How Could We Finance Low-Carbon Investments in Europe?
This year, Europe is confronted with a critical double challenge: addressing the climate change issue and pulling itself out of a persistent low growth trap. Today these two challenges are addressed separately. We propose to make private low-carbon assets eligible for the ECB asset purchase program.
Par Michel Aglietta, Etienne Espagne, Vincent Aussilloux, Baptiste Perrissin-Fabert
Billet du 22 octobre 2015
This article is part of a special series discussing the economic dimensions of environmental issues ahead of the - COP 21 Climate change Conference held in Paris on 30 November-11 December 2015. Read more about it here.
Head of the Economics and Finance department at France Stratégie, a public think tank advising the French Prime Minister. Previously, he was member of the private office of the French Minister for External Trade. He worked five years in the office of the chief economist of the Directorate General for External Trade of the European Commission. Between January 2009 and December 2011, Vincent was seconded to the UK Department for Business, Innovation and Skills, where he was in charge of economic analysis for various trade policies and European issues. From 1998 to 2004, he also worked for the French Treasury, mainly on international issues. Vincent holds a PhD in economics from the University of Montpellier and published in various scientific journals on international economic issues.
A climate economist at the French Ministry of the Environment, working on topics related to climate finance since the beginning of his PhD thesis, defended at the CIRED laboratory in 2014. Also a graduate of the École Normale Supérieure de Cachan and the French École des Ponts-et-Chaussées, he has published extensively in academic journals in the field of climate change economics.
Europe is currently confronted with two critical challenges: addressing the issue of climate change, and escaping from a persistent low growth trap. These two challenges are more urgent today than they ever have been, but they are being addressed separately. On the one hand, climate negotiations must reach a historical agreement at the Paris Conference in December 2015. On the other hand, the Juncker Plan and a massive asset purchase by the ECB have been put in motion to avoid a deflationary spiral and stimulate new investment.
In climate policy matters, the European position has been to rely mainly on setting a price for carbon. So far, this has been dramatically ineffective at encouraging low carbon investments. It has also meant that the potential power of the banking and savings channels (the targets of the ECB asset purchase program) has been neglected entirely.
We suggest giving private low-carbon assets preferential eligibility to the ECB asset purchase program. The carbon impact of these assets would benefit from a public guarantee based on a politically agreed upon value of the carbon externality. This would compensate for the temporary lack of an adequate price on carbon. This mechanism would immediately trigger additional private investments with a direct and positive effect on growth.
The Difficulties of Pricing Carbon
Judging from current climate policies, it is obvious that carbon pricing faces major political difficulties. Theoretically, a carbon tax or an emission trading scheme are the best instruments to price carbon efficiently. Adjusted at their optimal level, they minimize the cost of global efforts by setting the same marginal cost of abatement across sectors.
In practice, by affecting the returns of past investments and existing stock of capital, carbon pricing directly erodes the value of installed capital and stifles current patterns of consumption. This generates a financial transfer from the owners of carbon intensive capital to those who own or invest in low-carbon capital, as well as additional costs for households and businesses. This is why the “losers” of the transition are currently fighting tooth and nail to avoid paying the microeconomic cost of carbon pricing.
These short-term distributive effects, which elected governments lack the power to solve, explain in part the social opposition to carbon pricing instruments. Additionally, while compensation through lump-sum transfers is theoretically possible, it has proven very difficult to implement.This does not mean that carbon pricing initiatives should be abandoned. On the contrary, innovative efforts to adequately price carbon must be pursued further, until the political circumstances improve and the price can be significantly increased.
Bridging Short-Term Constraints and Longer-Term Objectives
Instead of relying solely on a “penalty” mechanism (carbon tax or emission quotas), a mechanism rewarding low-carbon investment while gradually penalizing carbon intensive capital should be more politically acceptable, and would mitigate the cost of the low carbon transition. It combines pricing instruments such as taxes/quotas, fixed at low levels during a transition period – but set to increase– with funding instruments incorporating a public guarantee based on a high value of the carbon externality (social cost of carbon – SCC). The valuation of carbon has to be set high enough to trigger new waves of low-carbon investments. The impact of existing carbon prices on the returns of low-carbon projects is not large enough to meet the gap between private and social returns on such projects
The particularly capital-intensive profile of these projects increases their relative investment risks. Risk-adjusted returns may therefore appear too low to investors and restrict access to credit. Such a financial barrier justifies the use of specific tools to support low-carbon investments by integrating the social value of CO2 abatement when calculating the overall risk-adjusted returns.
This strategy provides a pragmatic combination between theoretical first-best instruments, calibrated at (temporary) sub-optimal levels, with financing instruments aimed at immediately stimulating low-carbon investments. In other terms, we suggest building a financial intermediate better suited for low-carbon investments (EPE-CIRED, 2014).
An Instrument to Fund the Transition
Figure 1: A financial Intermediation Mechanism Backed by a Carbon Value
Defining the Social Cost of Carbon (SCC)
The SCC is neither a market price, nor a carbon tax incorporated in the prices of goods. It is a notional price defined as the social value of avoided CO2 emissions. Available estimates of the SCC cover a wide range of values, depending on assumptions made regarding key socio-economic parameters (Espagne et al. 2012; Pottier et al., 2015). This is why the SCC ultimately rests on a political decision by governments.
Defining an Amount of Carbon Assets Backed by a Public Guarantee
The government commits to guaranteeing the value of carbon assets at the level of the SCC for a given period of time and a given amount of carbon assets, consistent with its domestic contribution to the global emission reductions. This value is renegotiated upwards (as forecasted by most models) at the end of the commitment period. The key element here lies in the predictability of the signal on the value of avoided CO2 emissions.
Certifying Emission Reductions
An independent body would be in charge of monitoring low-carbon projects. It would define a typology of such projects as well as methodologies for appraising emission reductions according to the technologies, sectors, and time horizons of each project. Private entities would receive carbon certificates attached to each project type based on their realized emission reductions. These certificates are the material medium of carbon assets created by the proposal.
Turning Carbon Certificates into Eligible Carbon Assets
The European Central Bank announces that it is ready to refinance low carbon loans delivered by commercial and development banks up to the value of the effective emission reductions as certified ex post by the independent body. This comes down to making a new class of eligible carbon asset enter the ECB’s balance sheet. 
Redirecting Long-Term Savings
In addition to mobilizing the bank credit channel, this instrument also provides leverage to redirect the stock of savings towards lower carbon investments. The fact that the central bank accepts to “pay” for the emission reductions at their social value constitutes a sufficient guarantee to design, by way of specialized funds, a whole new range of highly rated financial products backed by carbon certificates.
The public guarantee on the value of the carbon certificates bought by the central bank is not a substitute fora “real” price on carbon. In a very pragmatic way, it protects existing capital stock from too strong a depreciation, while at the same time maintaining the appropriate incentives to invest in the energy transition. This considerably reduces the immediate redistributive effects of an optimal carbon price.
The mechanism also provides a strong incentive for the government to develop low-carbon fiscal resources to render the public guarantee neutral in terms of the public budget.
Addressing the Issue of Climate Change and Pulling Europe out of its Stagnation
Europe is the only region in the world which has not caught up with its 2007 production level. Weak investment levels, which have now dropped by 20% since 2007, threaten to severely restrict potential growth.
The asset purchase by the ECB aims at providing new leverage on the price level. But by restraining itself to assets traded on the secondary markets, it has only a modest effect on new investments, and limits the scope of the Eurozone’s recovery. QE under these conditions carries the risk that assets may be purchased with little to no effect on a sustainable recovery.
Our proposal offers precisely the opposite, a form of oriented QE (through the carbon metric), which improves growth quality while strengthening European competitiveness.
The European Union should promote monetary policy at the service of European investment and climate in order to steer future growth in low carbon. Europe can lead the way at the Paris Conference in December 2015 by proving that sustainable prosperity and ambitious climate goals can go hand in hand.
Aglietta M., Espagne E. and Perrissin-Fabert B. (2015), “A Proposal to Finance the Low-Carbon Transition in Europe,” La Note d’analyse n°24, France Stratégie.
CISL & UNEPFI (2014), Stability and Sustainability in Banking Reform: Are Environmental Risks Missing in Basel III?
EPE-CIRED (2014), Transition to a low-carbon society and sustainable economic recovery, a monetary-based financial device
Espagne É. et al. (2012), “Disentangling the Stern/Nordhaus controversy: Beyond the discounting clash,” FEEM working paper.
Ferron C. and Morel R. (2014) Smart Unconventional Monetary (SUMO) Policies: Giving Impetus to Green Investment, CDC Climat Research.
Pottier A. et al. (2015), “The comparativeimpact of integrated assessment models’ structures on optimal mitigation policies,”Environmental Modelling and Assessment, forthcoming.
 See CISL & UNEPFI (2014), Stability and Sustainability in Banking Reform: Are Environmental Risks Missing in Basel III ?, a report which analyses the measures taken by central banks to modulate the prudential regulations applied to banks according to the environmental risk and the nature of the assets they finance. Our proposal falls into the SUMO category (for Smart Unconventional Monetary Policies), summarized by Ferron C. and Morel R. (2014) Smart Unconventional Monetary (SUMO) Policies: Giving Impetus to Green Investment, CDC Climat Research.
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