Financing the transformation: a proposal for a credit scheme to finance the Paris Agreement

ABSTRACT

To achieve the goals of the Paris Agreement, massive investments in the real economy are needed. We propose providing long-term interest subsidized loans to companies investing in sustainable projects with the primary goal of greenhouse gas neutrality. In detail, we propose linking loan interest rates to the EU Taxonomy and to future CO₂ prices. These links incentivize companies to decarbonize. Furthermore, this link can hedge companies against volatile CO₂ prices and incentivizes companies to make their business models more sustainable. Both elements support the transformation process of the economy.

Key policy insights

• By linking an interest rate discount to the investment’s alignment with the EU Taxonomy, companies are incentivized to invest climate-friendly even at low CO₂ prices.

• By coupling the interest rates to future CO₂ prices, the loans act as a hedge, which helps emission reducing activities when they need it the most.

• Additionally, these loans set incentives for companies to disclose their alignment with the EU Taxonomy and signal their exposure to CO₂ price risk, while helping governments to commit to their policy goals.

KEYWORDS:

• Carbon pricing
• policy failure
• financial incentives
• interest rate subsidy
• EU Taxonomy
• green finance

Acknowledgements

The authors received valuable comments on earlier drafts and would like to thank S. Brunner, J. Flasbarth, M. Kalkuhl M. Kopp, B. Linscheidt, E. Moench, K. Neuhoff, M. Pahle, S. Pex, G. Schürmann, N. Soendgen and three anonymous reviewers.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Although the EU Taxonomy is destined to become a widely used standard, it has been subject of some debate. In particular, the decision in early 2022 to label natural gas fired power plants (although only if they replace ‘dirtier’ alternatives and can burn clean fuels such as hydrogen in the future) and nuclear power plants (also under specific conditions) as ‘green’ has been criticized by politicians, environmental NGOs as well as large investors.

2 Market lending rates $r^M$ are determined at the beginning of the credit period and are assumed to be fixed interest rates. However, allowing for variable market lending rates would be unproblematic.

3 Instead of an allocation via the pertinent revenue, an allocation can also be made via related earnings. For details concerning this type of allocation, see the EU Taxonomy.

4 The EU Taxonomy Regulation requires capital market-oriented companies with more than 500 employees to report information on their Taxonomy compliance. However, smaller companies are exempt from this requirement.

5 How to best implement CO₂ prices is widely discussed in the literature (e.g., Hepburn et al., 2020).

6 For a fundamental discussion of different approaches that address the credibility problem, see Brunner et al. (2012).

Additional information

Funding

This work was supported by Bundesministerium fur Bildung und Forschung: [grants number 01LN1703A and 01LA1824A] and by Stiftung Mercator: [grant number 19026202] for the project ‘Wissenschaftsplattform Sustainable Finance’ (Rahmenprogramm Sustainable Finance).