Dual interest rates: unlocking green investment during monetary tightening

August 1, 2023|Written by New Economy Brief|Bank of England

Like many central banks, the Bank of England (BoE) has been increasing interest rates to control inflation. Those rates now stand at levels not seen since before the financial crisis of 2008.

‍Yet this risks limiting private sector investment and poses a political problem for a government hoping to ramp up capital investment to grow the green economy.

But what if the bank had dual interest rates with a lower rate for green projects, as Japan does? Green credit guidance can keep finance flowing towards net zero, and Megan Greene – the newest member of the monetary policy committee which sets interest rates – has previously spoken in favour.

‍Raising interest rates harms the whole economy, but particularly green investment

Markets are pricing in further interest rate hikes, 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 people trying to repay their mortgages and on the higher costs of government borrowing, but less attention is being paid to the impact on business investment.

How will the UK meet its legally-binding net zero targets, when the financing needed for the green transition becomes more expensive? Achieving an environmentally sustainable, 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 £562.7bn in public and private money would have been pumped into the economy.

Higher interest rates will be particularly detrimental for green transition investments, given that those projects typically have high upfront capital costs, even though they generate operational savings in the long term.

The irony is that the BoE’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 primarily caused by fossil fuel-related energy price shocks – by providing more lending for building retrofits and clean energy projects.

Green investments will also protect longer term financial stability from climate-related risks but, because of that higher upfront capital, it is green investment that will suffer the most from higher interest rates.

Dual interest rates can drive green investment

The UK government’s net-zero strategy outlines its plan to meet 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) says it is “an ambitious, credible path for UK decarbonisation… in line with the Paris Agreement”.

Higher borrowing costs then pose a political problem for the Conservative party currently in power and the opposing Labour party, both of which have emphasised the importance of ramping up private sector finance to stimulate green investment.

One proposal for making green investments cheaper is to have a reduced interest rate for investment in low-carbon projects. This dual interest policy is part of a wider framework called green credit guidance.

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. There is historical precedent – offering lower costs of credit played an important role in supporting Western economic and industrial policy between 1945 and 1973, and more recently in aiding the rapid development of East Asian countries.

More recently, the Bank of Japan (BoJ) has provided zero-interest financing to lenders supporting action to address climate change. The BoJ’s governor justified taking action on climate by arguing that doing so falls within the bank’s price stability and financial stability mandates. Christine Lagarde has also put green credit guidance as one of her top priorities during her presidency of the European Central Bank (ECB).

Frank van Lerven and Lukasz Krebel of the New Economics Foundation (NEF) have proposed that the UK could adopt such a scheme by repurposing the Bank of England’s term funding scheme (TFS). This currently provides cheaper credit to businesses and households, and could also provide cheaper credit to banks to lend for sustainable investments.

Van Lerven and Krebel 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 [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.”

More interventionist credit policies would be particularly useful to stimulate private finance in order to fill the UK’s green investment gap and ramp up spending on net zero without using public money. However, economists have warned that “fiscal policy must lead the way on the green transition”, and that green credit guidance should not be seen as a “silver bullet”, but part of a holistic strategy of discouraging dirty investments as well as increasing both public and private green finance.

A holistic strategy for green finance and decarbonisation

The scale of the funding gap has led many to suggest that private finance alone is not enough to address the environmental emergency, and that public finance is particularly important. Indeed, public investment can play a crucial role by directly investing in critical projects which 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.

Common Wealth’s Melanie Brusseler has said 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”.

Separately, NEF has made the case that the UK’s state-owned financial institutions should also be given net-zero mandates to redirect their £7bn annual investments and scale them up to help grow the green economy.

The experience of green credit guidance policy in France and Japan has also shown 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 have explained how an “allocative green credit policy” regime can be organised around green industrial policy objectives and democratically agreed green “missions”.

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, such as tax relief for North Sea oil producers. Realising this, 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 should they be elected to power.

There are clear reasons why the BoE and the UK government should work in tandem to achieve net-zero targets: one creating the right conditions through monetary policy, and the the other providing the investment strategy.

While interest rates remain high, dual interest rates are the solution to low-carbon development being disadvantaged in terms of capital investment.

This is an edited version of an article that appeared in the Digest published by the New Economy Brief.

This page was last updated August 1, 2023

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