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Can we avoid green collateral damage from rising interest rates?

Image: Pixabay

By Asker Voldsgaard (UCL IIPP), Florian Egli (Zürich ETH) and Hector Pollitt (University of Cambridge)

Classic monetary theory implies that raising interest rates is an effective way to counter raising prices. However, there may be a green collateral damage to this strategy. Many green energy technologies are more capital intensive than fossil-based technologies and thus become comparatively more expensive when central banks use monetary policy to raise the cost of financing. We suggest three policy strategies to shield the green transition.

Tightening monetary policy

Supply-chain disruptions from COVID-19 and changed demand patterns in conjunction with disorderly fossil fuel markets have led to rising prices. We are now seeing further price increases from the ongoing Russian aggression in Ukraine and resulting sanctions. The macroeconomic knee-jerk reaction to rising prices is for central banks to raise interest rates.

A general concern is that central banks are ‘behind the curve’ when it comes to controlling prices. A too slow response could lead to higher inflation expectations that will feed into higher wage demands, potentially leading to a wage-price spiral. The US Federal Reserve has pivoted decisively towards higher rates — most recently with the first 0.75 percentage point increase in 28 years — although we are still well short of a Volcker shock. The Bank of England has raised rates five times since December. The European Central Bank (ECB) has shown more restraint, in part because the European price index is mostly elevated by energy prices, war has returned in the EU’s neighborhood, and the ECB has a discredited history of untimely rate hikes after the financial crisis.

While there is now a monetary policy strategy in the eurozone that is more tolerant of short-term price increases, market actors have been speculating on monetary tightening in the Eurozone based on a brewing hawkish pivot within the ECB. Now the ECB has promised to hike its policy rate in July followed by a potentially larger increase after the summer. The current hiking cycle runs against the backdrop of longstanding calls for ‘normalising’ monetary policy with higher interest rates as well as official projections for rates to return to theorised equilibrium values. From this perspective, higher rates should be the new normal.

Green collateral damage

The commencement of a new hiking cycle in monetary policy is terrible news for the green transition. The green transition requires a shift from technologies with high operating costs (fuel and labor) to technologies with large up-front capital expenditures. In short, we are moving towards an energy system with a much higher CapEx-OpEx ratio (capital vs. operational expenditure). This means a different business model is required. For example, while a gas-fired power plant may use its current revenues to pay for new fuel, an offshore wind project uses its current revenues to service debt. The higher the cost of capital, the less attractive the offshore wind farm is.

Figure 1 illustrates the dynamic by showing the levelised cost of electricity (LCOE) for a set of low- and high-carbon technologies with different capital costs. Increasing the cost of capital from 5% to 10% would increase the cost of electricity from offshore wind by 47%. The cost of onshore wind and utility scale solar PV would rise by 52–54% and rooftop solar by 60%. In contrast, the cost of gas-fired electricity would rise by only 8%.

The higher cost of rooftop solar would especially limit civic engagement in the energy transition.

Figure 1: The cost of renewable electricity is more sensitive to higher cost of capital

Source: The Danish Energy Agency’s LCOE calculator. Note: LCOE = Levelised cost of electricity. The Y-axis shows the cost increase from rising cost of capital relative to the cost of electricity with no cost of capital.

Recent empirical analysis by the International Energy Agency (IEA) has emphasised the importance of keeping a benevolent financial environment for renewables. Financing is flagged as the largest cost component of an offshore wind farm and the IEA’s 2019 report on offshore wind power concluded that: “Offshore wind in Europe has benefited from low interest rates and debt risk premiums, allowing developers to decrease project weighted average cost of capital, the largest component of the levelized cost of electricity” (p. 41).

As figure 2 below illustrates, lower base rates — strongly determined by monetary policy — have been decisive for lowering the cost of generating electricity from offshore wind. An academic analysis of historical data on German onshore wind and solar PV plants reaches the same conclusion.

Figure 2: The indicative cost of debt for offshore wind projects

Source: The International Energy Agency. Note: Data based on European markets for offshore wind

At least six compounding factors further complicate the picture.

1. Commodities and supply chains

Supply chains remain disrupted from the pandemic and raw material costs are rising. For capital intensive technologies, such as offshore wind, this has a disproportionate effect on costs, putting companies in financial difficulties. Major wind turbine manufacturers are therefore raising turbine prices — Vestas by 20% for example.

To some extent, high prices of natural gas and coal offset these effects. However, the investor must compare cost expectations over plant lifetimes (e.g. 25 years). They may not expect fuel costs to stay high, whereas for wind turbines it is the costs now that matter.

Meanwhile, higher financing costs could be locked in over project lifetimes. The worst-case outcome for renewables would be if fuel prices fell but others prices remained high, increasing equipment costs while simultaneously pushing central banks to tighten monetary policy.

2. No more subsidies

In addition to the upward pressure on costs, investors face a downward pressure on revenues, with increasing risk. Because renewable energy technologies have reached cost parity with fossil fuel alternatives (as record-low auction results around the world have shown), policymakers are now phasing out revenue support schemes for renewable energy.

Exposing renewables to the variability of merchant prices puts them at a further disadvantage. Unlike gas-fired power plants, renewables cannot ramp generation up at times of high electricity prices. The synchronised production patterns of renewable technologies lower their capture price. Generating profits with renewables becomes more difficult and unpredictable, and therefore financing becomes more costly.

Energy finance consultants have estimated for Wind Europe, the wind industry’s business organization, that the cost of electricity from a typical offshore wind farm with a price guarantee increases from €50-€60/MWh to €90/MWh if it is solely exposed to the spot price of electricity. Private power purchase agreements can mitigate the price risk to the extent credible long-term offtakers are available. Another part of the solution to the variability challenge is to integrate energy and production systems further via ‘green domino’ technologies predicated upon the availability of cheap, clean electricity.

3. Tilting the green dominos

There are a range of burgeoning technologies that could both help to clean up the energy supply and decarbonise the hard-to-abate sectors. At closest proximity, electric vehicles are starting to replace the stock of cars with internal combustion engines and battery-based vehicles are also shaping up to take over land transport and ferries. Other promising examples include grid-scale energy storage facilities that redistribute variable clean electricity. Hydrogen and hydrogen-based electrofuels from large electrolysers could provide clean energy for heavy industry, aviation, and shipping.

However, these deep decarbonisation technologies are ‘green domino bricks’ in the sense that they depend on a massive supply of cheap, clean electricity. If we have this supply available, the cross-sectoral synergies among next generation technologies could be unleashed. The road to deep decarbonisation would be much less cumbersome.

Like renewable energy installations, these ‘green domino’ technologies are capital intensive, long-lived assets that depend on the availability of cheap finance. For example, grid-scale energy storage facilities are capital intensive and will suffer the same cost blow from higher interest rates as renewables.

Deep decarbonisation technologies therefore risk a double hit from tighter monetary policy because it pushes up both electricity and financing costs. If the deployment of renewables stalls because of prohibitive financing costs, the pace of deep decarbonisation will slow because green domino technologies will remain economically unviable for longer.

4. A green bubble?

Massive financial resources and increasing demands to be ‘green’ have led investors to pour unprecedented amounts of investment into green technologies and companies. However, some indicators, such as the high price-to-earnings valuations of green companies, point to a potential green bubble, as the Bank for International Settlement warned last year.

Carlota Perez has famously described how financial bubbles have historically played a key role in structural transformation of socio-economic systems, by facilitating a rapid scale-up of novel technologies. A possible green bubble serves the cause of the green transition by lowering the financing cost for green endeavors even further. A monetary tightening may reduce the willingness of investors to bet on the future earning potential in emerging technologies, which could lead to a disproportionate drawback of investment from green assets.

5. Schumpeterian dynamics

As evolutionary economists have stressed for decades, innovation is path dependent. If we are to create alternatives to fossil fuel-based systems, we need to divert sufficient resources to R&D. This R&D will be largely funded by reinvested profits.

If green company profits come under pressure from financing conditions (and other market tendencies, see above) there will be a strain on green innovation. In contrast to oil companies, green companies do not have legacy profits and balance sheets. With fewer alternative financing options, lower profitability impacts the investment plans of green companies harder.

Furthermore, lower deployment of technological frontier solutions means slower learning-by-doing and fewer economies of scale for the clean solutions we need. By the same mechanism, financial learning, which contributed substantially to making renewables competitive with fossil fuel alternatives, will slow. Consequently, we can expect the cost of sustainable technologies to be higher in a high interest rate scenario — in addition to the direct financing effects.

6. Higher carbon prices needed

Finally, the higher costs of green technologies change the level of CO2 pricing needed to spur substitution away from polluting production methods. In a recent paper, it was shown that, in the presence of higher interest rates and merchant exposure of renewables, the optimal CO2 price is initially lower with a steeper price path in the future.

The intuition is simple: If renewables are costly, it makes sense to delay the massive shift to green technologies, because their costs decrease with deployment. Such a course of action puts the transition at serious risk. Precious time to build the interest coalitions for a transition and tip the political economy balance is lost. During this time fossil fuel profits remain high, strengthening the coalition that will oppose the necessary future increases in CO2 prices.

Central banks therefore must confront the fact that if they attempt to limit price increases by raising interest rates, they put renewable energy production and ‘green domino’ technologies at a disadvantage. Their actions will work against substitution away from fossil-based energy production. They will increase clean electricity prices for hard-to-decarbonise sectors, such as heavy industry and heavy transport.

Market neutrality?

Over recent years the concept of ‘market neutrality’ has been heavily debated in European monetary policy circles. Central banks have been criticised for passively mirroring corporate bond markets in their asset purchase programmes. While their approach has been ‘market neutral’ on the surface, critical voices have persuasively countered that the economic status quo is at odds with the Paris Agreement. Central banks have therefore propped up an unsustainable status quo. But the outlook is changing.

The Bank of England is now targeting a 25% reduction in the carbon intensity of its corporate bond portfolio. Last year, executive board member of the ECB Isabel Schnabel acknowledged the critique: “A transition from the market neutrality principle to the market efficiency principle would be an important step in acknowledging the presence of climate externalities”. The Swedish Riksbank applies a “norm-based negative screening”, which implies it only buys corporate bonds issued by companies deemed to comply with international standards and norms for sustainability.

There has therefore been a remarkable climate-oriented shift in the implementation of monetary policy targeted at long duration rates via asset purchases. Now the debate must also widen to monetary policy for short-term interest rates (that anchor the term structure). Central bankers must be transparent that raising interest rates will slow the green transition. There is no obvious market neutral position now, after decades of delayed green structural transformation.

Three potential policy solutions

So, what can be done to avoid green collateral damage from the policy response to rising prices? We suggest two policies that aim to offset the effect of rising interest rates. In addition, we believe it should be considered if higher interest rates should be reflexively used to address rising prices or if a more coordinated macroeconomic policy mix is warranted.

1. Fiscal policy shielding

The first potential solution is to use fiscal policy to shield the green transformation. This could be done by making debt servicing costs partly tax deductible for renewables, subsidising renewable electricity generation relative to interest rates or by subsidising the cost of electricity for decarbonisation purposes in the hard-to-abate sectors.

Such measures would protect the profitability of renewables against higher financing costs and preserve the availability of low cost of electricity for deep decarbonisation technologies. The downside is the fiscal cost and the distributional impact of subsidising the income of financial institutions.

2. Monetary policy shielding

The second option is to use the monetary policy toolkit to shield clean investment against interest rate hikes. This could be done by offering banks refinancing at preferential rates for financing clean investments in the real economy. This is a well-known tool of credit guidance that has helped the advanced economies to industrialise.

This form of credit guidance is already a core instrument of the ECB, which uses its Targeted Longer-Term Refinancing Operations (TLTROs) programme to provide cheap finance to banks that lend to non-financial corporations and households, as long as it is not for housing acquisitions. As of June 2021, the ECB had issued €2.2 trillion in this form of preferential refinancing. It has been suggested to use this tool in a focused way to support the green transition. Such Green TLTROs could be introduced before any base rate hikes to avoid green collateral damage. As Jens Van’t Klooster has advocated: “new TLTRO criteria should emphasize bolstering the economy against inflationary shocks and advancing a smooth green transition.” Most recently, also ECB President Christine Lagarde has stated she is “not giving up on” green lending facilities with reference to other central banks already considering or using green refinancing.

3. Macroeconomic policy rethink

The third option is less reliant on interest rates as the weapon of choice to manage business cycles and inflation. After all, interest rate management is a very blunt tool to tackle rising price indices that emanate from specific sectors. A recent study by the Bank for International Settlements finds “sector-specific price developments have become much more prominent in driving fluctuations in aggregate price indices.” Moreover, monetary policy rates only affect “a rather narrow set of prices, limiting the policy’s ability to steer inflation within tight ranges”. This suggests more targeted policies may be more appropriate when specific sub-sectors begin to drive aggregate price indices.

In addition to bluntness, the operation of monetary policy can be affected by opaque feedbacks from pricing. As we have focused on in this piece, the cost of financing can be a significant cost component in production. Raising interest rates could therefore lead corporations to raise prices to preserve their markups in a hiking cycle (as we expect them to do with rising wages and energy costs), which provides a perverse feedback signal to monetary policy makers who risk hiking into a financial crisis rather than a soft landing, as we saw in 2008.

At this moment, monetary policymakers are at the risk of causing stagflation because demand would need to fall substantially to lower the prices of energy, food, transport, housing, and semiconductors. If financial fragility leads to another major recession, investors may be less willing to embrace the risks of sustainable technologies (see point 4 above), as we saw after the great financial crisis. As we have laid out, even if interest rates are raised without creating a recession there may be substantial green collateral damage.

Crucially, an insufficiently strong push for decarbonisation today would maintain the economy exposed to the volatility of fossil fuel prices tomorrow — and thus more rounds of inflation in the future. It could be a pyrrhic victory.

Instead, a new macroeconomic consensus could shift more of the burden to fiscal policy and targeted solutions to the specific supply-side sources of inflation. This shift is already underway, following the inability of monetary policymakers to hit their inflation targets over the last decade. We are now at the risk of having too high interest rates if monetary policymakers attempt to control prices that are out of their reach, while other authorities believe central banks have the tools to get prices under control.

Conclusion

We have raised concerns about the future of renewable energy investment in the context of rising interest rates. The falling cost trajectories of sustainable technologies have become common knowledge, but it is under-appreciated to what extent these technologies rely on a low cost of capital.

In the age of global heating, raising interest rates is not a ‘market neutral’ monetary policy because it favours the less capital-intensive fossil-fuel based technologies. Moreover, the technologies we need to develop for decarbonisation of heavy industry and transport rely on the availability of both cheap, clean electricity and a low cost of finance.

The currently commencing hiking cycle therefore risks creating green collateral damage by slowing the very investments that we need to scale up. We suggest that green collateral damage could be avoided by using either fiscal or monetary policy instruments to subsidise production or use of electricity from renewable energy in tandem with rising interest rates.

A more comprehensive solution would be to continue the ongoing shift in macroeconomic policymaking by placing the primary burden of price stability on fiscal and regulatory authorities, while monetary policy authorities prioritise handling financial stability risks.

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