Here’s how a lower interest rate for green investments could work.
European leaders are once again showing innovative sustainability thinking by considering special lower interest rates for green investments. Many sustainability proponents say the step could be a model for governments and central banks around the world looking for ways to accelerate the green economic transition.
The European Central Bank (ECB) has been resisting calls for a “dual interest rate” for green lending. But French president Emmanuel Macron endorsed the concept at COP28. And now the central bank seems to be considering it.
Major central banks already use different interest rates for different purposes, such as the Federal Reserve’s discount rate, and federal funds rate. So advocates have called on the ECB to lower rates for green projects such as financing greener homes.
ECB executive board members Isabel Schnabel and Frank Elderson have spoken in favor of dual rates. Schnabel said the ECB should “intensify efforts to green our lending operations,” although Elderson has cautioned that a lack of data to validate green labels would make this too difficult for the central bank for now.
Still, some think it’s possible that the ECB could introduce green interest rates as soon as the summer.
“Now that we are also having inflation decreasing in Europe, I think it will give more openness and leeway to the European Central Bank to adopt such a type of policy,” said Maud Abdelli, who leads the World Wildlife Fund’s greening financial regulation initiative.
What’s a dual interest rate?
Central banks encourage economic growth by offering loans at relatively low “funds rates.” Non-government banks pass down those funds to borrowers. When the central bank wants to stimulate growth, it will lower rates, making it less expensive to borrow money. When there’s too much growth, i.e., high inflation, central banks will raise rates, increasing the cost of borrowed money.
Central banks can offer lower rates to encourage banks to lend more to specific sectors. A “green interest rate” would offer loans at a lower interest rate for green projects than other types of lending.
A “green interest rate” would offer loans at a lower interest rate for green projects than other types of lending.
In times of higher interest-rates such as the past two years, these lower rates would encourage more investment in renewable energy projects, which often have high upfront costs. Legacy industries such as utilities, banks and others historically have favored investments in the existing fossil fuel-based infrastructure, especially since many believe that it’s less expensive. However, multiple studies have found that renewable energy generally is now less expensive, and pays for itself over time.
The current high cost of borrowing is one reason why advocates are calling for dual interest rates, said Sayuri Shirai, a visiting fellow and advisor at the Asian Development Bank and former policy board member at the Bank of Japan (BoJ).
“The interest is so high, a lot of companies are not doing well, so they stopped doing renewable energy supply projects.”
Some economists have worried about the inflationary effects of dual interest rates, others say it could help combat inflation.
“It can be used by each and every central bank because it’s really a way to fight inflation,” said Abdelli. This is especially true in the case of renewable energy, she said, since fossil fuels can sharply increase inflation. Russia’s invasion of Ukraine, for example, spiked oil and gas prices and global inflation. Economists say that increased renewable energy investment would reduce dependence on fossil fuels and cut inflation.
Lower interest rates would need to be paired with clear regulations to limit greenwashing, said Lydia Prieg, head of economics at the New Economics Foundation. “We don’t want to be offering low rates of interest to people who aren’t actually greening the economy or might even be doing harmful activities.”
Because the EU is still working out its green investment taxonomy, Prieg expects that the ECB will release a pilot program before offering a lower green interest rate more broadly.
Something old, and something new
Dual interest rates designed to support specific policies would be new in some parts of the world – but not in a growing number of countries. The EU, UK, U.S. and Japan have all used dual interest rates to encourage specific kinds of projects. In fact, Japan’s central bank offers a lower rate for green energy projects so if the ECB adopts a program it wouldn’t be the first. After the financial crisis, the ECB offered lower interest rates to banks under the targeted longer-term refinancing operations (TLTRO) while the BoJ’s green lending program provides zero interest loans to lenders supporting renewable energy projects.
“The mechanism is there in the EU and the UK, it just hasn’t been used specifically for green purposes,” said Prieg.
But these programs are not without controversy. The BoJ’s lending program has come under scrutiny because it includes fossil fuel companies in its bonds. The Japanese government plans to include controversial tech such as carbon capture, green hydrogen and ammonia in its green bond issuance initiative. Because the BoJ follows government policy, some of this controversial tech is also reflected in the central bank’s green lending program.
“The Bank of Japan’s intention is good but the impact is very limited,” said Shirai. Ultimately, they are just following the policies that the government has put in place.
Central banks that want to implement lower interest rates for green projects need to make sure they not only have the mandate to do so, but that they have the right tools in place, she said.
Central banks need to know which projects are green and which are carbon-intensive, but “they don’t have the authority” to decide that; governments do.
One issue with the BoJ program, for example, is that Japan does not have a green taxonomy so the central bank has no framework to base projects on. Meanwhile, while lending is supposed to only go to companies that use the Task Force on Climate-related Financial Disclosures recommendations, the standards are not required by the Tokyo Stock Exchange, Shirai said, resulting in a lack of consistency.
Central banks need to know which projects are green and which are carbon-intensive, but “they don’t have the authority” to decide that; governments do, she said.
“That kind of lending should be done by the government because the government can also provide subsidies and do the guarantee for the bank loans… If central banks do it, [it’s] very politically challenging,” she said.
Others say dual interest rates can actually save governments money, especially in the EU and UK. Instead of governments providing subsidies or direct investments to help with the transition to a green economy, lowering the borrowing rate of banks encourages private funding of green projects.
“One of the big appeals politically of this dual rates approach is it allows the state or Europe as a whole to support green investments,” Prieg said, “but without actually spending treasury or government money.”
