industry, it increased from 45.8% to 66.9% during the same period.

In addition, as a result of analyzing the factors affecting the sales of the self-employed, there was a tendency for the surplus of self-employed people to significantly decrease sales. When the surplus increased by 1,000 people, the sales of the self-employed in wholesale and retail business decreased by 0.76 to 0.94 million won, and the sales of the lodging and restaurant businesses tended to decrease by 1.49 to 2.36 million won.

Lastly, the surplus of self-employed and rising costs in the wholesale and retail business lowered the average annual operating profit by 1.26 million won and 1.11 million won, respectively, and these magnitudes were strong enough to reach 3.95% and 3.48% of the operating profit. In the case of the lodging/ restaurant industry, the decrease in operating profit due to oversupply and rising costs was found to be 6.07 million won and 2.12 million won on average, which corresponded to 25.04% and 8.75% of the average operating profit.

Summary

Policy Study KOR A Study on Effective Innovation Policy: Focusing on Vaccine R&D

Vaccines can be an effective means to cope with infectious diseases from a social point of view, but investment by private firms in the development of new vaccines could be suboptimal. First, this study briefly discusses a typical vaccine development process and the characteristics of a vaccine product to explain the causes of this market failure.

Next, this study analyzes the optimal use of ‘push incentives’ and ‘pull incentives’ to enhance R&D incentives for a vaccine development firm. More specifically, here, push incentives can lower R&D costs and alleviate the firm’s financing constraint (regardless of R&D result); pull incentives can raise the level of reward from a successful R&D result. This study shows that (i) it is optimal to use only push incentives if the firm faces severe financing constraints, and the social planner’s budget is relatively small; (ii) It is optimal to use both push and pull incentives if the firm faces severe financing constraints, and the social planner’s budget is relatively large; (iii) It is optimal to use only pull incentives if the firm does not face any financing constraints; (iv) In cases where the rewards that the firm can obtain from a successful R&D result are quite limited (i.e., the market size is small), providing push incentives alone is not sufficient to enhance the company's R&D incentives.

Lastly, after examining vaccine R&D support policy in Korea and a few other foreign countries, this study provides relevant policy implications, including the circumstances under which providing pull incentives play an important role, the need for a vaccine innovation policy for harmonious use of push and pull incentives, and institutional improvements required to use pull incentives more effectively.

Summary

Policy Study KOR Impacts of Climate Policies on Industrial Competitiveness in Korea

This study quantifies the impact of major climate policies on industrial competitiveness in manufacturing sectors that require large-scale decarbonization in the future. Two climate policies, the Target Management System for GHG and Energy (TMS), a command-and-control type policy introduced in 2011, and the Emission Trading System (ETS), a market-friendly policy introduced in 2015, are mainly considered, where both policies cover selected companies that emit heavily. Based on pathways through which climate policies can affect industrial competitiveness, we estimate impacts of the abatement burden through channels of the level of energy intensity (energy consumption per production) and the level of emission intensity (emissions per energy use) by covering 2011~2019. Furthermore, based a firm-level survey, we estimate determinants that drive and hinder the implementation of abatement practices and determinants that enhance environmental and economic performance.

As a result of the analysis, during the last 10 years (2011-19) it was confirmed that the higher the level of energy intensity and emission intensity, the negative impact on production cost and value added, which are direct indicators of the manufacturing industry’s competitiveness, was greater. Impacts become greater when limiting to the energy-intensive and emission-intensive sectors, such as “iron and steel”, “non-ferrous metals”, “chemicals”, “petroleum refining”, and “non-metal” industries. Meanwhile, it is found that there is no signficant impact on sales. Overall, it is understood that the upward pressure on production costs was at a level that could be endured through a decrease in value added rather than leading to a decrease in production. Furthermore, it is confirmed that while negative impacts on competitiveness through energy-intensity has gradually increased during the analysis period, that through emission-intensity has decreased after the introduction of ETS. Meanwhile, burden of carbon abatement has not yet been realized in earnest for some large companies that have been active in introducing abatement measures. Nevertheless, in line with the strengthening of climate policies in the future, policy considerations to ensure the sustainability of the manufacturing sector should be accompanied.

Policy suggestions this study provides are tow-fold. First, it is necessary to understand the extent to which TMS and ETS actually affect and to identify detailed impact pathways. Considering the results of previous studies and this study, there is a possibility that in the manufacturing industry the distribution of abatement burden is not proportional to that of emissions. Therefore, it is essential to broaden the perspective and consider impact pathways at the level of the production and supply chain. Second, it is necessary to set TMS targets and allocate ETS allowances using multiple indicators. Industries with high direct emissions such as fuel combustion can lower their emission intensity through their own strategies (switching to environmentally friendly fuels, etc.), while in industries with high indirect emissions, energy intensity adjustment may be a more effective means than emission intensity adjustment. Altogether, it needs to enhance the sustainability of manufacturing industry in the process of decarbonization by differentially allocating as much burden as necessary to the firms under TMS and ETS, and by alleviating the burden that firms outside the system may bear in a disproportionate way to their emissions.

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