Credit Rationing Can Cause Problems for Low-Carbon Investment

To limit global warming to below 2 degrees Celsius, as stipulated in the Paris Agreement, a shift toward carbon-neutral economies is imperative. Such a transformation requires substantial investment in low-carbon technologies, from research and development to deployment and use of these technologies.

It is therefore crucial to understand what potential obstacles prevent companies from making these investments, so policy instruments can be designed to overcome the barriers. In our study this year, we showed that carbon taxes are a key instrument to incentivize low-carbon investments, but might not be sufficient.

Carbon-intensive versus carbon-neutral technologies. We developed a theoretical model to analyze companies’ investment in low-carbon technologies. Initially, each company operates using a carbon-intensive (or dirty) technology, with varying emission levels: Some technologies are associated with high emissions, some with low emissions.

We considered the following decision: Companies can choose to invest in a carbon-neutral (or clean) technology as a replacement for their existing dirty technology. To do so, however, businesses need an initial investment—for example, for research and development that is required to introduce the new clean technology.

As innovations usually bear some risk, this clean investment is modeled as risky—with a positive probability that the investment in clean innovation won’t be successful. And consistent with empirical observations, we assume the clean investment needs to be financed externally.

So, in addition to companies’ investment behavior, we analyzed whether banks are willing to finance a company’s investment in a carbon-neutral technology.

Carbon taxes incentivize investments in carbon-neutral technologies. What drives a company’s technology choice? A company decides based on expected returns—the profit they anticipate from using either clean or dirty technology. Here, climate policy, such as a carbon tax, plays a crucial role. Without such a tax, companies don’t have sufficient incentive to switch from their carbon-intensive technologies.

A tax that puts a price on carbon emissions provides incentives for firms to invest in low-carbon technologies. Carbon-intensive firms would choose such investment, which would be an ideal outcome from a societal perspective.

There is, however, a potential issue that might limit the effectiveness of the carbon tax—do high-emission firms that choose the clean innovation obtain a bank loan for their investment? To answer that question, it makes sense to look at the bank’s perspective.

Financing constraints deter carbon-neutral investments. A bank’s decision to lend and the conditions it sets are based on the assessment of the likelihood of a business being successful with its carbon-neutral innovation.

While businesses are equipped to assess the likelihood of success for their low-carbon investment, this assessment presents a challenge for banks. There are therefore information asymmetries between banks and potential borrowers.

These information asymmetries are particularly large if carbon-neutral technologies are new and not mature, and thus particularly risky. In such circumstances, banks might choose to lend only to low-risk businesses by offering loan conditions that these firms are willing to accept.

Consequently, there is credit rationing. Some of the businesses that do want to invest in clean technologies, namely the more risky ventures, don’t receive financing. As a result, they continue to use their high-emission dirty technologies.

Addressing credit rationing. Credit rationing of high-emission businesses that want to invest in clean technologies isn’t desirable from a societal perspective. A straightforward solution would be to combine the carbon tax with additional interventions in financial markets. By offering either interest rate subsidies or loan guarantees, a government can make lending for banks more attractive.

In the case of interest rate subsidies, the government takes over part of the premium banks charge for more risky clean technology investments. With a loan guarantee, policy directly takes over part of the risk by guaranteeing the bank a certain share of the loan repayment if an investment fails.

However, in certain circumstances carbon taxes alone can solve the issue of credit rationing. If technologies aren’t too risky, the government can slightly increase carbon taxes. In this case, the alternative of using the high-emission technology becomes even more costly for firms, which are then willing to compensate the banks more for the risk. This makes it more likely that banks and firms agree on loan contracts that are acceptable to both parties.

In any case, both measures—financial market intervention and higher carbon taxes—are likely only temporary. As carbon-neutral technologies evolve, they become less risky.

At the same time, there are learning effects in the financial sector: By financing clean investments, banks learn to understand and assess the risks of technologies. Consequently, information asymmetries decline and ultimately credit rationing disappears.

Policy Implications

There are implications for the role carbon taxes play with investments in carbon-neutral technologies.

A carbon tax incentivizes particularly emission-intensive companies to switch to carbon-neutral technologies. However, if these technologies are immature, credit rationing might occur, and not all firms that want to invest in clean technologies may receive the necessary financing.

While our findings highlighted that a carbon price—for example, in the form of a carbon tax—is the key to an effective and cost-efficient transition to a sustainable low-carbon economy, it might not be sufficient, and additional measures might be necessary.

This issue can be addressed by government-funded interest rate subsidies, loan guarantees, or in some cases, carbon tax increases. In any case, the issue of credit rationing is only temporary if the risks of carbon-neutral technologies decline over time as they develop.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Christian Haas is a postdoctoral researcher at Frankfurt School of Finance & Management-UNEP Collaborating Centre for Climate and Sustainable Energy Finance.

Karol Kempa is director of Frankfurt School of Finance & Management-UNEP Collaborating Centre for Climate and Sustainable Energy Finance.

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