A European Climate Emergency Fund
- The European Commission estimates the transition to a “low CO2” economic model would entail an investment effort of around 1.5% of GDP annually until 2030. This calls for creating a new long-term funding capacity with public sector involvement to avoid “crowding out” effects.
- Here we use the precedent of the European Stability Mechanism (ESM) to describe how a European Climate Emergency Fund (ECEF) could provide significant financial support to for green transition. We believe this could be done with a low level of risk for investors, while assuaging concerns in core countries over any drift towards an “unconditional transfer union”.
- The ECEF would differ from the ESM on front-loading issuance – taking advantage of the current extraordinarily low interest rates environment – and the possibility to lend to corporates directly.
- Beyond facilitating the transition to a “de-carbonised” economic model, the ECEF, thanks to its leveraging capacity of EUR500bn, would bring collateral benefits. These would include the ability to provide Europe with a joint, low-risk reference asset, and allow for another step in the economic, financial and political integration of the European Union.
A unique window of opportunity
In this paper, we explain how a European joint debt issuance instrument could help fund the green transition, drawing on the successful experience of the ESM in dealing with the 2012 sovereign debt crisis. This approach, which combines low-risk and low-cost funding with effective conditionality would assuage concerns in core countries about the risk of drifting into an “unlimited transfer union, i.e. the risk that mutualisation ends up being “played” by fiscally spendthrift member states.
Ideally, we think such vehicle should front-load its debt issuance, to take advantage of the current environment of extremely low interest rates. With adequate size, this could come with significant collateral benefits – such as at long last, the creation of a proper reference asset at a European level. This would in our view meet significant demand from long-term investors.
A major investment effort ahead
In June 2019, the European Union (EU) unveiled another ambitious plan for its transition to a “de-carbonised” economic model. According to the European Commission (EC), this would entail a capital expenditure effort of around 1.5% of GDP annually until 2030. Some of this will be easily funded by the private sector, and institutional investors are keen to take their part. However, some of the Green projects will become profitable only over a very long horizon. Large scale re-allocation of labour and capital from currently CO2-intensive, but highly productive activities, to sectors with returns which are not yet tangible will likely entail adjustment costs. This calls for the emergence of additional long-term funding capacity with public sector involvement.
At the same time, the current accumulation of macroeconomic risks, the readiness of the European Central Bank (ECB) to provide support and the current fiscal stance in Germany are combining to bring a large part of the yield curve into negative territory. This has created a unique opportunity to build a war chest, by front loading issuance.
If this was pooled at the EU level, the emergence of substantial joint debt issuance would finally provide the region with a proper liquid low-risk-asset, at a time when the supply of its de facto reference paper (German Bunds) is diminishing on trend. This would help the euro to compete with the US dollar as an international reserve currency, and with the associated benefits – particularly making the ECB’s monetary policy less sensitive to US policy decisions given the latter’s bond market dominance. The risk profile of such a joint instrument, coupled with front-loaded issuance, could be consistent with low but positive interest rates, attracting demand from long-term investors both inside and outside of the EU. Another externality of such an approach is that it would spur another step towards the political, economic and financial integration of Europe.
Discussions around “joint debt issuance” in Europe have always hinged on conditionality issues. Core countries who lend their credibility to such vehicles and become liable to potential losses generated in other countries, demand some sort of control over the end use. A joint Green Fund can only emerge if the subsequent spending can be, and is, precisely monitored. This would also be a condition for the fund to retain its appeal to investors as a low-risk asset on par with the best signatures within the European Monetary Union (EMU). The euro area, when faced with the sovereign crisis of 2012, managed to create an institution which combined joint issuance, joint responsibility and enforceable conditionality – the ESM. We think we can draw from this experience to help the EU deal with the environmental emergency.
The ESM model
The ESM lends at a low interest rate to eurozone member states which are losing access to market funding. This is made possible by its unique financial construction.
The ESM’s total capital stands at EUR700bn, of which EUR80bn of paid-in capital, which is apportioned according to the share of each member state in the EU’s GDP and population. Callable capital is there to cover possible losses or defaults on the loans made by the ESM. The maximum lending capacity stands at EUR500bn, funded by the paid-in capital and the ESM debt issuance. In other words, it is over-collateralized. This improves its risk profile, while also offering some protection against the default of one of its backers. This ensures a strong rating of ESM bonds.
Crucially, the member states’ spending on paid-in and callable capital is not considered in the calculation of their public deficit. It is treated as an increase in equity for the government i.e. as a pure financial transaction. The loans taken from the ESM raise the public debt of the requesting government with no impact on the other member states’ debt position. In other words, a government which does need, or chooses not to use the fund, is not going to be worse off when it comes to its underlying fiscal position. This matters for countries which have embedded fiscal rules in their constitutional framework.
Loans can only be granted by qualified majority of the shareholders. This de facto gives the “Northern club” a veto right on lending.
Loans cannot be granted without explicit and precise conditionality. Governments taking those loans must enter into a contract with the EU institutions, allowing for in situ surveillance. Loans are disbursed by tranches, dependent on delivering on previous commitments, reducing the possibility of free-riding behaviour.
How to apply this to Green investment? A few tweaks
We think green projects would lend themselves quite well to an “ESM-like” design. Conditionality would rest on the EU’s now increasingly precise list of environmental objectives. Member states now produce National Energy and Climate Plans which could gradually resemble the annual stability programmes they have been providing as part of the fiscal surveillance framework which forms the basis of ESM conditionality. A scientific board would advise the Green Fund – which we call in this note the European Climate Emergency Fund (ECEF) – on the suitability of the initiatives bidding for support in regard of the EU’s objectives. In addition, since by nature green projects can only be gradually implemented, a “tranche-by-tranche” approach to disbursement, allowing for regular surveillance, would be natural.
However, we would highlight two key differences to the ESM:
Front-loading: Today, the ESM issues debt to fund loans but does not pre-fund. Conversely, our Green Fund would want to leverage itself as much as it can, as quickly as possible, to take advantage of the current backdrop of low interest rates. This may well warrant a bigger spread than what the ESM currently pays relative to Bunds – 30 bps on a 30-year bond – but we think that there would be enough interest from long-term investors to keep funding costs attractive. An issue of course is that managing the reserves could be costly given the high proportion of the yield curve which is in negative territory. We discuss in Box 1 how to address this.
Box 1: What to do with the reserves created by front-loading issuance?
There are (at least) two non-mutually exclusive options:
In the first, the proceeds of the front-loaded issuance would be merely held in cash on the ECB’s balance sheet. Ideally this should be done directly, by granting the green fund the banking licence which would allow it to access the ECB’s facilities. We note however that core countries in 2012 rejected the possibility to do this for the ESM, since it would have potentially opened the gates to funding the ESM by the ECB. It was therefore sailing too close to the wind regarding the Treaty’s prohibition of monetary funding of fiscal spending. It could however be done indirectly, with the fund’s custodian banks parking the cash on their accounts at the ECB. The ECEF would be charged the ECB’s negative deposit rate, i.e. -0.5%, resulting in an annual loss of 0.8% (the difference between the ECEF’s funding costs – proxied by those of the ESM – and the deposit rate). However, governments, as the national central banks’ shareholders, are the ultimate beneficiary of the profits made by the ECB arising from the negative deposit rate. Those profits could be transferred to the ECEF, reducing the spread between the cost of funding and the return on reserves to 0.3% per annum, which could be easily recouped by charging a few extra bps on the future loans (with a duration which will largely exceed the time the Fund would stay “idle”).
In the second option, is just like the ESM today when it comes to managing its paid-in capital. As such the ECEF would engage in prudent but active capital preservation investment, along precise guidelines, which could involve investing in ecologically responsible assets, helping to sustain the development of this market segment.
Opening-up to the direct private sector lending. Today, the ESM only lends to sovereigns, which is how it was designed. When it comes to environmental projects though there is a strong case for direct lending to corporations, especially on long-term projects with a back-loaded return on investment, on which market rates could be prohibitive. Obviously, the ECEF would charge a risk premium on these loans beyond what the ESM charges for sovereigns, but as a non-profit seeking institution with low funding costs, the overall price of credit to borrowers would remain attractive.
This would raise the overall risk profile of the bonds issued by the ECEF but again in the current environment, we think there would be interest from investors. Technically, we think the ECEF issuance could offer two options: one funding loans to government, as the ESM does, with the national authorities using them to fund their own transition projects (e.g. subsidizing a change in their domestic energy mix), the other one granting loans to corporations (e.g. to fund long-horizon R&A projects), albeit at a higher premium. In any case investors purchasing such bonds would be better protected than by taking the risk directly via purchasing the debt of the corporates, thanks to the capital structure of the Fund.
To address the “crowding out” risk, where private investors who would be ready to fund directly transition projects at sustainable rates would face a loss of opportunity because of competition from the ECEF, a “first look” condition for private investors could be added to the structure. This would ensure that only the projects in actual need of the indirect support of the governments’ guarantees would benefit from the new facility.
We also think that there is a good case to allow the ECEF, in some limited cases, to take an equity stake in some projects (in this instance operators would have to create a specific entity to implement the projects).
Fiscal rules would need to change if the “sovereign funding” option is used
The ESM was designed to offer funding only to sovereigns “in need”. Ideally the ESM would be there only as a precaution and would never be tapped. Conversely, the ECEF ideally should be used to full capacity. If the “sovereign funding” option was used, member states whose own funding costs exceed that of the ESM would be incentivized to use the facility, but they may be stopped by European fiscal rules prohibiting deficits exceeding 3% of GDP – or lower for highly indebted countries.
This is a very sensitive area for policymaking at the Euro area level. There has been a lot of discussion in Europe recently on the possibility to exclude the investment component of public spending from the calculation of fiscal rules. We think an issue with this approach is the leeway around the definition of what constitutes proper public investment. In our outline, the only part of public spending which could be excluded from such fiscal rules would be projects sanctioned by the ECEF. This would provide reassurance to any countries worried about potential free-riding by other member states in case of a blanket relaxation in the Stability and Growth Pact, since their support for the loans will have been needed beforehand. In such a configuration a “green rule” would replace the “golden rule” according to which it is economically sound to fund public investment with debt.
Incidentally, this would provide an incentive for countries currently paying low-funding costs to tap the facility as well, since this would allow them to protect their non-green public investment effort and press on with concrete action on cutting CO2 emissions at a moderate interest rate premium.
Box 2: Examples in practice
The purpose of this paper is to provide an outline. At this stage we cannot get into the technicalities – e.g. a quantification of the premia those benefitting from the Fund would incur. But we can lay out how the general framework would apply to illustrative transition projects, under option 1 where the Fund finances sovereigns and option 2 financing private firms.
Funding energy transition in Poland
Some 75% of electricity generation in Poland comes from coal-fired generators, contributing massively to the country’s high CO2 emissions (in 2017 the CO2/GDP ratio stood at 0.31 in Poland, against 0.19 in the EU on average). The Polish government funds itself currently at 1.7% in 30-year bonds denominated in euros, i.e. 140 basis points (bps) above the ESM, which we use here as a proxy for the funding cost of the ECEF. Funding the transition through the ECEF would thus be financially rational for Warsaw(1).
The government would make a formal application, describing in detail how the loan would be used to fund the transition. The ECEF’s scientific board would assess the suitability of the Polish government’s plan for the EU’s own objectives. The project would then be formally approved by qualified majority at the ECEF executive board. The necessity of finding a qualified majority would be conducive to the emergence of “soft proportionality” i.e. no country could capture a too high a share of the ECEF’s total lending capacity.
The ECEF would then tap into its front-loaded resources (paid-in capital and bonds already issued and managed as reserves) to fund phased-in disbursements to the Polish government. These would gradually repay the ECEF at a small premium over the fund’s cost of funding to cover the fund’s operating costs. The ECEF would organise regular surveillance of the energy transition and future tranches would be withheld in case of non-compliance.
Funding new battery technology in the car industry
The lithium batteries on which most electric and hybrid cars rely may have reached the peak of their potential, which undermines such cars’ capacity to compete with traditional combustion engines in range and cost. New solutions are being developed, such as moving to solid-state devices instead of the current liquid lithium-ion approach or replacing lithium with magnesium. Development costs are daunting though and as is often the case, the potential returns on investment are back-loaded.
Very few European corporates issue debt at a very long horizon (the outstanding amount at 30 years and above stands at only EUR0.3bn), and in these cases the premium over the ESM is significant (250bps). In this instance, the corporate would bid the ECEF for funding, following the same process as the sovereign, while the loans would entail a risk premium on top of the ECEF’s operational costs. This would however remain below market levels, given the ECEF’s capacity to pool risks and low funding costs.
Effect on financial markets
The impact of the ECEF on market conditions would obviously depend on the size and speed of issuance. A good starting point may be the current lending capacity of the ESM, of EUR500bn. This would be enough to fund a quarter of the transition-related investment estimated by the EC over the coming decade. Fortunately, the ESM did not have to issue its total capacity – it currently has debt of EUR300bn when consolidated with its predecessor the EFSF. With EUR500bn, of which EUR420bn is debt, the ECEF would be smaller than the German government as it is today (EUR741bn for the outstanding volume of Bunds).
However, two points need to be noted. First, German debt is falling on trend, which is creating a shortage of safe assets in Europe and it is also helping drive the decline in market interest rates. Second, it would trump all other sovereign issuers on the long end of the curve – 30 years would be the ECEF’s preferred maturity – since only EUR188bn of Bunds mature beyond 2029. The impact on the long end of the curve would be compounded by front-loading.
This could kick-start a normalisation of the whole European bond market, with a steeper curve and probably an exit from negative yields. This would stem from the combination of the direct impact of ECEF issuance on the supply and demand conditions of the bond market and the indirect effect on the long-term growth prospects of the EU. This would provide a credible way to implement a successful ecological transition without massive crowding out effects on ordinary public spending. In addition, this would add to the solidity of the EU by adding another layer of political and financial integration to the project.
We think an added benefit of such a scheme is that it would allow institutional investors with strong environmental, social and corporate governance (ESG) guidelines to invest beyond assets which are already environmentally responsible. Indeed, by purchasing ECEF bonds, they would also be investing directly in the transition process, which in turn would magnify impact investing.
We think the risk of seeing the ECEF “crowd out” ordinary investors from potentially profitable investment opportunities would be low. Beyond the “first look” condition for private sector projects, the ECEF would focus on the long end of the curve, where there is little appetite for private investors to take direct risk from private issuers. Moreover, our contention is that a lot of important, but not immediately profitable, transition projects would simply be abandoned rather than funded via the private sector, without the support of a government-sponsored structure such as the ECEF. Finally, we believe accelerating the transition would ultimately increase the overall pool of assets in which the ESG-aware investment community could invest.
Avoiding “institutional inflation”
There has been a lot of new European initiatives supporting investment in the recent years, and we are aware of the risk of creating yet another programme adding little to the overall “fire-power”. Still, relative to the “Juncker plan” for instance we think our proposal would be additive precisely because it would create a new type of asset with characteristics in terms of maturity (30+ year) and finality (funding transition and not “already green” activities) which are particularly appealing to investors at the current juncture.
We are also aware of the political complexities and management costs creating a new European institution would entail. To be clear our focus in our project is on the financial structure, not on whether an autonomous administrative body called “ECEF” would emerge. The Fund itself could be operated by an existing institution. The European Investment Bank for instance would be a natural candidate for the administration of the Fund.
What we have outlined and described above is a highly ambitious project, at a time when appetite for more financial solidarity in Europe in large segments of public opinion is not high. However, this reluctance must be balanced against the rising awareness in public opinion across the continent of the vital necessity of swift action against climate change. We believe this is the level of ambition commensurate with the task at hand i.e. avoiding the catastrophic consequences of global warming.
 Obviously moving away from coal would also bring direct savings (Poland has spent about EUR50bn in direct and indirect subsidies to the coal industry in 25 years) but the transition costs do not simply entail building new capacity but also dealing with the social aspects (labour displacements).
This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.
It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date. All information in this document is established on data made public by official providers of economic and market statistics. AXA Investment Managers disclaims any and all liability relating to a decision based on or for reliance on this document. All exhibits included in this document, unless stated otherwise, are as of the publication date of this document. Furthermore, due to the subjective nature of these opinions and analysis, these data, projections, forecasts, anticipations, hypothesis, etc. are not necessary used or followed by AXA IM’s portfolio management teams or its affiliates, who may act based on their own opinions. Any reproduction of this information, in whole or in part is, unless otherwise authorised by AXA IM, prohibited.
This document has been edited by AXA INVESTMENT MANAGERS SA, a company incorporated under the laws of France, having its registered office located at Tour Majunga, 6 place de la Pyramide, 92800 Puteaux, registered with the Nanterre Trade and Companies Register under number 393 051 826. In other jurisdictions, this document is issued by AXA Investment Managers SA’s affiliates in those countries.
In the UK, this document is intended exclusively for professional investors, as defined in Annex II to the Markets in Financial Instruments Directive 2014/65/EU (“MiFID”). Circulation must be restricted accordingly.
© AXA Investment Managers 2019. All rights reserved