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The Role of Effective Capital Markets in Climate Protection and Energy Transition

Recent research looks into the importance of successful capital markets in climate protection and energy transition. 

Banking district in Frankfurt/Germany. Image Credit: Unsplash

This has an impact on investments in fossil-free steel facilities, power generation, and heating systems. The investigation by the Potsdam Institute for Climate Impact Research (PIK) and the Mercator Research Institute on Global Commons and Climate Change (MCC) has been published in the prestigious Journal of the Association of Environmental and Resource Economists (JAERE).

The study revealed that the current disparity between savings and lending rates, 5.1% points on average globally, leads to an additional 0.2 °C of global warming as compared to a frictionless economy with zero interest spread. In its model-based analysis, the research team envisions a climate policy based on the cost-benefit principle.

This means that the government would know the exact level of climate damage that increases over time, making CO2 emissions more expensive in proportion to the damage they cause, and would thus obtain a cost-optimal time path for increased carbon pricing. Alternatively, if the policy is based on a set temperature objective, the existing interest spread implies that a carbon price 27% higher than in a world without a credit cost premium is required.

Governments need to take a close look at whether the higher interest rate for loans merely reflects the actual intermediation costs or whether it is also a result of too little banking competition, for which there is some evidence. If the market structure is indeed the reason for the spread, and cannot be modified in the medium term, then policymakers can effectively counteract it in the short term by subsidizing investment.

Kai Lessmann, Study Lead Author, Potsdam Institute for Climate Impact Research

In this context, the study shows that if the government decides to provide economy-wide investment support, this is better for the climate and the economy than if eco-projects alone are subsidized.

Kai Lessmann adds, “The structural change toward fossil-free technologies then occurs automatically. These are generally more capital-intensive and thus benefit to a greater extent from reduced credit costs. Also, the carbon price, which increases over time, exerts its steering effect.”

The research team created a sophisticated computational model for the study and gave it empirical data.

We identify eight different channels through which the credit cost premium ultimately affects climate gas emissions. To be sure, there are also restraining effects—for example, high interest rates reduce the growth of economic output and thus also of energy consumption. But the climate-damaging impact predominates. For example, the credit cost premium increases the abatement costs per tonne of CO2, so that when oriented to the cost-benefit calculation, less climate protection is then practiced as a result.

Matthias Kalkuhl, Study Co-Author, Mercator Research Institute on Global Commons and Climate Change

The negative impact of high borrowing costs on climate protection, which is now more prominent than ever, is a major issue, particularly in the Global South. In many countries, annual capital costs as a proportion of the investment amount are in the double digits.

While many solar and wind power parks would be more profitable in the long run than gas or coal-fired power plants, they are not being built since the initial capital required per megawatt of installed capacity is more. Governments frequently lack the resources to react, so they must rely on assistance from the wealthy North.

Journal Reference

Lessmann, K. & Kalkuhl, M. (2023) Climate finance intermediation: interest spread effects in a climate policy model. Journal of the Association of Environmental and Resource Economists (JAERE).

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