The Role of Finance in Environmental Innovation Diffusion: An Evolutionary Modeling Approach

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ARTICLE IN PRESS [m3Gsc;December 26, 2018;13:28]

Journal of Economic Behavior and Organization xxx (xxxx) xxx
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Journal of Economic Behavior and Organization

journal homepage: www.elsevier.com/locate/jebo
The role of finance in environmental innovation diffusion: An

evolutionary modeling approach
Paola D’Orazio a,∗, Marco Valente b,c,d
a
Lehrstuhl für Makroökonomik - Faculty of Economics and Management, and Research Department Closed Carbon Cycle Economy,
Ruhr-Universität Bochum, Universitätsstraße 150, Bochum, 44801, Germany
b
Dipartimento di Ingegneria Industriale e dell’Informazione e di Economia, University of L’Aquila, Italy
c
LEM Sant’Anna, Pisa, Italy
d
SPRU, University of Sussex (UK) and Ruhr-Universität Bochum, Germany
a r t i c l e i n f o a b s t r a c t
Article history: The implementation of climate adaptation and mitigation policies depend on the develop-
Received 31 December 2017 ment of green technologies whose diffusion is constrained by a number of barriers which
Revised 4 December 2018
prevent them to spread broadly and at a fast pace. By means of an agent-based computa-
Accepted 16 December 2018
tional model, the paper investigates the macro and micro economic dynamics considering
Available online xxx
the role of a “traditional” commercial bank and a state investment bank that explicitly sup-
JEL classification: ports green investments. Simulation results emphasize that green finance matter and that
G2 the market diffusion of environmental innovation is more pronounced when the presence
L1 of the public investment bank is combined with strong consumers’ preferences oriented
O33 towards environmental quality. The relevance of the paper is twofold. Besides contributing
O44 to the literature on the finance-innovation nexus by considering the role of climate finance
Q55 within a complex systems framework, it provides a model that can be used as a tool to
explore policies to foster environmental innovation diffusion.
Keywords:
Agent-based computational economics © 2018 Published by Elsevier B.V.
Climate finance
Public investment banks
Environmental innovation
Industrial dynamics
Innovation diffusion
1. Introduction
In the past decades, the research community from different disciplines has agreed on the compelling need to tackle
climate change (Oreskes, 2004), because of the natural, social and economic disruption it risks to generate (see Carney,
2015; Figueres et al., 2017; Rockström et al., 2009, among others).
Both capital markets and the financial sector play a crucial role in delivering the necessary investments in low-carbon
technologies to achieve green structural change (see Ang et al., 2017; Hall et al., 2017; Mrkajic et al., 2017; Pollitt and Mer-
cure, 2018; Wang and Zhi, 2016, among others), so that in past years the term global climate finance (Linnenluecke et al.,
2016) has become very common in policy debates. Climate finance is composed of two main aggregates; namely, private
and public finance. Private finance includes lending by commercial financial institutions, financial commitments by corpo-
∗
Corresponding author.
E-mail addresses: paola.dorazio@ruhr-uni-bochum.de (P. D’Orazio), marco.valente@univaq.it (M. Valente).
https://doi.org/10.1016/j.jebo.2018.12.015
0167-2681/© 2018 Published by Elsevier B.V.
Please cite this article as: P. D’Orazio and M. Valente, The role of finance in environmental innovation diffusion: An evolu-
tionary modeling approach, Journal of Economic Behavior and Organization, https://doi.org/10.1016/j.jebo.2018.12.015
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2 P. D’Orazio and M. Valente / Journal of Economic Behavior and Organization xxx (xxxx) xxx
Fig. 1. Private and public climate finance, total over the period 2012–2016, US bn $. In every considered year, the majority of funds came from the private
sector. Regarding the composition of these two aggregates, the majority of public resources came from developmental financial institutions ($ 56 billion in
2016) while climate funds contribute to a less extent ($ 2 billion from 2012 to 2016)(Data are retrieved from the 2017 Climate Policy Initiative Report. See
Buchner et al. (2017)). Private climate finance is characterized mainly by project developers’ funds ($ 125 billion in 2016), followed by commercial financial
institutions ($ 55 billion in 2016), households savings ($ 31 billion in 2016) and corporate actors ($ 28 billion in 2016). Authors’ elaboration on OECD and
Climate Policy Initiative data.
rate actors, institutional investors’ financing, households’ investments, private equity, and venture capital, while the sources
of public finance are development financial institutions (national, bilateral or multinational), governments, agencies, and
climate funds1 As we summarized in Fig. 1, currently available financial resources are reported to be insufficient to fund
the investments required to limit the increase of global warming to 2 degrees. Moreover, after three years since the Paris
agreements (COP, 2015), the global financial system still faces significant challenges in mobilizing the resources to achieve
the climate goals. The main hindrance to filling the so-called “green financial gap” is the peculiar financial framework of
the main advanced economies, characterized by macroeconomic and financial instability, as well as climate-related financial
risks (Carney, 2015). If prior to the financial crisis, several empirical studies suggested that there was no evidence for financ-
ing constraints for innovative firms (Mina et al., 2013), after 2007 both the firm sector and the financial sector are influenced
by the so-called “short-termism” (Haldane, 2011), that in turn affects the type of investments firms can carry out and pursue
(Minsky, 1980). Since investments related to a green structural change requires long-term commitments and entail high-risk,
the changed attitude in financial markets has profound consequences for this class of investments. Additionally, financial in-
stability has become a threat to the transition to a low-carbon economy in that it directly affects the supply of bank credit,
and consequently investments’ dynamics, especially at the level of small and medium-size firms (Fazzari et al., 1988). On
the contrary, large corporations are less exposed to the credit crunch, because they rely mainly on bond and equity markets
to get the additional financial resources they need for investments2 As a consequence, the increasing costs of the bank’s
credit together with the decreased willingness to lend (especially long-term) by banks results often in the rationing of firms
that are more willing to invest in green innovation.
To study the dynamics of environmental-friendly innovation and the role of climate finance in the promotion of invest-
ments aimed at a “greener economy”, we built an agent-based model populated by heterogeneous consumers and firms and
implemented a financial mechanism which adopts different attitudes towards green innovation. We investigate the macro
and micro dynamics in presence of a “traditional” commercial bank and the role played by a state investment bank (SIB)
that explicitly supports green investments (Mazzucato and Penna, 2015). Our investigation focuses in particular on small and
medium innovative firms (SMEs), for which external financing is especially relevant (Arrow, 1962; Nelson, 1959; Schumpeter,
1942). Indeed, SMEs do not usually have internal funds available for R&D and have to resort to external finance to carry out
their investment plans (Myers, 1984; Vos et al., 2007). The lack of sufficient resources (both internal and external) is thus
crucial for the investigation at the core of this paper, in that it prevents the adoption of green strategies, thus constraining
1
For a comprehensive analysis of climate finance, we refer the reader to (OECD, 2016).
2
The availability of financial capital for green investments is relevant especially for Europe, whose economy is significantly more dependent on bank
intermediation than other economies (see Ayyagari et al., 2007; Beck and Demirguc-Kunt, 2006; Hernández-Cánovas and Martínez-Solano, 2010; Namara
et al., 2017, among others).
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P. D’Orazio and M. Valente / Journal of Economic Behavior and Organization xxx (xxxx) xxx 3
also the achievement of environmental goals. Additionally, we study how this framework, together with the role of heteroge-
neous demand, can create new technologically sustainable landscapes and shift the economy towards a green technological
trajectory.
Addressing these issues is of utmost importance, because beside the credit constraints due to financial instability, en-
vironmental innovation face more hindrances than traditional innovation when it comes to the financing process (Ghisetti
et al., 2017; Mancusi and Vezzulli, 2010). Eco-innovations are indeed riskier and entail a higher degree of uncertainty re-
garding future returns and success (Barbieri et al., 2018). Because of their “nature”3 , they require more patient long-term
committed financial capital that can be provided by a different type of financial institution, namely, public investment banks
(Mazzucato, 2013; Perez, 2004).
The rest of the paper is organized as follows. Section 2 discusses the relevant literature. Section 3 presents the behavioral
equations and the interaction mechanisms of the agent-based model. In Section 4, we present and discuss the results of the
simulation study. Finally, in Section 5 we offer some concluding remarks and discuss the policy implications of our study.
2. Related literature
The central argument of this paper links two strands of literature that have been developing separately: the literature
on eco-innovation diffusion and the research on the link between innovation and finance. We review them briefly in the
following.
The literature that studies eco-innovation diffusion addresses two aspects: (a) the role of consumers’ preferences and
their behaviors in affecting the structural change (Lorentz et al., 2015; Valente, 2012); (b) lock-in and path dependence
(Arthur, 1989; Cowan and Hultén, 1996), which depend on consumers’ preferences but also on regulations and policies on
the supply side (see Cecere et al., 2014, for a review) by relying either on the dynamical general equilibrium approach
or the agent-based computational economics (ABM) modeling approach. The benchmark model used by the equilibrium
approach is the one developed by Nordhaus (2013, 1994); following his contribution, many studies have been carried out
(see Acemoglu et al., 2016; Hassler and Krusell, 2012; Krusell and Smith, 2009, among others).
Our analysis draws rather on the ABM approach, and in particular on evolutionary economics methods (Metcalfe et al.,
2005; Nelson and Winter, 1982; Safarzynska et al., 2012), because they provided evidence of a valuable alternative to the
general equilibrium models (van den Bergh, 2007; Tesfatsion and Judd, 2006), allowing to study the so-called emergent
properties without imposing mathematical “straitjackets” (Arthur, 2013; D’Orazio, 2017).
Considering the very broad existing literature on the role of consumers’ preferences and demand, we have taken into
account a set of contributions (Cantono and Silverberg, 2009; Hohnisch et al., 20 08; Janssen, 20 02; Windrum et al., 2009b)
with which we share the modeling principles, as well as concerns regarding environmental innovation diffusion. One of the
first contributions in this sense is offered by Hohnisch et al. (2008). The authors set up a model of new-product diffusion
in which a site-percolation dynamics represents socially driven diffusion of knowledge about product’s characteristics in a
population of consumers. They find that diffusion of a new product takes place when there are learning effects, that play
a role in lowering the price of the product, or when there are network effects (tested by changing the network topology
- scale-free network) which increase the individual valuations by consumers, resulting in an increasing number of buyers.
Cantono and Silverberg (2009) focus more explicitly on the interrelations between social and technical aspects involved in
the diffusion of environmentally friendly technologies. They draw on the model developed by Hohnisch et al. (2008) and
enrich it by introducing policy actions, such as subsidies policies, intended to trigger the adoption of a new product. The
model explains product’s diffusion as a process of spreading news or “keeping up with the Joneses” in order to account for
the fact that the adoption of new technologies is also dependent on imitative behaviors. Adopting a socio-psychological per-
spective, Janssen (2002) models agents’ behavior by using the“consumat” approach. The proposed model simulates market
dynamics that emerge from agents’ choice between multiple products which are replaced as soon as they become un-
profitable. It is not a dedicated diffusion model, but its results relate to innovation diffusion. In particular, findings indi-
cate that a scale-free network leads to a market dominated by far fewer products as opposed to a small-world network.
Windrum et al. (2009b) focus on the trade-offs faced by heterogeneous consumers between environmental performance,
qualities of service and price and the extent to which this affects the generation and diffusion of “pro-environment” techno-
logical paradigms. The paper shows how the timing and direction of the diffusion of environmental innovation are shaped
by the distribution and evolution over time of consumers’ trade-offs and preferences.
Although the literature is relatively rich of models that emphasize the role of demand for market dynamics (see Frenken
et al., 2008; Janssen, 2002, 2002; Kocsis and Kun, 2008; Malerba et al., 2007; Schwarz and Ernst, 2009; Weisbuch et al.,
20 08; Windrum and Birchenhall, 20 05, among others), to the best of our knowledge, there are only few studies (Caiani
et al., 2014; Fagiolo et al., 2017; Lauretta, 2018; Vitali et al., 2013) that take into account the interaction among the demand
side, the supply side and its innovation dynamics, and the financial side. The article by Vitali et al. (2013) stresses the im-
portance of policymakers that are orientated towards innovation-led and inclusive growth. The authors use an agent-based
model to study how different types of innovators affect the macroeconomy in different ways. Focusing on single innova-
tors, collaborative innovators, and imitators, the analysis looks at the impact of these three categories on micro, meso, and
3
Green innovation is “inherently” different from other types of innovation processes; indeed, it reduces the negative externalities of the production
process and, at the same time, it entails knowledge spillovers and imitation effects that produce positive externalities (Rennings, 20 0 0).
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macro aggregates. Allowing for switching behaviors among these categories, the authors find that collaborative firms have
the highest impact on the economy. By introducing banks, a tradeoff between short-term (profit) maximization and long-run
efficiency emerges. By using the stock-flow consistent approach, Caiani et al. (2014) study the long-term structural change
process triggered by innovation and the related financial dynamics. The model is composed of consumption and capital
goods industries, a banking sector, and two household sectors. Reported results show the importance of the link between
finance and innovation in shaping the long-term business cycle triggered by technological change. Fagiolo et al. (2017) study
the finance-growth nexus in an ABM where firms produce a homogeneous good using existing technologies, perform R&D
activities to introduce new techniques, and imitate the most productive practices. By assuming that both exploration and
imitation require resources provided by banks, they find that the banking activity has a positive impact on growth but only
up to certain point, finding that excessive financialization can indeed hamper it. Similarly, Lauretta (2018) focuses on is-
sues related to the excessive financialization of the economy. The paper introduces a rate of financial innovation (RoFIN)
which captures the financial agents’ business decisions on how to use financial innovation tools. The analysis shows that
the economy’s financial instability resides mainly in the financial structure, where financial innovation plays a relevant role.
However, none of the papers surveyed makes reference to the importance of climate finance aimed at a sustainable eco-
nomic transition. This paper aims to contribute to the two streams of research described above by extending and improving
the study put forward in D’Orazio and Valente (2018), where we started investigating the so-called “deterring barriers”
(D’Este et al., 2012) faced by eco-innovation, by explicitly considering the role of finance in our agent-based model.
3. The model
The model represents a stylized economic system designed to highlight the relation between demand’s preferences, firms’
innovation activities, and financial constraints on innovation projects.
The purpose of the model is to investigate how those three elements collectively affect the overall level of economic
activity in general and, in particular, the industrial profile of the system, i.e., which innovation pattern is adopted by firms
subject to competitive pressure.
Formally, the model is composed of three modules:
• a household sector populated by heterogeneous consumers (they differ for the preferences regarding the products);
• a production sector populated by heterogeneous firms indexed by f ∈ {1, . . . , F };
• a financial sector composed of a standard commercial bank and a public investment bank.
In the following, we discuss the main structure and the interaction mechanisms of the model.
3.1. Demand-supply interaction
The consumer side is modeled by considering the set up described in D’Orazio and Valente (2018), as well as evolutionary
models that put particular emphasis on the role of demand (see Valente, 2012; Windrum et al., 20 09a, 20 09b). The modeled
mechanism is as follows. Each firm offers a product which is characterized by three different qualities; namely, user quality,
bf , environmental quality, gf , and efficiency, ef . The user quality is a products’ feature that is positively evaluated by con-
sumers and represents the performance of the product as used by consumers. The green quality is also a products’ feature
that is positively evaluated by consumers, but it is negatively related to the environmental impact caused by the product.
Efficiency indicates the preference of consumers for cheaper products and is computed as a negative function of the price,
by means of a sigmoid function, as follows:
Me
e f (t ) = (1)
1 + expγe ( p(t )− pˆ )
where Me is a parameter that bounds from the top the level of convenience, γ e is a parameter regulating the slope of the
function and pˆ determines the position where price affects the convenience more strongly.
In our model, we assume implicitly that consumers make their consumption decisions based on the three variables,
contributing to an individual utility function with different relative weights. Consumers, therefore, distribute their collective
sales, at the aggregate level, according to market shares proportional to the utility function.
Rather than implementing the individual choice, we implement the computationally more efficient equivalent format of
directly computing the market shares for each firm. Accordingly, each firm f is assigned an index computed as follows
λ λ
I f = eλf e × b f b × g f g (2)
where λb and λg are the parameters that describe consumers’ preference for the user quality and green quality respectively,
while λe = 1 − λb − λg . The index If is then used to compute individual firms’ market shares
α
I f (t )
ms f (t ) = α (3)
F
j=1 I j (t )
where α determines the concentration of market shares.
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Consequently, sales rf (t) are computed as

r f (t ) = ms f (t ) × GDP (t − 1 ) (4)
where GDP (t − 1 ) is the aggregate output value observed in the previous period.
Our modeling choice emphasizes the importance of heterogeneous consumers’ preferences as they strongly influence
the production of more or less environmentally friendly products. The production process is however constrained by the
technological landscape, technology costs and financial constraints, as explained in Section 3.4.
3.2. Prices, profits, dividends and wealth dynamics of firms
As described in Eq. (5), firms set their price, pf (t), as a (constant) markup, μ, over the variable costs, cf (t) (Blinder et al.,
1991), which are one of the aspects that firms are able to modify when they perform innovation (see Subsection 3.4):
p f (t ) = c f (t )(1 + μ ) (5)
Firms are heterogeneous not only with respect to the product’s qualities but also in their fixed costs, fcf (t) which can be
defined also as indirect costs or overheads: they do not depend on the level of goods produced by the firm, but rather on
the firm’s size, and they are time-dependent. Accordingly, they are defined as:
f c f (t ) = ψ f c f (t − 1 ) + (1 − ψ ) × r f (t ) (6)
where ψ is a parameter determining the speed of adjustment of the current level of fixed costs to their long-term level. The
latter is computed as a fixed percentage, , of total revenues. Given the slow adjustment of the fixed costs, their dynamics
actually tracks asymptotically a fraction of the total revenues.
Firms’ profits, π f (t), are equal to revenues minus costs, both variable and fixed:
r f (t )
π f (t ) = ( p f (t ) − c f (t )) − f c f (t ) (7)
p f (t )
The profit is added (or subtracted in cases of losses) to the past levels of firm’s wealth, s f (t − 1 ) in order to determine
the present level of wealth:
s f (t ) = (1 − δ )s f (t − 1 ) + π f (t ) (8)
Therefore, firms’ wealth is increased by profits and reduced by a share past wealth, δ , (hypothetically) distributed as a
dividend to the company owner(s).
3.3. Market dynamics: Entry-exit and imitation mechanisms
The model features a mechanism that endogenously determines the exit of firms from the market and a mechanism that
exogenously defines the entry of new firms into the system. The exit is based on the evaluation of the level of wealth and
market shares, and it is activated in the case a firm has negative wealth and its market share is below a minimal threshold,
msf (t) < τ .
The entry process is activated at each time step t and is determined by a probability, Prnew . The new firm is configured
with characteristics similar to one of the existing firms, which is chosen with a certain probability proportional to the
normalized market shares msη , where η is a parameter determining the concentration of probabilities used to select the
firm to be imitated by the new entrant.
The probabilities to imitate an existing firm are computed as:
η
ms f
P rimit = η (9)
j ms j
For higher values of η, the new entrants will have higher chances to imitate larger firms. The core features of the new
entrants are differentiated from those of the existing-imitated (indexed with i) firms as follows:
ci
enew = , bnew = bi , gnew = gi (10)

where 0 < < 1 is the percentage of the imitated firms’ values. By adopting this mechanism, we make sure that new firms
do not have an advantage with respect to the imitated incumbent firm.
3.4. Innovation and financing mechanism
Firms compete by offering products that differ in the three dimensions described in Section 3.1. However, considering
that firms are characterized by the same costs functions and the mark-ups are fixed, product innovation is the only process
that allows them to improve their competitive position. In particular, innovation is used to explore the available technolog-
ical landscape and improve one of the three product’s characteristics. An overview of the financing-innovation process set
up in the model is shown in Fig. A.12 in Appendix A.
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As described in D’Orazio and Valente (2018), we assume that the technological landscape is constrained, so that each
firm can improve one characteristic only at the cost of reducing the value of the other two4 Each firm determines its
g
innovation strategy in terms of probabilities to engage in specific R&D projects: Pie , Pib and Pi are the probabilities to target
R&D projects aimed at, respectively, reducing costs, increasing user quality and increasing green quality. These probabilities
can be interpreted as the strategic profile of a company, determining which innovation pattern they are built to follow. This
aspect of a firm is determined randomly when it enters the market and does not change during its lifetime.
The initial distribution of these probabilities is uniform on the market, with the only obvious constraint that Pie + Pib +
g
Pi = 1 for each firm at the beginning of the simulation run and for new firms entering the market. The selection of firms
exiting the market is, in general, not independent from their innovation strategy. Therefore, the average values of the prob-
abilities observed on the market at the end of a simulation run provides useful indications on best innovation strategy for
that specific type of market, i.e. type of consumer preferences and financial arrangements.
Each firm is assumed to run a single R&D project per time, which is expected to last over several periods (see below).
When a firm is not undergoing a research project, the algorithm chooses randomly project with probabilities proportional
to Pe , Pb and Pg , respectively. Once the type of innovation project has been chosen, the firm tries to get a loan to finance it.5
The financial sector’s decision on whether to grant the loan is defined by an algorithm designed to represent an esti-
mation of the financial viability of the firm applying for the loan. The estimate considers a measure of the firm’s wealth,
relative to its turnover, an exogenous probability to finance a specific type of innovation project and an index of the cur-
rent economic conditions. For each application by firm i requesting the financing of innovation of dimension x the model
computes the probability
si (t )
Pix (t ) = × P rlx × I (t ) (11)
ri (t )
where the index It is a proxy for the current cyclical economic conditions cycle. The index is computed as the ratio between
two indexes tracking short-term GDP variation. These two tracking indexes have different weights so that one proxies a sort
of “long-term” GDP level, while the other can be interpreted as a proxy for the “short-term” level.

MAYL (t ) = MAYL (t − 1 ) × δ Long + Y (t ) × 1 − δ Long (12)

MAYS (t ) = MAYS (t − 1 ) × δ Short + Y (t ) × 1 − δ Short (13)
where δ Long > δ Short .

In practice the “long” tracking index smooths much of the short-term volatility of the GDP, while the “short” version
tracks GDP more closely. The index I(t) is computed as:
MAYL (t )
I (t ) = (14)
MAYS (t )
and expresses the notion that if short-term GDP appears above its long-term average we are in an expansive stage of the
cycle while, on the opposite, we are in a recession when short-term estimates are below long-term levels. The probability of
banks to provide financing is therefore pro-cyclical, higher during expansive periods and lower during recessions (see Borio
et al., 2001; Jiménez et al., 2012, among others).
According to this decision-making process, the provision of loans for innovation purposes depends therefore on (1) the
“financial soundness” of the firm proxied by the wealth/revenues ratio: the lower the wealth, the lower the probability to
get the loan; (2) the phase of the business cycle.
If the firm’s search for credit fails, it does not engage in innovation and waits the next time step to start the innovation-
financing process anew. If the loan is granted the innovation project begins; each loan type is defined by a length, Lx , i.e.
the number of periods it takes for the innovation project to be concluded. During this period, the firm cannot start a new
innovation project; when the process is over, the firm assesses the resulting innovation, which can either be successful or
fail, depending on quality-specific probabilities, P rxsucc . As summarized in Table 1, assuming a sort of negative externality
inherent the process of innovation based on the interaction among the different characteristics, in case of a successful R&D
process, the targeted characteristic is improved while the other two are worsened.
Overall, the innovative activity of a firm can potentially improve all characteristics because the benefits obtained from a
successful innovation project increase the targeted characteristic of a fixed value K, while the costs incurred by the other
characteristics cause a reduction by a level k < K/2. Hence, a firm may potentially rotate across the three types of innovation
increasing each quality by K − 2k, which is necessarily positive. However, a firm may choose to pursue a narrower innovative
strategy by performing more frequently one type of innovation project producing a fast improvement of one characteristic
and generating, as a result, a deterioration on the other two.
4
A similar mechanism has been implemented in Bleda and Valente (2009). In that modeling framework, however, the trade-off involves only two
products’ characteristics and it is considered as only one option, out of three, available to firms.
5
As explained at the end of Section 2, in this model, we make the assumption that firms (SMEs) resort always to external credit in order to finance
their innovation strategies; we thus rule out any possibility to resort to other forms of financing (Myers, 1984) or to use a detailed capital structure.
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Table 1
Implications of a successful innovation project on the three product’s char-
acteristics. The improvement obtained on the targeted characteristic is K
while the reduction on the two other characteristics is k < K/2.
Cost-reducing User quality Environmental quality

innovation innovation innovation
c f (t ) = c f (t − 1 ) − K c f (t ) = c f (t − 1 ) + k c f (t ) = c f (t − 1 ) + k
b f (t ) = b f (t − 1 ) − k b f (t ) = b f (t − 1 ) + K b f (t ) = b f (t − 1 ) − k
g f (t ) = g f (t − 1 ) − k g f (t ) = g f (t − 1 ) − k g f (t ) = g f (t − 1 ) + K
3.5. Allowing for the subsidiarity principle to sustaining green investments
In the modeling of the financial sector, we account also for the role of a mission-oriented state investment bank (SIB)
(Mazzucato, 2013, 2015). In a set of policy scenarios, we consider indeed the action of a public sector whose policy is
devoted to achieving a set of environmental goals by means of the public financing of green innovation.
Since the onset of the financial crisis, SIBs have been drawing new attention because of their potential fruitful coun-
tercyclical role in economic crises, and for their support of structural change (Mazzucato and Penna, 2015). SIBs are public
entities because, usually, the majority of their equity is held by the state and their mission is to promote economic devel-
opment and socioeconomic goals, by complementing, rather than competing with commercial private banks. Their funding
structure is diversified across countries; it can be composed by deposits, government bonds, budget allocation from the
government, or they can rely on their own equity from bond issuance, carbon taxes revenues, etc. Because of the easier
access to capital (e.g., re-capitalization) in the form of equity by means of government funds, and because they suffer from
fewer deposits withdrawals (which could potentially lead to bank runs) than private banks, they can tolerate more risk
than standard private banks (Iannotta et al., 2013). In the last years, many SIBs are acquiring a “green mandate”6 , meaning
that they are explicitly aiming at supporting a low-carbon, climate resilient transition (see Macfarlane and Mazzucato, 2018;
Stumhofer et al., 2015).
As already discussed in the introduction, environmental innovation is difficult to be financed by private actors because
of the higher risks, and therefore higher costs, it entails, as well as because of the competition from incumbent “brown”
technologies (Ang et al., 2017). The green sector thus usually benefits from public subsidies, which offer, however, only
short-term competitiveness advantages (Stucki et al., 2018). Bearing these caveats in mind, in this paper we rather want to
focus on different public policies used to support the diffusion of green technologies, thus favoring the green transition. In
particular, we take into account the collaborative model that exists between the public and private banking sector which
relies on the so-called “subsidiarity principle” (see Stumhofer et al., 2015). According to it, the loans that are granted to
commercial bank customers are actually funded by a government agency which can be a state investment bank, a green
bank, a development finance institution, depending on the definition adopted by the country. Additionally, we take into
account the fact that the lending attitude of public banks is less pro-cyclical than that of commercial banks (Bertay et al.,
2015; Micco and Panizza, 2006).
To implement the subsidiarity principle, we abstract from the capitalization sources of the SIB and focus on its interaction
with our standard commercial financial sector. This allows us to “test” for the contribution of the green public policy to the
aggregate dynamics of the model by analyszing two specific frameworks:
1. the “standard financing scenario”, in which the credit supply for innovation purposes is managed by a standard com-
g
mercial bank, whose behavior is characterized by P rl ∈ [0, 1];
2. the “extra green financing scenario”, where we explicitly take into account the role of a SIB, which does not compete
with the existing commercial bank, but rather supports it, according to its “green mandate”, to fostering environmen-
tal innovation. The role of the SIB is activated in specific scenarios’ frameworks (see Section 4, Table 3), to control
for other possible influencing factors, and is modeled as the “contribution” to the commercial bank’s “willingness to
g
lend” to green innovation projects, P rl , so that the probability to get a loan aimed at green innovation becomes
g
P rl,SIB = P rlg + σ (15)
3.6. Aggregate income
At each time step, the aggregate income is computed as
Y (t ) = ζ Y (t − 1 ) + (1 − ζ )Y T (t ) (16)
6
For example, in the German Kredit für Wiederaufbau (KfW) statute it is explicitly stated that it promotes environmental protection (Article 2, paragraph
1, number 1 d). Additionally, it is strongly connected to the larger German Federal strategy for sustainability, such as the Energiewende Action Plan.
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where ζ is a parameter expressing the inertia of GDP to changes, while YT (t) indicates the aggregate income level that, given
sufficient time, the system will asymptotically reach if every aspect of the economic system remained constant at the levels
of time t. YT (t) is thus the potential aggregate income level that changes at every time step; the actual aggregate income
Y(t) changes slowly in that direction.
The different types of innovations contribute to the determination of the aggregate income of our artificial economy. To
model their effects, we draw on the extensive empirical research that has characterized this field.
Product innovation, i.e., innovations in user quality, is found to affect economic growth positively (see Antonucci and
Pianta, 2002, among others), while process innovation, i.e., R&D activities aimed at improvements in the efficiency quality
of the product, consistent with both the Schumpeterian view and the empirical evidence (see Antonucci and Pianta, 2002;
Calvino and Virgillito, 2018; Pianta and Vivarelli, 2003, among others), is considered to have negative effects on the potential
aggregate income level. Indeed, although process innovation, by implying a reduction in unit costs, and consequently a
reduction in prices, can lead to an increase in consumer demand and thus an increase in output, in reality, this mechanism
is hindered by several feedbacks which affect the final effect on the employment level, and therefore economic growth.
First, as pointed out by Antonucci and Pianta (2002), if firms do not have enough market power, the decrease in cost can
hardly be translated in price reduction, so that the increase in consumer demand is not guaranteed. Second, by adopting a
Keynesian perspective, demand might be saturated and the price reduction might not be sufficient to stimulate it. Finally, the
reduction in total wages implied by the process innovation might depress the purchasing power more than the reduction in
prices can actually boost. Regarding green innovations, their positive effects on employment have been empirically detected
(see Horbach and Janser, 2016; Horbach and Rennings, 2013; Kunapatarawong and Martínez-Ros, 2016; Rennings et al., 2004,
among others).
Considering the above-discussed available empirical evidence, the model takes into account the fact that the type of in-
novations performed by firms in a system is non-neutral with respect to the aggregate income level. While cost-reducing
innovation reduces comparatively the potential aggregate income, the other two types of innovations increase it. We rep-
resent this perspective by modeling the potential, or target, aggregate income as a weighted average of the three different
contributions from R&D in the three products’ dimensions:
Y T (t ) = Y (t − 1 ) × GT (t ) (17)
where GT (t) (see Eq. (19) below) represents the potential growth rate resulting from the innovative activities of the firms.
This index is computed starting from the cumulated aggregate income shares pertaining to firms that started an R&D project
to improve characteristic x at time t. Concerning the characteristics affecting positively the potential aggregate income, i.e.,
user, and environmental quality, their contribution is computed as follows:

x (t ) = msi (t − 1 ) (18)
i∈Rx (t )
where Rx (t) is the set of indexes of the firms that, at time t, initiated a research project aimed at improving a characteristic
x.
The growth rate, GT (t) introduced in Eq. (17) is computed as:
(Gmax − Gmin )
GT (t ) = [ωg g (t ) + ωb b (t ) − ωc c (t )] + Gmin (19)
2
where the parameters ωx represents the weights for the three characteristics and Gmin and Gmax are the exogenous extreme
growth rates. This implies that the dynamics of the potential aggregate income, YT (t), is exogenously constrained within a
given range, getting closer to the upper limit when a large share of firms undergo R&D projects concerned with user and
environmental quality and, conversely, approaching the lower limit when a large share of economic activity is pursuing
cost-reducing innovations.
3.7. Model validation
The model presented above is designed to investigate the interactions among a selected set of components of an eco-
nomic system with the purpose to support the development of specific policies. For this reason, the model cannot be consid-
ered as a tool for the analysis of the replication of existing empirical evidence. Rather, it aims at providing the possibility to
investigate the chain of implicit consequences stemming from the model’s structure which are too complex to be analyzed
deductively (Valente, 2017). Although the model does not aspire to be a “perfect reproduction” of real-world systems, its
purpose is to strike a balance between sufficient simplicity, in order to allow the full exploration of its internal properties,
and sufficient complexity to reflect the empirical properties generally observed in real-world systems, which are relevant to
the phenomenon of interest.
As a consequence, we present a validation of our model by showing a few common features of economic systems, so as
to ensure that the overall results are compatible with the most general empirical observations. Table 2 summarizes the prop-
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Table 2
Overview of the model’s emerging properties with related empirical evidence.
Model’s emerging property/Stylized fact Empirical evidence
Procyclical R&D investments Wälde and Woitek (2004)

Aghion and Howitt (2008)
Firms’ size distribution: right skewed Kwasnicki (1998)
Axtell (2001)
Gaffeo et al. (2003)
GDP growth rate distribution: fat tailed Fagiolo et al. (2008)
Franke (2015)
Williams et al. (2017)
Table 3
Overview of the sensitivity and policy scenarios.
Scenario Special settings Financial sector
Private Bank SIB
1 Constant supply No entry/exit

a. only user q. λ b = 1 , λe = 0 , λg = 0 ✗
b. only green q. λ b = 0 , λe = 0 , λg = 1 ✗
c. green & user q. λ b = 0 . 5 , λ e = 0 , λg = 0 . 5 ✗
2 Even Preferences λb = 0.3, λe = 0.3, λg = 0.3
a. Standard financing ✗
b. Extra green financing σ = 0.2
3 Low green preferences λ b = 0 . 4 , λe = 0 . 4 , λg = 0 . 2
4 Hampered green innovation Prlg = 40%
erties considered in our analysis. Sections 3.7.1, 3.7.2 and 3.7.3 report evidence from the model supporting the consistency
of the simulations’ results with the main stylized facts relevant to our analysis7
3.7.1. Procyclical investments

A common property found in macroeconomic data is the positive relationship between investment levels and GDP
growth. In our model, we do not have an explicit demand-supply feedback. Actually, one type of innovation (the one aimed
at reducing variable costs) is negatively related to GDP. It is thus relevant to ensure that total investments, measured as the
sum of all firms carrying on a research project at any given time, are positively related to GDP.
It is worth to note that, in our model, investments are related to innovation projects. Moreover, the time frame of these
investments spans several time periods, while the GDP growth rate is computed at each simulation period. Together, these
considerations would require some statistical elaboration to identify with greater precision the relationship between invest-
ments and GDP. However, for the purpose of validation, we consider sufficient to present the raw interpolation between the
growth rates of investments and GDP that, even if noisy, anyway supports the claim that our model correctly replicates the
positive correlation between the two considered variables. We show this result in Fig. 2, which reports on the horizontal
axis the growth rates of total innovation investments and on the vertical axis the GDP growth rate measured at the same
time step. The interpolating line indicates the positive relationship between the two variables, confirming the capacity of
the model to replicate this property.
3.7.2. Firms’ size distribution

In our model, firms’ sales depend on the products’ qualities; namely, price (derived by costs), user quality and green
quality. These values are set randomly at the beginning of the simulation; during the simulation, they are endogenously
modified as a result of innovation and selection processes. There is, therefore, no explicit mechanism ensuring the typically
skewed distribution of market shares. However, Fig. 3 shows that the endogenous interactions among all the component of
the model generate such a distribution.
The figure reports the size of the firms’ market shares ranked in descending order. Though the precise slope of the curve
may vary by modifying some of the parameters of the model, the graph clearly supports the claim that the model produces
skewed firms’ size distribution, broadly compatible with the empirical evidence.
7
To generate these emerging properties, we use the first configuration reported in Section 4.2, characterized by equally distributed preferences. Any
other configuration generates essentially the same results in terms of validation.
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Fig. 2. The relationship between investments’ growth rates and GDP growth rates.
3.7.3. Fat-tailed GDP growth rates

The third, and last property, proposed as in the model’s validation concerns the distribution of GDP growth rates.
It is well known that relative increases of GDP do not come symmetrically distributed but rather show a marked bias
such as fat-tails, i.e. positive extreme are more likely than expected in case of a normally shaped distribution. In our model,
we have an exogenous small growth trend around which the model endogenously generates fluctuations. Fig. 4 confirms
that the model correctly generates a right-side fat tail.
The results presented in this Section support the claim that our model, albeit partial and highly stylized, provides suf-
ficient similitudes with the empirical evidence available from real-world economic systems to be relied upon as a tool to
study the outcomes of different conditions in terms of demand structure, innovation opportunities, and financial conditions.
In the following Section, we present the main contributions of this investigation.
4. Simulations
The model is simulated across discrete time steps.8 During each step, the following “fundamental” activities are per-
formed:
(i) Trading, assigning sales to firms and updating their accounts;
(ii) Each firm attempts or continues an innovation project, whose successful conclusion leads to the updating of firm’s
product characteristics;
(iii) Exit and entry of firms from and in the market.
Fig. 5 sketches the sequence of events performed at each time step of the simulation. Each simulation run comprises
2500 time steps, each t corresponds to one week so that the simulation length is of about 50 years. Different scenarios will
8
The model is implemented by using the LSD platform (Laboratory for Simulation Development). See www.labsimdev.org for additional information. The
code is available upon request.
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Fig. 3. Market shares distribution measured at the end of a simulation run. Market shares refer to firms with sales above a minimal threshold, comprising
roughly 25% of all firms existing at that time.
Fig. 4. Frequencies of one-period GDP growth rates.
be considered for the investigation; an overview is presented in Table 3 which highlights the main assumptions for each set
of configurations with respect to the baseline parametrization reported in Appendix B.
The results of different scenario analyses will be reported and discussed in the following Sections. We start be presenting
preliminary exercises using the model with a simplified configuration so that it is easier to appreciate the main drivers of
the results. These preliminary results also validate the central assumption that different innovation strategies are required
for different types of markets.
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Fig. 5. Sequence of events. Discrete time is represented as a circular flow over which the agents’ actions are executed at each time t of the simulation. The
initialization is executed only at t = 0. Authors’ elaboration.
The main results we present are three sets of simulations in each of which we compare the outcomes generated by a
standard financial system, subject to pro-cyclical propensity of lending, and one endowed with a non-economic actor, such
as State Investment Bank, tasked with improve the chances of financing for green innovation projects.
The first set of simulations assume consumers preferences equally divided among all the three characteristics. The second
considers consumers with lower interest on the green quality in respect of the other two. The third and last set of simula-
tions consider the case in which the probability of success on green innovation is lower than innovation projects aimed at
cost reductions or improvements in user quality.
4.1. The role of demand: Preferences, innovation dynamics and market shares
As preliminary results, in order to clarify the internal dynamics of the model, we set a configuration meant to expose
the interplay between consumer preferences and the firm’s innovation strategies. For this purpose, we configure the model
to prevent exit and entry during a simulation run so that the same set of (randomly initialized) firms compete against
each other. At the end of the simulation, we compare the market shares distribution with respect to the firms’ innovation
strategy, i.e., the probability to innovate the three products’ dimensions. The results will show how the innovation strategy
affects competitive conditions determined by the demand, i.e. consumers’ preferences.
In order to facilitate the interpretation of the results, we consider three extreme preference settings. In the first two
settings, all consumers pay attention exclusively to one characteristic, the user quality, and the green quality, ignoring the
other two. The third setting shares the preferences equally between the user and green quality9 In order to improve the
reading of these results, we also raised the probability of financing innovation projects and of succeeding in innovate to
100%. The complete parametrization for this Section is reported in Table B.4 in Appendix B.
9
We neglect the analysis of consumers interested in price only because the results are essentially identical.
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Fig. 6. Preference for user quality (left panels) and green quality (right panels). Configurations without entry and exit mechanism. Top-panels: effects of the
randomly assigned probabilities to innovate on the product’s qualities at the end of the simulation run. Mid-panels: impact of the qualities on the market
shares. Bottom-panels: consequential effect of the probability to innovate on the market shares.
This analysis highlights the extent to which different demand landscapes reward a different type of firms in each of the
three cases. In the first case, the winning firms are those that allocate their innovation budget to increase the user quality;
in the second case, higher market shares are observed in the case of green innovation; finally, in the latter case, the best
performing firms are those that allocate their budget to increase both the user and environmental quality.
While these results validate the central assumption of this work, that is, innovation drives the success of firms, the
analysis of the simulation allows to appreciate the transmission mechanisms from innovation to product’s qualities and,
eventually, to market shares.
The left column in Fig. 6 refers to the setting including preferences based on user quality only, while the right column
refers to preferences for green quality. The two bottom panels show that firms initialized with the appropriate innovation
strategy enjoy the highest market shares, in a sense validating the implementation of the model. The planes in the graphs
g
report the probabilities to innovate on two product characteristics of user quality, Pib , and green quality, Pi 10 The distribution
10
The value for the third probability of innovation on cost reduction can easily be inferred by the requirement that Pie = 1 − Pib − Pig .
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Fig. 7. Preferences give the same relevance to user and green quality. Configuration without entry and exit. Top-panels: effect of probability to innovate on user
quality (A) and green quality (B). Bottom-panels: Panel C reports the effect of the two qualities on the market shares. Panel D reports the consequential
effect of probabilities to innovate on the market shares.
of the probabilities is uniform by construction and not modified during a simulation run because firms’ exit from the market
is precluded in this preliminary exercise.
The first two rows in the Figure highlight the two intermediate steps by which the results are obtained. The first row
reports two graphs showing the relation between probability to innovate and the levels of the relevant quality reached at
the end of the simulation run. The second row shows the relation between quality levels recorded by the firms at the end
of the simulation run and their market shares. We can, therefore, conclude that to be “successful”, a firm needs to innovate
the product quality most appropriate to the type of consumers in the market.
The results reported in Figure with respect to 7 consider the slightly more complex case in which consumers have their
preferences equally divided between user and green quality. The panels A and B show the levels of the two qualities with
respect to the innovation strategies. Panel C reports the relationship between the levels of the two qualities and the market
shares at the end of the simulation run, which panel D concludes showing the relation between probabilities of innovating
the two qualities and the final market shares. This exercise shows that for each set of consumer preferences there is an
optimal innovation strategy composed of the appropriate mix probabilities to innovate on the different qualities.
In these preliminary exercises, we assumed the initial set of firms to remain forever in the market. In the following,
however, we will allow for entry and exit. While new entrants have their innovation strategy randomly initialized, the
firms exiting the markets will be those with the “wrong” probabilities to innovate. Consequently, the average values of the
probabilities to innovate among all firms surviving on the market will be distorted in favor of the innovation strategy most
appropriate for the market conditions.
4.2. Equally distributed consumers’ preferences
In this Section we consider the complete model, including firms’ entry and exit, configured with standard values con-
cerning innovation. We will consider the entire time frame of the simulation so as to appreciate the time evolution of the
simulated markets. Since our model entails a large number of random values, to ensure the robustness of our conclusions
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Fig. 8. Equally distributed preferences. Comparison of average values for the three qualities bi , gi and ei (upper panels) and of the probabilities to innovate
(lower panels). The left panels show the simulations’ results in the case in which only private banks provide financing; right panels report the results
accounting for the presence of a SIB, which contributes to the probability of financing specifically for the green innovation projects. All graphs include the
upper and lower limit comprising 95% of the inter-simulation variability.
we replicated 100 times the same simulation for each configuration. The results are the average values produced by the
variables, together with the confidence interval of the average with 95% probabilities11
As a first exercise using the complete model, we assume that consumers distribute their preferences equally among all
the three product characteristics. The graphs reported in Fig. 8 show on the left column the results produced assuming that
only private banks are allowed to finance innovation projects, while the right column shows results from configurations in-
cluding the possibility of financing green innovation projects by a state investment bank that enters into the model through
the subsidiarity principle described in Section 3.5.
The upper panels report the absolute levels of the average qualities, while the lower panels concern the average prob-
abilities of financing innovation projects. All panels report average values (weighted by firms’ market shares) computed at
each time step of the simulation, showing the evolution of the variables under scrutiny considering the combined effects of
competitive success and selection.
The left column shows that the dynamics concerning the user and green quality are statistically identical, apart from
some noise due to stochastic effects in the firms’ initialization and process, as may be expected. The slope of all the qualities
(top panels) is always positive, indicating that only firms dividing their innovation investments over all the qualities can
prosper, while firms concentrating innovation efforts on only one dimension (thus causing the others to decrease, because
of the mechanism described in Section 3.4) are quickly kicked out of the market. The change in the rate of growth of the
absolute values of the variables is explained by the change of direction in the average probabilities to innovate, as reported
in the bottom panel. These results emphasize that firms initially find profitable to improve their cost-effectiveness. However,
at around time 600, further improvements in cost reductions do not bring additional benefits in terms of market shares;
consequently, firms prefer to focus on improving the other two qualities. This result is due to the different nature of the
cost-quality with respect to the other characteristics: costs are indeed downward limited, while green and user quality are
assumed to be unlimited, making investing in the latter more profitable after a certain limit is reached.
Turning to the case where a SIB facilitates the financing of green innovation (right column), we observe different results
with respect to the previously discussed case. Indeed, the average level of green quality consistently grows more than the
11
Formally, for each variable at each time step we compute the standard deviation across all the 100 simulation runs. The upper and lower boundaries
of confidence intervals are computed summing to and subtracting from the average value the standard deviation multiplied by 1.96.
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Fig. 9. Low preferences for green. Comparison of average values for the three qualities bi , gi and ei (upper panels) and of the probabilities to innovate (lower
panels). The left panels show the simulations’ results in the case in which only private banks provide financing; right panels report the results accounting
for the presence of a SIB, which contributes to the probability of financing specifically for the green innovation projects. All graphs include the upper and
lower limit comprising 95% of the inter-simulation variability.
other two. The rationale for this result is twofold. First, firms find it more profitable to direct innovation investments towards
improvements in green quality because it is more likely to get “green finance” (knowing about the presence of the SIB in the
economic system). The focus on one quality leads the other two to deteriorate, or grow, at a slower rate. As a consequence,
firms gradually decrease the probability to invest in green projects, leveraging on the increased percentage of financing for
these projects in order to balance the total number of funded projects.
In the concluding paragraph of the results’ Section, we will discuss in more details the extent to which this change has
relevant macroeconomic consequences; namely that GDP growth is far more pronounced in presence of a SIB under every
configuration used. However, it is worth noting an additional positive effect, potentially highly relevant in terms of policy:
while we are assuming that any innovation project seeking funding is identical, in real-world cases we can expect that
projects are differentiated in terms of social welfare. In case a share of innovation projects in green technology requires
financing by a not-for-profit entity, governments can direct innovation towards sectors considered more relevant for the
society, even though they may be less attractive in terms of short-term profitability (Mazzucato and Perez, 2015).
4.3. Low preferences for green
In this Section, we describe the simulations’ results considering a lower preference for the green quality (see Scenario 3,
Table 3). As for the previous exercise, we distinguish between a setting characterized by a standard financial sector and one
characterized by the presence of a SIB. We report the simulation results in Fig. 9. As a general feature, we observe a regular
pattern (in both settings) robustly repeated across all the simulations, as indicated by the relatively narrow confidence bands
around the mean.
Reported results allow for a comparison between the role of standard finance and finance aimed at green innovation. In
the first case, as shown in the top-left panel of Fig. 9, the diffusion of the qualities is consistent with the type of demand
faced by firms: higher preferences for the user and efficiency qualities, are observed together with higher and increasing
qualities’ levels in the market. Regarding the green quality, a lower and decreasing pattern is observed across the whole
simulation. Faced with these type of preferences, firms adopt different innovation strategies (bottom-left panel) with re-
spect to those observed in Section 4.2. In this framework, the increase in costs inherited from the starting periods, provide
the most effective path to success until around time 1200, when the competitive advantage comes from investing in the user
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Fig. 10. Low propensity to innovate for green quality. Comparison of average values for the three qualities bi , gi and ei (upper panels) and of the probabilities
to innovate (lower panels). The left panels show the simulations’ results in the case in which only private banks provide financing; right panels report
the results accounting for the presence of a SIB, which contributes to the probability of financing specifically for the green innovation projects. All graphs
include the upper and lower limit comprising 95% of the inter-simulation variability.
quality. Thus, firms characterized by a higher propensity to produce cost-reducing innovations gain market shares by raising
the average value of Pe in the first phase of the market development. Such dynamics produces a comparative disadvantage
for the two other dimensions, namely the user and environmental quality, respectively. However, consistently with the dom-
inant demand, we observe a fall in the propensity to innovate in green technologies, but a steady increase (although lower
than the cost-innovation) in the probability to innovate in user quality, which becomes predominant after around t = 1200.
When we consider the active role of the SIB, the model dynamics differ from the previously discussed framework. By
observing the right column of Fig. 9, we can distinguish among three different phases. At the beginning of the simulation,
consistent with the assumed demand, user and cost quality dominate over the green quality. In the second phase, because of
the presence of the SIB, the probability to direct innovation towards green technologies increases until time period t = 1200,
when the competitive advantage is given by investing in cost-reductions innovations. As a consequence, the third phase is
characterized by a higher propensity to innovate in cost-reduction; however, a higher level of green quality is observed
(top-right panel) when compared to the former framework. Moreover, a difference is observed in the propensity to innovate
in green projects. In the first framework, it is always downward sloping, until reaching a stable (and lower, with respect
to the other two propensities) values after around period t = 1875. In the second framework, the propensity to innovate in
green projects dominates the other two until around period t = 1200, after which it starts to decrease, due to the fact that
in presence of the SIB, fewer investments are needed in order to increase the number of green projects.
4.4. Hampered green innovation: Disentangling the role of finance
As a last simulation experiment, we now turn our attention to the effects of possible “barriers” to green innovation;
namely, a lower preference for the green quality (on the consumer side) and a lower propensity to innovate in green projects
(on the firms’ side), on the diffusion of green quality and firms’ innovation strategies (see Scenario 4, Table 3). The aim of
this proposed investigation is to analyze whether the presence of a SIB improves the overall economic framework with
respect to the diffusion of green projects.
The simulation’s results reported in Fig. 10 reveal similar dynamics and patterns for both the diffusion of qualities (top
panels) and the propensities to innovate (bottom panels) in presence of the two different type of finance. Consistent with
the type of assumed demand, we observe higher levels of efficiency and user quality, and lower levels of green quality which
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Fig. 11. Average log GDP values generated from Scenarios 2, 3 and 4 considering the role of standard finance, and a SIB.
correspond to lower propensity to innovate in green projects. However, in the case of the SIB, we observe higher levels of
green quality in the market, across the whole simulation period.
All in all, these results emphasize the importance of the type of finance and the role of governmental institutions in
pursuing an innovation policy that goes beyond the mere “fixing the markets’ failures” (Mazzucato and Penna, 2016).
4.5. GDP Dynamics: The contribution of innovation and finance to aggregate income
Before concluding, we report the analysis of the effects of different demand settings and innovation strategies on the
GDP. Results are shown in Fig. 11, in which we distinguish between the framework with standard finance and SIB for every
scenario that accounts for the complete model setting (as described in Table 3).
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First, the role played by the SIB emerges quite strongly; the GDP grows faster, and shows higher levels when the SIB is
taken into account. Second, as already emphasized in Section 4.1, consumers’ preferences also play an important role in the
model dynamics. Additionally, their interaction with the propensity to lend of the financial sector gives rise to interesting
patterns. We observe indeed that when consumers attach the same preferences to the three product’s characteristics, the
GDP is higher and grows at a faster pace, while in the case of a lower preference for the green quality (mid panel) and
hampered green innovation (bottom panel), the GDP is characterized by a lower growth rate.
5. Conclusions and policy implications
Concerns related to the economic impact of climate change are becoming more widespread in the last decades because
the scientific community has shown that the ecosystem is heading toward a tipping point which poses risks to the global so-
ciety. In particular, the implementation of adaptation and mitigation policies is based on the development of green technolo-
gies whose diffusion is, however, constrained by a number of “barriers” (D’Este et al., 2012). In particular, the higher risks
and longer-term revenues - with respect to standard innovations - prevent them to spread broadly and at a fast pace. Bear-
ing these caveats in mind, in this paper, we focused on the role of the financial sector in delivering the required resources to
increase environmental innovation diffusion. We explicitly took into account two different financial actors; namely, a stan-
dard commercial bank and a public investment bank. In particular, the presence of the latter is justified by the existence of
investment projects, such as those oriented to the development of environmental technologies, that require specific types of
funding but are characterized by high uncertainty regarding their returns and success.
By means of the agent-based computational approach, the paper shows how the presence of a public investment bank,
especially in the case it acts as an instrument of innovation and industrial policy could be beneficial for the economy as a
whole. We started by considering a production sector populated by heterogeneous firms that compete in the market and
receive goods’ demand from the consumption sector. Firms have different cost structures and offer goods that are differenti-
ated along three dimensions. Their needs for finance is determined according to the result of the competitive dynamics and
the received demand. We then explored the innovation-finance nexus, in presence of different behaviors of financial actors.
Although the financial sector is not fully modeled, the paper allows for the investigation of the effects of different types of
“willingness to lend” on the environmental quality diffusion and on the contribution of different types of finance to GDP.
Reported simulations show how both the level of aggregate green quality and the green propensity to innovate are higher
in presence of a SIB that explicitly supports the standard commercial bank “attitude” towards environmental projects. We
observe, indeed, an increase in the diffusion of green innovations and higher GDP growth. Our findings are consistent with
a growing body of theoretical (see Andrianova et al., 2008; Brei and Schclarek, 2015, among others) and empirical literature
(see Allen and Gale, 1998; Brei and Schclarek, 2013; Cull and Peria, 2013, among others) that has provided evidence for
the countercyclical role played by the government through public banks during financial crises. Additionally, an important
emergent property of the model is that the highest levels of green quality are achieved when the presence of the SIB is
combined with strong consumers’ preferences oriented towards environmental quality.
The relevance of the paper is thus twofold. Besides considering the role of public investment banks within a complex
systems framework, it provides a model that can be used as a tool to explore policies to foster green innovation diffusion.
The model has, however, some limitations, in particular, the presence of a financial sector which is not fully modeled and
the absence of a comparison with other tools and instruments, such as (macro)prudential regulation aimed at increasing
climate finance (D’Orazio and Popoyan, 2018). We leave the inclusion of these features and further analyses for future work.
Our results suggest a potentially crucial role for public investments banks in improving the functioning of the financial
system (especially during crises) and sustain economic resilience by filling the so-called green financial gap. Currently, suc-
cessful case studies of active SIB are the Brazilian BNDES (Banco Nacional de Desenvolvimento Economico e Social) and the
German KfW (see Mazzucato, 2015; Mazzucato and Penna, 2015; Wruuck et al., 2016, for an overview). However, although
important public finance commitments are made in this direction - such as those made during the latest COPs - it takes
time to translate them into actual investments. For the moment, the so-called “Paris effect”12 on climate finance is thus
difficult to be detected. According to our findings, we maintain that more efforts should be put forward by governments to
create, or improve, public financial institutions in order to deliver the adequate financial resources to tackle climate change.
Acknowledgments
The authors gratefully acknowledge helpful comments received from the participants of the Conference on Finance and
Economic Growth in the Aftermath of the Crisis, University of Milan, September 2017, and thank two anonymous referees for
comments that greatly improved the manuscript. All usual disclaimers apply.
Appendix A. The finance-innovation mechanism
12
This expression denotes the effects of the agreements made by the United Nations countries during the COP21 in Paris in December 2015 (see
COP, 2015) about the increase of climate-related financial resources.
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Fig. A1. Flowchart of the financing process.
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Appendix B. Parameters’ setting
Table B1
Initialization and baseline parameters’ setting.
Parameter Description Value In Equation/In Section
Initialization
H Number of consumers 10 0,0 0 0
F Initial number of firms 10
Consumers
Me Maximum of the efficiency function 200 (1)
γe Slope of the efficiency function 0.03 (1)
pˆ Position of the efficiency function 100 (1)
λe Weight of convenience 0.3 (2)
λg Weight of green quality 0.3 (2)
λb Weight of user quality 0.3 (2)
Firms
α Market shares concentration 20 (3)
μ Mark-up 0.01 (5)
ψ Speed of adjustment of fixed costs 0.3 (6)
Share of revenues that determine fixed costs 0.05 (6)
δ Share of dividends 0.3 (8)
τ Threshold for firms’ exit 0.3 (Section 3.3)
minAge Minimum age for firm’s exit 10 (Section 3.3)
Prnew Probability new firm entrance 0.5 (9)
η Imitation of existing firms 0.85 (Section 3.3)
Percentage of imitated firm’s values 0.85 (10)
L Wealth-revenues ratio 1 (11)
Firms & Finance
Lc Length cost loan 4 (Section 3.4)
Lb Length user quality loan 4 (Section 3.4)
Lg Length green loan 4 (Section 3.4)
Prcsucc Probability of success cost loan 1 (Section 3.4)
Prbsucc Probability of success user quality loan 1 (Section 3.4)
Prgsucc Probability of success green loan 1 (Section 3.4)
Prlc Probability to get loan for cost reduction 1 (Section 3.4)
Prlb Probability to get loan for user quality improvement 1 (Section 3.4)
Prlg Probability to get loan for green improvement 1 (Section 3.4)
σ State investment bank parameter 0 (15)
Aggregate Income
ζ GDP adjustment speed 0.025 (16)
ωg Weight for green quality 0.1 (17)
ωb Weight for user quality 0.8 (17)
ωc Weight for cost 0.1 (17)
Gmin increase of GDP 1.015 (19)
Gmax decrease of GDP 0.99 (19)
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Contents lists available at ScienceDirect

Journal of Economic Behavior and Organization

The role of ﬁnance in environmental innovation diffusion: An

3.1. Demand-supply interaction

Consequently, sales rf (t) are computed as

3.2. Prices, proﬁts, dividends and wealth dynamics of ﬁrms

3.3. Market dynamics: Entry-exit and imitation mechanisms

3.4. Innovation and ﬁnancing mechanism

where δ Long > δ Short .

Cost-reducing User quality Environmental quality

3.5. Allowing for the subsidiarity principle to sustaining green investments

3.6. Aggregate income

At each time step, the aggregate income is computed as

3.7. Model validation

Model’s emerging property/Stylized fact Empirical evidence

Procyclical R&D investments Wälde and Woitek (2004)

Scenario Special settings Financial sector

Private Bank SIB

1 Constant supply No entry/exit

3.7.1. Procyclical investments

3.7.2. Firms’ size distribution

3.7.3. Fat-tailed GDP growth rates

Fig. 4. Frequencies of one-period GDP growth rates.

4.2. Equally distributed consumers’ preferences

4.3. Low preferences for green

4.4. Hampered green innovation: Disentangling the role of ﬁnance

5. Conclusions and policy implications

Appendix A. The ﬁnance-innovation mechanism

Fig. A1. Flowchart of the ﬁnancing process.

Appendix B. Parameters’ setting

Parameter Description Value In Equation/In Section

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