Interest rates and green investment

Good morning from New Economy Brief.

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The Bank of England's Monetary Policy Committee is set to raise interest rates again tomorrow. 

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This risks limiting private sector investment and pose a political problem for a government wanting to ‘ramp up’ capital investment to grow the green economy.

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But what if the Bank had a lower interest rate for green projects (as they do in Japan)? Read on for an explanation of how green credit guidance - a policy solution championed by the Monetary Policy Committee’s newest member, Megan Greene - can keep finance flowing towards net zero.

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Raising interest rates harms the economy in various ways…Markets are pricing in further interest rate hikes before the Bank of England’s Monetary Policy Committee meeting tomorrow, as the UK’s persistently high inflation rate is expected to stay higher than comparable economies, for much longer than expected. Media commentary is focusing on the negative impact of higher interest rates on people trying to repay their mortgages and on the higher costs of government borrowing, but less attention is being paid to another consequence of rising interest rates; the impact on business investment. How will the UK meet its legally-binding Net Zero targets, when financing the investments needed for the green transition are becoming more expensive?

• …but green investment will particularly suffer.  Achieving an environmentally sustainable and Net Zero economy requires a significant increase in investment in green technologies and sectors. Unfortunately, the UK has an absolutely dire recent record on investment, both public and private. As new research from the Institute for Public Policy Research explains, the UK is at the bottom of the G7 league table for business investment. If the UK had invested at G7 average levels from 2006-2021, an extra £562.7 billion in public and private money would have been invested in our economy. Higher interest rates will be particularly detrimental for investments in the green transition, given that those projects, while generating operational savings over a longer term, typically have high upfront capital costs.
• Is monetary tightening self-defeating? Higher interest rates will be particularly detrimental for investments in the green transition, given that those projects, while generating operational savings over a longer term, typically have high upfront capital costs. The irony of this is that the Bank’s aims of price stability are being further hindered by its own blunt tool of monetary tightening. Green investment can reduce the exposure of the UK economy to future bouts of ‘fossilflation’ - inflation that was primarily caused by fossil fuel-related energy price shocks - e.g. by providing more lending for building retrofits and clean energy projects. Further, green investments will also protect longer term financial stability from climate-related risks, but it is green investment that will suffer the most from higher interest rates.
• How will the government fill the green finance gap? The UK government’s Net Zero Strategy outlines their plan to meet their legal emission reduction targets. It estimates that additional capital investment must grow to “an average of £50-60bn per year through the late 2020s and 2030s”, which the Climate Change Committee (CCC) assesses is “an ambitious, credible path for UK decarbonisation…in line with the Paris agreement”. (Keep an eye out for the CCC’s latest analysis of the government’s progress on Net Zero report, due out next week...watch this space!). Higher borrowing costs then pose a political problem for the Conservatives and Labour Party, both of which have emphasised the importance of ramping up private sector finance to stimulate green investment.

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Is green credit guidance the answer? One proposal for making green investments cheaper is to have a lower interest rate for borrowing for low-carbon projects. The policy has been championed by the newest member of the Monetary Policy Committee, Megan Greene. This ‘dual interest policy’ is part of a wider framework called ‘green credit guidance’. 

• How it works. Monetary policy can ‘shield’ green investments from interest rate hikes by offering banks refinancing at preferential rates for financing clean investments in the real economy. Interestingly, offering lower costs of credit played an important role in supporting economic and industrial policy during the 1945 – 1973 ​‘golden age’ in the West, and more recently in aiding the rapid development of East Asian countries. 
• The experience of other countries. Green Central Banking’s David Clarke has covered how the Bank of Japan (BoJ) have been “providing zero-interest financing to lenders supporting action to address climate change” since early 2022. The BoJ’s governor justified taking action on climate by arguing that doing so falls within the BoJ’s price stability and financial stability mandates. Christine Lagarde has also put green credit guidance as one of her top priorities for her presidency of the European Central Bank.

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Implementing a dual interest rate policy in the Bank of England. The New Economics Foundation’s (NEF) Frank van Lerven and Lukasz Krebel have proposed that the UK could adopt such a scheme by repurposing the Bank of England’s Term Funding Scheme (TFS) - which currently providers cheaper credit to businesses and households - to provide cheaper credit to banks to lend for sustainable investments. This would keep interest rates lower for green investments. (The question of which investments qualify for the lower interest rate, and how to determine if they are actually sustainable, will be explored in a future Digest.)

• How it works. The authors illustrate how the policy would work in practice with accelerating investment in building retrofits: “The interest rates for the TFS green credit lines to banks could be set at 0%, or in all cases below the Bank rate, to ensure lower costs of green credit. The refinancing rate could be made negative (echoing the European Central Bank (ECB) on the condition that commercial lenders pass on a minimum predefined rate discount to retrofit borrowers – for example, by offering loans to households and businesses at 0% interest.” (Watch their video explainer.)

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A holistic strategy for green finance and decarbonisation. Whilst more interventionist credit policies would be particularly useful for political parties looking to stimulate private finance as a way to fill the green investment gap in the UK and ‘ramp up’ spending on Net Zero without using public money, economists have warned that “fiscal policy must lead the way on the green transition” and green credit guidance should be not be seen as a ‘silver bullet’, but part of a holistic strategy of discouraging ‘dirty’ investments as well as ramping up both public and private green finance. 

• The importance of public investment,… The scale of the funding gap in addressing the environmental emergency has led many to suggest that private finance alone is not enough, and that public finance is particularly important. Indeed, public investment can play a crucial role by directly investing in critical projects that the private sector is reluctant to support, as well as those that are socially important but do not generate high returns. Furthermore, many economists have argued that direct public investment can help to ‘crowd in’ private investment into strategically vital areas. A principally market-coordinated transition that is overly reliant on private finance also risks normalising extractive behaviours in the green economy, such as profiteering and greenwashing. (Read our previous Digest explaining the risks of relying on private finance to decarbonise the economy.) Common Wealth’s Melanie Brusseler explains that publicly-led coordination is necessary for a timely and effective transition. She argues that “Market coordination—premised on private investment and profitability—cannot effectively deliver this in line with climate targets and economic functioning” and that “building institutions to coordinate the transition should be Labour's first term focus”. NEF have argued that the UK’s state-owned financial institutions (such as the British Business Bank, UK export finance and the CDC group) should also be given Net Zero mandates to redirect their ~£7bn annual investments and scale them up to help grow the green economy.
• …industrial strategy,... The experience of green credit guidance policy in France and Japan showed that it worked best when the state made clear policy directions through a solid industrial strategy, giving the private sector more certainty to make the necessary investments. Economists Katie Kedward, Josh Ryan-Collins and Daniela Gabor explain how an ‘allocative green credit policy’ regime can be organised around green industrial policy objectives and democratically agreed green ‘missions’. 
• …and discouraging dirty investment. Penalising loans that promote high carbon activity and phasing out investments in fossil fuels will also be important for meeting the UK’s climate targets. A key part of the green finance equation is ending government support for fossil fuels, e.g. through tax relief for oil producers in the North Sea. This week, the Labour Party released a briefing outlining how it plans to ‘make Britain a clean energy superpower’, including a pledge to ban future licences for oil and gas exploration.