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Central banking and the energy transition

Continuous renewable energy deployment may be less certain than previously thought. If interest rates rise, the cost of renewable energy is disproportionately affected compared to fossil fuel alternatives. Thermostatic policies can help ensuring renewable energy deployment in such environments.

Image above: Continuous deployment of wind farms may be less certain than previously thought. Aerial take from a wind farm. Photo by Thomas Richter on Unsplash

Unfortunately, no rooftop bar in Singapore and no conference dinner in the foothills of Tuscany mark the beginning of this research project. Instead, the development of this paper demonstrates the gradual nature of research. Over the last two years, we spent an awful lot of time discussing the role of finance in the energy transition as part of the EU Horizon 2020 research project INNOPATHS. We met with investors to try to understand their behaviour, we interviewed policymakers to figure out what their intentions and constraints were in designing policy and we collaborated with academics to find out what exactly we already know about the enabling role of finance in energy transitions.

In this process, we discovered the pivotal role of experience in the financial sector, which led to a paper in Nature Energy (free read-only) demonstrating that decreasing financing costs contributed a large share to making renewable energy cost competitive with fossil fuel alternatives. In fact we discovered not only the importance of experience, but even more so the decisive role that general interest rates play in determining the competitiveness of renewable energy. Our analysis showed that lower general interest rates decreased the levelised cost of electricity (LCOE) by 4% to 20% for utility-scale German solar photovoltaics and onshore wind respectively between the period of 2000-2005 and 2017. Soon we asked ourselves; to what extent does large-scale renewable energy deployment depend on extremely expansive monetary policy as we have seen it in the aftermath of the 2008/09 financial crisis?

So we set off to find out. In a new paper in Nature Sustainability (free read-only), we looked at the same two technologies, onshore wind and solar PV, in Germany and developed three scenarios. A flat scenario, where interest rates stay at the current record-low levels. A moderate scenario, where interest rates recover with the same speed as they declined after the financial crisis. And an extreme scenario, where interest rates rise to pre-crisis levels at twice the speed they declined before. In the extreme scenario, LCOEs for the two technologies increase by 11% (solar photovoltaics) and 25% (onshore wind) over just five years (2018 to 2023). Even in the moderate scenario, the higher financing costs outweigh the expected decreases of hardware cost for onshore wind (LCOE +9%) and almost entirely eat up these technology cost reductions due to learning (LCOE -2%) for solar photovoltaics. As a result, we show that adding new renewable energy capacity becomes economically unviable compared to hard coal power plants takes a severe hit if interest rates rise again.

In light of the recent EU decision to scrap binding renewable energy deployment targets for member states these results may announce difficult times for renewable electricity deployment and hence climate targets. However, one may ask, are these scenarios realistic? The temptation is to respond with a sounding no. Just this month, the European Central Bank confirmed record-low interest rates, its president Mario Draghi openly speaks of evaluating new ideas, such as venturing more into fiscal domains using the Modern Monetary Theory, and there is an ongoing debate about expanding the toolkit of central banks to provide cheap liquidity. In the United States, the central bank acted differently: it steadily increased interest rates since December 2015, until it changed course in August 2019 and lowered the interest rate twice. Some commentators see more structural factors (e.g., aging population, low immigration, few investment opportunities) behind the ongoing struggle to unleash economic growth and judge expansionary monetary policy as the wrong remedy for the curse. Proponents of the secular stagnation, like Larry Summers, would favour rising interest rates in combination with rising government spending in education and infrastructure and potentially more liberal immigration laws.

Image 2: The decision hub for European monetary policy – and renewable energy policy too? Night shot of the European Central Bank’s headquarters in Frankfurt. Photo by Paul Fiedler on Unsplash

In sum, the discussions around appropriate monetary policy and hence future interest rate levels are far from being resolved. While interest rates currently remain low in the European context, it is far from certain that this will be the case in the future too. Consequently, climate policy and renewable energy policy in particular need to keep an eye on interest rate developments. Ideally, thermostatic policies would be in place that automatically adjust given the current interest rate environment. In the short run, renewable energy auctions fulfil this criteria and counter potential cost hits on renewables due to interest rate increases. In the longer run however, a transition away from renewable specific support policies seems likely. In such a case, existing emission trading schemes, such as the EU or the Californian ETS, could be equipped with a price floor to ensure renewable energy deployment even in high interest rates environments.

Unfortunately, even countries such as Germany, which used to be known for progressive renewable energy policies, remain rather far from this ideal. For example, to reach its Paris target, Germany would need to install about 5 new wind turbines a day, but only connected 35 to the grid so far this year. A natural next step for research would hence be to investigate, how significant interest groups can be formed to support thermostatic policies and how these policies can be designed in order to survive government changes after elections. Comparing the results of our paper with reality, we circle back to the start and find the next exciting research question… Perhaps we should have a kick-off meeting at a fancy place this time!

Originally published on the Nature Sustainability Research Community page, Wednesday 25th September 2019.

Adverse effects of rising interest rates on sustainable energy transitions

Increasing the use of renewable energy (RE) is a key enabler of sustainable energy transitions. While the costs of RE have substantially declined in the past, here we show that rising interest rates (IRs) can reverse the trend of decreasing RE costs, particularly in Europe with its historically low IRs. In Germany, IRs recovering to pre-financial crisis levels in 5 years could add 11% and 25% to the levelized cost of electricity for solar photovoltaics and onshore wind, respectively, with financing costs accounting for about one-third of total levelized cost of electricity. As fossil-fuel-based electricity costs are much less and potentially even negatively affected by rising IRs, the viability of RE investments would be markedly deteriorated. On the basis of these findings, we argue that rising IRs could jeopardize the sustainable energy transition and we propose a self-adjusting thermostatic policy strategy to safeguard against rising IRs.

Written by Tobias S. Schmidt, Bjarne Steffen, Florian Egli, Michael Pahle, Oliver Tietjen & Ottmar Edenhofer

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Two main ingredients for a successful energy transition? A diverse financial system and the right policies

The discussion and action points for moving to an almost carbon-free energy supply have shifted from developing technologies towards a question of how to most effectively and efficiently implement the energy transition without compromising economic development and well-being [1,2]. Transforming our energy systems into more decentralized and renewable energy sources will require a vast deployment of innovations and, accordingly, huge investment. Estimates for the total investment begin at about USD 700 billion, which amounts to a mere 1% of global GDP [3]. There are two key levers to accomplish this task that are cited in almost every publication and report since the early 2000s. These are the use of private financial resources, and an appropriate policy framework. There has been a lively debate about what enabling elements are required for these elements to drive the transition and “shift the trillions” [4].

Financing energy technology innovation – the need for diversity

There is no doubt that the financial sector could, in principle, finance the transition. The financial system gives direction to the development of the real economy. Its traditional role is to mobilize and transform savings into productive investments. However over the last 20 years, driven by consolidation, the race for efficiency and deregulation and financial markets lost a lot of the diversity that is needed to finance innovation (see Figure 1). Many markets are dominated by just a few banks and institutional investors, which have been severely affected by the 2010 financial and subsequent regulation, driving a lot of risk carrying capacity out of banking and insurance markets, which turn provide financing risk-capital such as venture capitalists. The focus of the ecosystem for financing towards debt and later stages of the innovation cycle creates a bias towards calculable risks and, importantly, the maintenance and expansion of the existing capital stock in existing firms rather than new ventures. New forms of alternative finance innovations (such as crowdfunding or community-based credit unions) that could provide the necessary investments might be able to fill this gap, but their volumes are still (too) small. A very important ‘side-effect’ of increasing the diversity of players in financial markets is that the system as a whole becomes more resilient against shocks. Many different players with many different decision heuristics are less prone to making the same errors (Polzin et al. 2017).

Figure 1: Financial instruments to finance clean energy innovation (Source: Polzin et al. 2017)

Policy framework – clear directions and a choice of instruments

Given the current financial landscape we see two main strands of policy interventions to increase both attractiveness of low-carbon energy technologies and the diversity of sources of finance that can be mobilised.

First, innovation policy such as grants for R&D, demonstration support, risk-sharing facilities, tax-credits or Feed-in Tariffs will attract the necessary early-stage investments for future generations of technologies needed for an energy transition (for example organic batteries or power to gas). To overcome the so-called ‘valley of death’ in the innovation chain, public loans or loan guarantees might be suitable, but the risk of over-funding rapidly growing firms should be taken into account. Governments could also invest directly to create a technology ‘track-record’, important for investors [5]. In the later stages of innovation, especially for renewable energy, depending on the design features, portfolio standards or recently popular capacity auctions, prove effective tools. All these efforts should be embedded in a clear and long-term policy strategy consistent with the commitments of the Paris Agreement to be credible to investors. Consistency, stringency and predictability to reduce deep uncertainty and policy risk are deemed especially crucial.

Second, equally important for achieving a mostly privately-financed energy transition are appropriate financial market conditions and regulations [3]. Unprecedented monetary policies in the Eurozone (Quantitative Easing) have driven the cost of debt finance to zero or below and flooded financial markets with cheap debt finance. Still, only very little of that monetary expansion finds its way into the real economy, let alone into clean energy. Framework conditions for either debt or equity-based instruments influence their contribution to a clean energy transition, as a developed capital market is needed to channel resources. In this regard, a fiscal preferential treatment of debt finance, which is widespread today, should be avoided. Typically, interest is deductable as costs, while dividend payments only occur after tax. Policy makers should try to level the playing field across sources of finance. Furthermore capital market regulation shapes investment mandates and risk models and thus ultimately determines the feasibility and viability of investments into clean energy. Regulation (for example Basel III, Solvency II), especially since the financial crisis, is almost exclusively geared towards stability and security. Hence institutional investors and their intermediaries are forced to stay away from risky asset classes such as venture capital. A no-regret solution would be to require financial intermediaries to lower their overall leverage ratio (debt to equity) and operate with more equity. With more ‘skin in the game’, banks and institutional investors can responsibly handle more risk and uncertainty on their balance sheets. New alternative finance such as equity and debt-based crowdfunding are also becoming more regulated in many countries. Regulators should abstain from clamping down on them, for example through a regulatory sandbox.

In sum, to effectively and efficiently mobilise private finance for innovation and diffusion of low-carbon energy technologies, it is paramount to increase diversity of financial sources available in the market and also, next to an adequate innovation policy, adjust financial market regulations and conditions. The INNOPATHS finance workstream, consisting of ETH Zurich, PIK, Allianz Climate Solutions and Utrecht University will further explore the dynamics finance-energy (innovation)-policy dynamics [see for example 5,6].

Resources:

[1] Mazzucato, M., Semieniuk, G., 2018. Financing renewable energy: Who is financing what and why it matters. Technol. Forecast. Soc. Change. 127, 8-22. https://doi.org/10.1016/j.techfore.2017.05.021

[2] Polzin, F., 2017. Mobilizing private finance for low-carbon innovation – A systematic review of barriers and solutions. Renew. Sustain. Energy Rev. https://doi.org/10.1016/j.rser.2017.04.007

[3] Polzin, F., Sanders, M., Täube, F., 2017. A diverse and resilient financial system for investments in the energy transition. Curr. Opin. Environ. Sustain. 28, 24–32. https://doi.org/10.1016/j.cosust.2017.07.004

[4] Germanwatch, 2017. Shifting the Trillions – The Role of the G20 in Making Financial Flows Consistent with Global Long-Term Climate Goals. https://germanwatch.org/en/13482

[5] Geddes, A., Schmidt, T.S., Steffen, B., 2018. The multiple roles of state investment banks in low-carbon energy finance: an analysis of Australia, the UK and Germany. Energy Policy 115, 158–170. https://doi.org/10.1016/j.enpol.2018.01.009

[6] Steffen, B., 2018. The importance of project finance for renewable energy projects. Energy Econ. 69, 280–294. https://doi.org/10.1016/j.eneco.2017.11.006

Latest papers published by INNOPATHS

INNOPATHS is a four year EU funded research project that aims to work with key economic and societal actors to generate new, state-of-the-art low-carbon pathways for the European Union. Below is a round-up of the latest research to come from INNOPATHS.

Anadón, L.D., Baker, E., Bosetti, V. (2017) Integrating uncertainty into public energy research and development decisions, Nature 2, Article number: 17071 Free access

Geddes, A., Schmidt, T., Steffen, B. (2018) The multiple roles of state investment banks in low-carbon energy finance: An analysis of Australia, the UK and Germany, Energy Policy 115, 158–170 Free access

Steffen, B. (2018). The importance of project finance for renewable energy projects, Energy Economics 69, 280-294 post-print manuscript

Verdolini, E, Anadon, LD, Baker, ED, Bosetti, V, Reis, L. (2018) The future of energy technologies: an overview of expert elicitations.’ Review of Environmental Economics and Policy Free access

The multiple roles of state investment banks in low-carbon energy finance: An analysis of Australia, the UK and Germany

Low-carbon energy technologies (renewable energy and energy efficiency) are considered essential to achieve climate change mitigation goals, so a rapid deployment is needed. However there is a significant financing gap and many policymakers are concerned that investment for the large-scale deployment of low-carbon technologies will not materialise quickly enough. State investment banks (SIBs) can play a key role in closing this finance gap and leverage additional private finance. Based on 52 interviews, this paper presents empirical evidence on the role of three SIBs in addressing the barriers to financing low-carbon energy projects; the Clean Energy Finance Corporation (CEFC) in Australia, the Kreditanstalt fuer Wiederaufbau (KfW) in Germany and the Green Investment Bank (GIB) in the UK. We investigate the activities and financial instruments offered by SIBs and compare these to the need for such from low-carbon developers when sourcing finance. Findings show that aside from capital provision and de-risking, SIBs take a much broader role in catalysing private investments into low-carbon investments, including enabling financial sector learning, creating trust for projects and taking a first or early mover role to help projects gain a track record.

Written by Anna Geddes, Tobias S. Schmidt and Bjarne Steffen

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INNOPATHS workshop on the ‘Dynamics of low-carbon energy finance’

On 21 September, Utrecht University School of Economics (U.S.E.) hosted the workshop “Dynamics of low-carbon energy finance” as part of the EU commission sponsored Horizon 2020 project INNOPATHS.

In three consecutive sessions, 18 participants from the financial sector, international organisations and academia discussed the financial implications of a low-carbon transition of the European Economy until 2050.

Future energy scenarios and corresponding technology mixes have differential implications for the sources of finance. Especially energy efficiency projects pose challenges to banks and other institutional investors. But also renewable power projects still face technology operation risks and political risks. In addition to debt-providers, the energy transition requires risk-bearing capacity. In this regard state investment banks that prove the investment case are crucial for financing innovative energy technologies.

Read the summary here