World Development Report 2024: The Middle-Income Trap

The destruction of outdated arrangements—enterprises, jobs, technologies, private contracts, policies, and public institutions—is essential for an economy to ensure that it has the appropriate balance of investment, infusion, and innovation. But in many countries the forces of destruction are weak during boom times, whereas crises often play an outsize role in weakening the forces of preservation, making way for the forces of creation.

In the context of energy, the oil price shocks in the 1980s increased the relative cost of fossil fuels and played a major role in accelerating investments in energy efficiency and the development of cleaner energy technologies. The global financial crisis of 2007–09 coincided with a significant increase in the uptake of renewables. Renewable energy use grew rapidly in the United States, China, and Germany in part because of the stimulus programs governments enacted to address the crisis. Today, two crises—the climate crisis and the global energy crisis—are combining to drive rapid progress in low-carbon technologies, defined as technologies or applications that counter the effects of climate change.

Discipline advanced economies to reduce the cost of global decarbonization

As middle-income countries move to a 2i strategy, they will have opportunities to join globalized supply chains for low-carbon products and reduce the cost of decarbonization worldwide. However, their success will depend on advanced economies easing up on protectionism in trade policy. Protectionist measures in advanced economies could prove to be the bane of the global energy transition.

Previous waves of middle-income countries have transitioned to high-income status with the help of coordinated trade policies in a globally integrated economy. By contrast, today’s middle-income countries are navigating a hazier trade landscape. Countries have not yet agreed on the key rules for low-carbon energy product supply chains. And “make local” subsidies will likely do a lot to relocate production—to the United States, to the European Union, and to a growing number of other economies that are embracing “reshoring” efforts and enacting local content requirements. For example, initial modeling suggests that the US Inflation Reduction Act will substantially attract industry toward the United States, Mexico, and Canada and away from other major producers. In effect, these subsidies and protectionist measures in high-income countries threaten to lock middle-income countries out of low-carbon value chains.

To be clear, subsidies have a role to play in a global transition to low-carbon energy sources in view of the positive externalities of such a transition and the extent of today’s market failures. But they should not distinguish between domestic and foreign suppliers. Each segment of the value chain should be located where a product can be made at the lowest cost, averting a risk of protectionist retaliation and a race to the bottom (the most distorted and least efficient market structure). But such globally rational thinking is rarely favored by leaders with domestic politics on their minds. They are unlikely to enact subsidies consistent with a globally integrated economy because such subsidies would allow gains from supply chain reallocation to accrue to firms based in other countries.

Faced with this conundrum, policy makers in advanced economies should consider that the energy transition to low-carbon energy sources has many benefits, not just through its effects on the climate, but also through its implications for the economic development of middle-income countries. To lock middle-income countries out of global value chains with protectionist measures is to deny firms and industries in those countries the benefits of learning-by-doing spillovers.

To accommodate middle-income countries and support a global transition to low-carbon energy, policy makers in advanced economies will need to update trade policy rules by limiting green subsidies, export controls, and import controls and using clear language to define their appropriate use. One option is to modify existing agreements with supplementary clauses, much in the same way that Articles 20 and 21 of the General Agreement on Tariffs and Trade (GATT) were used to carve out exceptions. Such clauses can transparently acknowledge that all countries need to nurture emerging domestic industries if they are to achieve a just transition with energy security. But the use of subsidies should also be restricted to specific circumstances, such as the need for public support to develop and commercialize innovative low-carbon technologies.

Decouple emissions from economic growth

Rising incomes increase the demand for energy—even as they tend to intensify public concern about the environment and awareness that carbon emissions drive climate change. Furthermore, as middle-income countries ramp up the sophistication of their economies by switching to 2i and 3i strategies and expand their use of artificial intelligence and machine learning, their demand for energy will rise dramatically. In fact, the International Energy Agency (IEA) has predicted that the electricity demand by global data centers will more than double from 2022 to 2026, with artificial intelligence playing a major role in that increase.

Middle-income countries will need to decide how best to reduce the carbon emissions of their growing economies—a combination of energy intensity (energy consumed per US dollar of GDP) and carbon intensity (carbon emissions per unit of energy). Today, emissions from a growing economy outweigh the reductions in emissions from lowering energy intensity and carbon intensity. To decouple emissions from economic growth, governments will need to discipline incumbency, reward merit, and derisk investments in low-carbon energy:

• Disciplining incumbency. Disciplining the incumbency advantage is especially important for increasing energy efficiency and decoupling emissions from economic growth. Market contestability, as well as opportunities for value-adding firms to grow, spurs the adoption of energy-saving technologies. In Georgia, for example, markets with a higher concentration have lower energy efficiency. In Argentina, firms with a higher share of skilled workers are better able to adopt advanced green technologies. Exporters also tend to have lower emissions intensity than nonexporters. If incumbents are disciplined, energy price increases hold considerable potential for firms to reduce energy intensity. In the longer term, increases in energy prices tend to be fully compensated for by higher efficiency. A major challenge is that energy prices do not reflect costs—economic or ecological. Estimates suggest that middle-income countries account for 93 percent of explicit fossil fuel subsidies. A promising approach is to consider the concept of total carbon price (TCP) to assess the price signal from a combination of direct and indirect carbon pricing instruments, including energy excise taxes and fuel subsidies. The incumbency advantage also should be disciplined in the electricity industry, where incumbent SOEs dominate fossil fuel power generation and block the entry of new players.

• Rewarding merit. The most efficient way to scale up the efficient provision of low-carbon energy is to respect the merit order: the sequence followed by grid operators selling power to the market. The starting point is set by the cheapest offer, made by the power station with the lowest running costs, which determines wholesale market prices. Any provider who can offer renewable energy at zero marginal cost—that is, with insignificant operating costs—should have priority in meeting demand. When the merit order functions as designed, it shifts prices along the supply curve, which energy economics calls the “merit order curve.”

• Derisking investment. The cost of capital for low-carbon energy such as solar photovoltaic and wind in middle-income countries is twice that in high-income countries, averaging 3.8 percent in high-income countries, but 7.2 percent in upper-middle-income countries and more than 8.5 percent in lower-middle-income countries (figure O.13). Addressing technology risk, development risk, and pricing risk can help incentivize investors—utilities, banks, or other institutions—to invest in low-carbon energy. Derisking requires a whole-of-economy approach. It depends on licensing, policy stability, and social acceptance, along with reducing technical, market, and regulatory risks. Derisking will make renewable energy projects less expensive, as well as reduce the public finance needed to support these projects.

The road ahead

Three decades ago, Professor Robert Lucas, Jr., likened the development strategies that led to spectacular economic growth in Korea to the making of a “miracle.” Given the changes in the global economy since the time that Korea was a middle-income economy, it would be fair to conclude that it would be a miracle if today’s middle-income economies manage to do in 50 years what Korea did in just 25. It might even be miraculous if they replicated the impressive achievements of other successful countries such as Chile and Poland. But that is exactly what governments in Bangladesh, Brazil, China, India, Indonesia, Mexico, Morocco, South Africa, Türkiye, Viet Nam, among others, hope to accomplish.

To do this, these countries will have to become more disciplined. They will have to time the shift from simpler investment-led growth strategies (1i) that worked well in the early stages of development to augmenting investment accelerations with intentional policies that aid the infusion of know-how from abroad (2i), and only then expend sizable resources on innovation (3i). Put another way, they will have to become more efficient in their use of capital—both financial and human—and labor and energy.

To do this, they will have to shed long-held prejudices about enterprise, talent, and energy. They will have to appreciate the importance of reliable information to shape and quicken the structural transformations that must accompany any durable increase in incomes and living standards. Depending on their special circumstance and the stage of development they have reached, they will need to adopt a sequenced and progressively more sophisticated mix of policies (table O.3). Low-income countries can focus solely on policies designed to increase investment—the 1i approach. Once they attain lower-middle-income status, they will need to shift gears and expand the policy mix to 2i, investment + infusion. At the upper-middle-income level, countries will have to shift gears again to 3i: investment + infusion + innovation. Middle-income countries will need progressively greater economic freedom, more open and informed debates, and—frequently—the political courage to change stubborn institutions and long-standing arrangements.