This is how climate and environmental policies influence energy investment choices

Governments use climate and environmental (CE) policies to affect the scale, pace, and nature of change across the energy sector by shaping the perceptions and behaviours of market participants. For example, environmental economists have long advocated for policy instruments, such as carbon tax or cap-and-trade, to price carbon emissions and to internalize the environmental damages caused by carbon dioxide emissions.

The effectiveness of policies resides primarily in their role in stimulating the growth of innovation and the capacity of renewable energy. This is often based on the assumption or perception that CE policies increase investments in renewable energy projects either directly or indirectly by reducing the cost of capital. The cost of capital is a key lever in the real economy, due to its ability to influence capital flows and investment decisions.

For example, an increase in the cost of debt from 1.5% to 7.5% will result in a 30% increase in the costs of the UK’s net-zero transition by 2050. So, if energy transition risk is embedded in the cost of capital, how might this influence the net zero carbon transition? However, there is a lack of empirical studies substantiating how CE policies affect the cost of capital and influence investors’ risk preferences.

In the Energy Transition Risk and Cost of Capital (ETRC) Project, we not only track the cost of capital for energy firms over time but also perform quantitative analysis to investigate the factors affecting the cost of capital, and how it shapes investment choices, with focus on low-carbon (i.e., green) vs high-carbon (i.e., brown) investments. In a recent paper on the ETRC project, we investigate the following question: Whether and how regulation risk affects investment decisions either directly or indirectly via influencing the cost of capital?

This analysis addresses the question by using longitudinal datasets in the syndicated loan market. We analyse a sample of 15,189 loan facilities from the LPC DealScan database between 2000 and 2019, involving 4,066 borrowers across 40 developed and emerging markets in energy production (i.e., renewable energy, oil & gas, and coal) and electricity (i.e., renewables and fossil fuel based) sectors.

Based on econometric analysis that controls for the project-, firm- and macro-level confounders, we examine the impact of CE polices - proxied by OECD environmental policy stringency - on loan spread and investment decisions and our findings are as follows.

1) In the energy production sector, we find that stronger CE policies reduce the cost of capital for green (i.e., renewable energy) production and increases it for brown (i.e., oil & gas and coal) production. For example, an increase of one standard deviation in the strength of CE policy results in a decrease of thirty-one basis points (or 0.31 %pts) in the cost of debt for renewable energy production compared to a loan issued to conventional energy sources. However, we do not find any similar impact of CE policies on green vs brown electric utilities.

2) CE policies directly affect investment choices between green and brown options. This is consistent across energy production and electric utility sectors. For example, stronger CE policies increase investment in renewable energy production compared to production in either oil & gas or coal. Similarly, more robust CE policies encourage greater investment in renewable electric utilities compared to those that rely on fossil fuels.

We find evidence that CE policies not only reduce the cost of capital for green vs brown investments but also increase investments in green vs brown alternative. This raises two questions:

What is the impact of the cost of capital on investments?

Given that policies impact investments directly as well as indirectly via cost of capital, what are the relative strengths of these two channels?

In answer to the first question, we find that a reduction in the cost of capital results in an increase in renewable investments – a finding that is implicit in the previous discussion above and is not surprising.

In answer to the second question, we find that while both channels are active, the direct channel is significantly (i.e., 14 times) stronger than the indirect one. While this finding – the significantly stronger impact of the direct channel – is surprising, it may be due to CE policies focusing on accelerating the deployment of costly renewable technologies at a cost (e.g., via feed-in tariffs). Furthermore, the indirect channel is likely to become more dominant as renewable technologies become more cost-competitive. Both hypotheses require further investigation in future research.

From a policy perspective, the key takeaway from this analysis is that stronger CE policies are effective in increasing green investments compared to brown ones. Furthermore, these policies largely act directly on increasing investments as opposed to indirectly via the reduction in the cost of capital. These findings imply that financial institutions, in general, are rational and integrate CE policy risk factors in investment decision-making. Thus, unsurprisingly, the implication is that policymakers aiming to accelerate the low-carbon transition should deploy stronger policy instruments to direct capital flows to low-carbon energy.

This article forms part of research done in collaboration with the Cost of Capital Observatory, an initiative from the International Energy Agency, the World Economic Forum, ETH Zurich and Imperial College London. The aim of the Observatory is to increase transparency in the energy sector and inspire investor confidence, especially in emerging and developing countries where data on financing costs is scarcer. It provides a free resource offering data on the cost of capital focused on clean energy projects in emerging and developing economies.