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Does Electrification cause Industrial Development? Grid Expansion and Firm Turnover in Indonesia

The idea that electrification causes industrial development dates back as far as Lenin(1). Even today, many governments and aid agencies around the world invest in energy infrastructure projects, especially in developing countries. For example, the World Bank has committed to lending 6.3 billion to the Energy and Mining sector worldwide in 2017 alone. The Kenyan government is currently investing 2.1 billion in the grid expansion to rural areas. The Kenyan policymakers expect this investment “to enhance industrialization and emergence of [...] industries”. There is consensus among policymakers that access to electricity is an essential ingredient for industrial development, which is considered a fundamental driver of growth.

1 Lenin stated that “Communism is Soviet power plus the electrification of the whole country” and he believed that electrification would transform Russia from a “small-peasant basis into a large-scale industrial basis”.

However, recent economic evidence shows that the benefits of electrification are not as large as previously thought. If you think about Sub-Saharan Africa, electrification in various countries there has increased substantially over the last decades, but these countries have yet to witness industrialization. So I ask: does electrification cause industrial development? Or do these investments have little impact on the pace of industrial development?

To answer this question, I use a rapid, government-led grid expansion during a period of rapid industrialization in Indonesia. I travelled multiple times to Jakarta where I spent time at the Indonesian state electricity monopoly Perusahaan Listrik Negara (PLN). I collected and digitized spatial data on the electrification infrastructure; which when combined with manufacturing census data, result in a comprehensive data-set covering a period of 11 years from 1990 to 2000. More precisely, I first map the expansion of the electric transmission grid over time and space in Java, the main island in Indonesia. I then map manufacturing activity in 25,000 administrative areas using more than 29,000 unique firm observations in Java, where 80% of Indonesian manufacturing firms are located.

For historical reasons, the Indonesian power sector remained underdeveloped compared to countries with a similar GDP. In 1990, Java, the most developed and densely populated island in Indonesia, was only around 40% electrified. The island has since witnessed a massive and successful government-led effort to expand access to electricity up until the year 2000. During that period, transmission capacity in Java quadrupled and electrification ratios increased to more than 90%. The impressive expansion of electrification in Javanese desas between 1990 and 2000 can be seen in Figure 1 below.

This is the first paper to examine the effect of the extensive margin of electrification (grid expansion) on the extensive margin of industrial development (firm entry and exit). The link between electrification and firms has been studied on the intensive margin and is mostly focused on the effect of shortages on firm outcomes. The evidence on the intensive margin of electrification and industrial development is important, but the effect of the extensive margin of electrification on industrialization is potentially different, and of greater relevance to those interested in long run development. Electrifying a new location can influence firms’ entry and exit decisions in that particular location. An economic mechanism through which the extensive margin of electrification affects industrial development is therefore firm turnover, driven by the entry and exit of firms. This affects the composition of firms in the market, and hence, average productivity. Whether or not electrification enhances or decreases manufacturing productivity is therefore a question that requires empirical verification.

Establishing a causal link between electrification and industrial development is empirically challenging. In any emerging economy, infrastructure and industrialization occur simultaneously, and separating demand-side from supply-side factors is difficult. My empirical strategy tries to make progress on this issue by using an instrumental variable strategy where I exploit the need of the state electricity monopoly to have a single interconnected electricity grid in Java. I construct a hypothetical interconnected electric transmission grid that is a function of incumbent disconnected electrification infrastructure built by Dutch colonial electric utilities and geographic cost factors. The hypothetical grid abstracts from endogenous demand factors that could be driving the expansion of the grid and focuses on cost factors only. I use distance to the hypothetical grid to predict access to the actual grid, conditional on various controls, including other types of infrastructure.

My results show that electrification causes an increase in manufacturing activity. This is represented by an increase in the number of firms, number of manufacturing workers, and manufacturing output at the desa level. Interestingly, electrification increases firm turnover by increasing entry rates but also exit rates. An important question is whether electrification creates new economic activity by attracting new firms or the estimated effects are due to existing firms moving from non-electrified desas to electrified desas. I conduct a series of empirical tests of general equilibrium effects which show that the extensive margin of electrification creates new economic activity.

At the firm level, I find that electrification causes average firm size to increase, both in terms of how much output the firm produces and how much inputs it demands. The results on firm turnover are confirmed in the firm-level analysis. Electrification increases the probability of exit, making it harder for inefficient firms to survive. In addition, electrification shifts the firm age distribution towards younger firms. This is a sign of healthy churning in the industry, created by increased entry (more young firms) and increased exit (firms die more often).

Finally, I find that electrification increases average productivity as well as allocative efficiency where the covariance between firm productivity and market shares is higher in electrified areas. These results are theoretically consistent with a decrease in the entry costs, suggesting that electrification increases aggregate productivity by allowing more productive firms in the market, increasing firm turnover, and enhancing allocative efficiency.