A Guaranteed Win for the Climate: Sustainable Loan Guarantees and Sustainable Loan Guarantee Facilities

In order to limit global warming to the levels set in the Paris agreement, an immense amount of additional investment has to be directed into sustainable technologies – a difference of between $610 billion (IEA 2020) and $2 trillion (IRENA 2020) per year as compared to Stated Policies scenarios. With additional sustainable investment in technology, infrastructure, energy generation, buildings, agriculture, transportation, and industrial processes carbon emissions can be contained to meet the 2015 Paris goals.

Despite climate policies such as carbon prices and subsidies being slowly implemented, climate risks remain mispriced by financial markets and investment falls short of the needed targets. Currently, a carbon price covers only 21.5% of global greenhouse gas emissions and is likely to be woefully insufficient to deliver the required amount of sustainable investment [1] to avoid catastrophic climate change. There are several additional reasons why investment flows to the green sector are impeded; myopia by investors, lack of credibility in climate policy, lack of information and understanding of climate risks (Carney 2015, Koch et al. 2016; Fuss et al, 2018; NGFS 2020). Against this background, all aspects of climate policy and institutional scope, including central bank policies, need to be leveraged to achieve global environmental goals.

The COVID pandemic response introduced some novel policy instruments: loan guarantee programs backed by governments coupled with liquidity facilities provided by central banks. These instruments have the advantage to limit public debt issuance in a context of high levels of public debt. Since many existing sustainable supportive policy options are also potentially limited by the high levels of public debt, it is worthwhile to examine if the new instruments can be modified to reduce the sustainable financing costs in a tractable manner.

During the COVID pandemic, most countries, including, the United States, Germany, the United Kingdom, Switzerland, Belgium, and Australia, [2] put in place various types of government loan guarantees for a certain percentage of the nominal value of loans provided by banks to businesses and households. As the guarantees reduced default risk, these measures enabled banks to lend to counterparties at reduced rates and at higher volumes. Since, particularly during a crisis, liquidity risk is a major issue, several countries combined these loan guarantees with a central bank liquidity facility through which loans made under the guarantee scheme could be borrowed against for liquidity [3]. With some modifications, these COVID19 loan guarantee programs and central bank liquidity facilities can be repurposed as climate policy instruments that support the highly capital intensive renewable energy sector.

Sustainable Loan Guarantee Programs (SLGP) and Sustainable Loans Guarantee Program Facilities (SLGPF) can be set up in tandem by governments and central banks to make sustainable investments more attractive by reducing financing costs along two dimensions; (1) reducing the default premium on sustainable loans and (2) reducing the liquidity premium. A high liquidity premium can be a serious issue due to the large amounts of upfront capital necessary to set up green energy generation or other mitigation measures. Upfront investment in wind and PV farms make up over 80% of lifecycle investment whereas those of coal and gas are about 65% and 32% respectively (Nelson & Shrimali 2014; Helms et al. 2020).

Under a SLGP, the government would provide the guarantee to banks that it will cover a certain percentage of the nominal value of a loan in case of default, with the accrued interest, provided the loan meets sustainability criteria. For example, with a 90% sustainable loan guarantee, in the case of a default with a recovery rate of 50%, the government would pay the bank the difference between the recovery rate and the guarantee, i.e. 45% of the nominal loan value plus the accrued interest. Because of the government’s sustainable loan guarantee, banks can reduce the premium required to cover the probability of default and hence a component of the sustainable cost of capital can be reduced. Under the SLGPF, commercial banks would be allowed to borrow against the sustainable loans from the central bank, which would eliminate liquidity concerns and, thereby, the liquidity premium associated with the sustainable loans.

While similar adjustments to the cost of capital could be achieved with an investment subsidy program, the SLGP and SLGPF instruments are, theoretically, considerably less costly in terms of public expenditures and amount of additional public debt needed, as they leverage commercial bank and central bank funds: rather than paying for the entire investment subsidy, the government only pays in case of default, while under SLGPF the liquidity is provided by the central bank. Moreover, rather than governments having to painstakingly evaluate sustainable projects, banks can use their considerable know-how and infrastructure to pick valuable projects.

If something is too good to be true, it probably is and there are some obvious potential issues that one needs to consider from our description of the policy instruments thus far. How might it be possible to prevent excessive risk taking by banks who may issue riskier loans or not bother to attempt to recover parts of defaulted loans? Evidence from past loan guarantee programs has shown that in fact these issues do not present themselves in reality. These programs have actually reduced default rates and increased the sales and assets of affected firms.

As a precautionary measure there are three manners in which the program could be structured in order to incentivise financial institutions to perform due diligence in loan creation and not put an undue burden on government guarantees: lower default coverage, penalty-based incentives systems, and reward-based incentives systems. All three approaches would allow a government to adjust its involvement such that guarantee payments do not exceed some acceptable levels.

• Lower default coverage: Governments can attempt to optimise the default coverage of loans in order to maximise the loan creation-default rate ratio. Small reductions in the percentage of default coverage have been shown to reduce the default rate of guaranteed loans. However, the reduction of coverage could disincentivise banks to extend sustainable loans. A dynamic approach in which governments adjust the default coverage after evaluating the ratio of loan creation to defaults could help to find the optimal incentivising percentage.
• Penalty-based incentive system: Under a penalty-based incentive system financial institutions would be penalised for creating too many defaulting sustainable loans under the SLGP. The penalties could be applied in a dynamic way in that, as the guarantee payments increase, so would the penalties. Under a penalty system as a bank’s guarantee payments increase, its access to the SLGP/SLGPF is reduced. This can be expressed in a lower guarantee rate for future loans or haircuts for the amount of liquidity that they can obtain from the central bank.
• Reward-based incentive system: A reward-based incentive system would seek to reward financial institutions who are consistently able to keep a low level of defaulting sustainable loans and a high rate of loan recovery. Similar to the penalty-based system the reward system would be dynamic over time in order to continue offering incentives to well performing financial institutions. A reward-based system would provide incentives for better screening of projects by banks. In a pure reward-based system, the rewards would have to be large enough such that it is less profitable for banks to misbehave than to perform better, which would require a relatively low level of screening at the status quo. There are different channels through which rewards could be given. One is through the expansion of loan guarantees under the SLGP for high performing banks. Another can involve an expansion of access to liquidity with the SLGPF through which the central bank would allow for SLGP loans to be swapped at a higher ratio than 1 to 1 for central bank liquidity.

A prudent manner to address the potential of banks not performing due-diligence in their loan selection would be to attach both reward and penalties as incentives to the SLGP/SLGPF. If banks perform well, they receive more access to SLGP loans and conversely, if they are consistently underperforming, they receive restricted access to loan guarantees under the program. Note however that attaching incentive schemes to the policy might perhaps undermine the ultimate aim of sustainable loan guarantees, which is to increase sustainable investment and reduce the cost of sustainable capital.

Despite the possibility of riskier investments and higher defaults being taken on by banks, the program might initially increase the volume of sustainable loans and decrease the cost of sustainable capital, triggering a virtuous circle for the transition to a sustainable economy. A substantive initial investment in the development of green technologies, triggering an accumulation of knowledge about them on the part of financial institutions can pave the way for further investments. This increase in knowledge could further reduce the cost of sustainable capital and could potentially create positive feedback to drive up sustainable investment and push down the costs of sustainable capital in the medium term.

Given the urgency of the climate crisis, it might be time to take risks and compensate higher default rates on sustainable loans in the short term if it means long term gains in technology and knowledge capital. Additionally, such programs would lead financial institutions to leverage some of the debt-bearing capacity of sovereign nations, as the programs would link private and public sustainable debt. If a high initial default rate with a SLGP can become the catalyst of a virtuous cycle, this would be a small price to pay for an accelerated transition. The many advantages of a SLGP/SLGPF program combined with the large potential for mobilising sustainable investment makes it a worthy consideration for policy makers trying to tackle climate change.

 

References

Carney, M. (2015). Breaking the tragedy of the horizon–climate change and financial stability. Speech given at Lloyd’s of London, 29, 220-230. https://www.bis.org/review/r151009a.pdf.

IEA (2020). Energy Technology Perspectives 2020. IEA, Paris. https://www.iea.org/reports/energy-technology-perspectives-2020.

Fuss, S., Flachsland, C., Koch, N., Kornek, U., Knopf, B., & Edenhofer, O. (2018). A framework for assessing the performance of cap-and-trade systems: insights from the European Union emissions trading system. Review of Environmental Economics and Policy, 12(2), 220-241.

Helms, T., Salm, S., & Wüstenhagen, R. (2020). Investor-specific cost of capital and renewable energy investment decisions. Renewable Energy Finance: Funding the Future of Energy, 85-111.

IRENA (2020). Global Renewables Outlook: Energy transformation 2050. International renewable Energy Agency, Abu Dhabi. ISBN 978-92-9260-238- . https://www.irena.org/publications/2020/Apr/Global-Renewables-Outlook-2020.

Koch, N., Grosjean, G., Fuss, S., & Edenhofer, O. (2016). Politics matters: Regulatory events as catalysts for price formation under cap-and-trade. Journal of Environmental Economics and Management, 78, 121-139. https://www.sciencedirect.com/science/article/abs/pii/S0095069616300031.

Lion, H., Steckel, J.C. (2016). The role of capital costs in decarbonizing the electricity sector. Environmental Research Letters, 11(11):114010. https://iopscience.iop.org/article/10.1088/1748-9326/11/11/114010.

Nelson, D., Shrimali, G. (2014). Finance mechanisms for lowering the cost of renewable energy in rapidly developing countries. Climate Policy Initiative. https://climatepolicyinitiative.org/wp-content/uploads/2014/01/Finance-Mechanisms-for-Lowering-the-Cost-of-Clean-Energy-in-Rapidly-Developing-Countries.pdf.

NGFS (2020), Overview of Environmental Risk Analysis by Financial Institutions. NGFS Technical Document, September 2020. https://www.ngfs.net/sites/default/files/medias/documents/overview_of_environmental_risk_analysis_by_financial_institutions.pdf.

Best, R., (2017). Switching towards coal or renewable energy? the effects of financial capital on energy transitions. Energy Economics, 63:75-83. https://www.sciencedirect.com/science/article/pii/S0140988317300294.

Yanovski, B., Lessmann, K., (2021) Financing the Fossil Fuel Phase-Out. Available at SSRN: https://ssrn.com/abstract=3903026 or http://dx.doi.org/10.2139/ssrn.3903026.

 

 

[1] See the World Bank’s global carbon price tracker – https://carbonpricingdashboard.worldbank.org/.

[2] For a full list of countries who instituted loan guarantee programs during COVID we would invite you to visit the IMF’s policy response to COVID19 tracker – https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#S.

[3] Notable examples of central bank facilities that supported federal loan guarantee or debt forgiveness programs are Switzerland’s SNB COVID-19 refinancing facility and the United State’s Paycheck Protection Program Liquidity Facility.