The Climate Bank: an interesting idea, but one that struggles to deliver on its promises (Note)

Usefulness of the topic : Using public investment banks to finance major projects such as the energy transition is an interesting idea, but it comes up against the refinancing requirements specific to investment banks. Due to these constraints and without direct financial support from the Central Bank, which would raise other issues, there is a risk that the volume of activity of such an institution would remain well below the objectives set by its designers.

Summary:

• Financing the energy transition requires at least 2% of GDP in investment each year in France (approximately €45 billion) and in the European Union (more than €300 billion), which the public and private sectors are struggling to finance.

• The creation of a European Climate and Biodiversity Bank (ECBB) is presented, notably in the draft treaty resulting from the « Climate Finance Pact, » as a solution for mobilizing these resources, offering states an annual « drawing right » equivalent to this amount.

• However, a more detailed analysis shows that the refinancing constraints weighing on public investment banks and the lack of direct monetary financing from the central bank make it difficult for the ECBB to achieve the objectives set by its designers, who seem to have overlooked several important parameters.

To finance the energy transition, the use of public investment banks is regularly mentioned as a tool to be mobilized. One of the proposals regularly mentioned in public debate is the creation of a European Climate and Biodiversity Bank (BECB). This idea is notably supported by the « Climate Finance Pact, » led by politician Pierre Larrouturou and climatologist Jean Jouzel, who have just published a draft treaty aimed at this objective and including a proposal for the drafting of the BECB’s statutes. It was taken up, under the title « Climate Bank, » in Emmanuel Macron’s address to Europeans on March 4, 2019.

However, several problems arise regarding the ability of this climate bank to meet the objectives set out in the draft treaty. The main objective is to allow all European Union member states to have a drawing right equivalent to 2% of their GDP each year (i.e., more than €300 billion annually) to finance their ecological transition operations.

But this ambition faces institutional and, above all, financial difficulties. It seems that the project’s designers did not take sufficient account of the issue of refinancing, which is central to the problems and functioning of investment banks.

1. What institutional forms and objectives for the climate bank?

The relevance of the idea of a climate bank stems from the existence of a market failure and the inadequacy of private and public financing for the ecological transition. In Europe, the European Investment Bank (EIB) is already a major player in this field. As Ambroise Fayolle, Vice President of the EIB, points out in an opinion piece in Les Echos, the EIB « has played a pioneering role in the green bond market by issuing the world’s first ‘climate-responsible bond’ (CRB) »[3]. It also invested €19.4 billion in the ecological transition in 2017 and is expected to invest nearly $100 billion in this area by 2020. However, despite these efforts, it should be remembered that the estimated annual investment required for the energy transition is around 2% to 5% of European GDP, or between €300 billion and €800 billion. For France, the I4CE institute estimates the amount to be between €45 billion and €75 billion per year (i.e., 2% to 3% of GDP), half of which should come from the public sector. Based on these figures, we are still a long way off the mark.

The Climate Bank should therefore do more and better than the EIB. On paper, the idea may seem attractive: the draft treaty provides for the establishment of the BECB as a subsidiary of the European Investment Bank (EIB) with legal personality and financial autonomy. The « treaty » thus recalls that Article 28 of Protocol No. 5 annexed to the Treaty on the Functioning of the European Union (TFEU) provides for the possibility for the EIB to create such a subsidiary, upon decision of the EIB’s Board of Governors.

The proposal also seems very ambitious in terms of the functioning and financial clout of this new institution: the bank would have the exclusive obligation and mission of financing the transition in all European countries. Each country would have a « drawing right, » essentially in the form of zero-interest loans, for an amount equivalent to 2% of its GDP. For France, this would represent around €45 billion. Mr. Larrouturou states:  » France would know that for 20 or 30 years, it would have a zero-interest loan of €45 billion every year. That would change everything: €7 billion for housing, €10 billion for transport, €5 billion for agriculture… « [4]. In addition, the climate bank would not only grant loans but could also offer guarantees or even take direct equity stakes in order to facilitate access to financing for actors who are less solvent in the immediate term. A vast and attractive program, at first glance.

However, the draft treaty does not describe in detail how the financing would flow from the BECB. It is conceivable that national investment banks (such as the Public Investment Bank or the Caisse des Dépôts in France) could benefit from this financing, according to an on-lending principle such as that practiced by Germany’s KfW, alongside direct relationships with private actors eligible for its programs. The issue of direct access by states or their agencies (such as the French Environment and Energy Management Agency (Ademe)) also seems to be covered by Article 3 of the draft treaty, which states:  » The BECB shall carry out this task through activities consisting of offering financing […] in any legally permissible form to its members or to private or public enterprises. » We will see later that this issue may give rise to legal and political complications, as the notion of  » legally permissible form  » tends to imply.

2. The inherent limitations of investment banks: an unconsidered constraint

However, there appears to be a major problem to which the « Finance Climate Pact » does not currently provide any convincing answers: how could such a climate bank generate the immense financial resources necessary for its operation (nearly €300 billion per year)? The initial capital provided for this bank by Article 6 of the statutes contained in the draft treaty is only €4.5 billion, 60% of which is subscribed by the EIB, 10% by the EU and the rest by the Member States. In terms of prudential requirements alone, this appears to be significantly too low to guarantee an annual business volume of nearly €300 billion (which is set to grow year on year).

According to Basel III rules, the minimum capital ratio is set at at least 7% (compared to only 2% under Basel II), which means that €4.5 billion in hard capital would not, in theory, allow for a balance sheet exceeding €60 billion. For the BECB to achieve the level of financing expected of it, it would need much more capital, or it would need to be endowed with secure assets equivalent to capital, which is not currently planned. By comparison, the EIB has capital of €243 billion, to which €68 billion in equity capital must be added[5] for a balance sheet of approximately €580 billion (the EIB’s equity/balance sheet ratio is deliberately set particularly high).

Then there is the key issue of financing the BECB’s operations. The authors favor the use of money creation, rightly pointing out that the European Central Bank, through its asset purchase policy, created nearly €2.6 trillion in liquidity between 2015 and the end of 2018, or around €850 billion per year. But the problem is that neither the EIB, nor this potential BECB, nor any investment bank are central banks. None of these institutions has the power to create liquidity.

Furthermore, they cannot create money in the same way as commercial banks, as they do not receive deposits. They must therefore have sufficient initial capital and/or issue various financing instruments on the markets (in particular bonds). In short, in order to grant loans, including and especially long-term loans at preferential or zero rates, they must first find sufficient financial resources on the markets, from governments or from any type of investor (e.g., other investment banks). However, as the proposal currently stands, the BECB’s capital appears to be particularly insufficient for this purpose, as it is set at only €4.5 billion according to Article 6 of the proposed statutes in the Climate Finance Pact[6].

To compensate for this initial weakness in capital, one could imagine that the climate bank would issue large quantities of bonds each year, which would enable it to acquire the liquidity necessary to subsequently finance the loans it grants or the equity investments it makes. But who will buy them? To attract investors, listing the bonds issued by this climate bank on the list of assets eligible for refinancing by central banks is an important first step, but it is not enough. The markets also expect a certain return. However, the BECB’s operations are not expected to be profitable immediately, or even in the medium term, since their very purpose is to provide low-interest financing to players who are not necessarily profitable in the short or medium term. It is certainly conceivable that the bonds issued by the EIB could be attractive from a portfolio diversification perspective, given the quality of the issuer (a subsidiary of the EIB whose capital is guaranteed by governments) and the guarantee of a green investment certified by the European authorities. However, it is far from certain that this will be enough to raise €300 billion each year from investors.

Similarly, governments do not necessarily have sufficient financial leeway, or the will, to invest or provide guarantees, as evidenced by their reluctance to increase the capital of their own public investment banks (Bpifrance in France in particular). The only technically viable alternative would therefore be for the ECB to finance this climate bank directly by purchasing the bonds it issues, in sufficient quantities to make this annual drawing right of €300 billion from member states a concrete reality. However, the use of massive monetary financing by the central bank raises many other questions, on which the authors, who say they do not want to change the ECB’s mandate, do not comment.

2. Monetary financing that raises many questions and seems difficult to conceive of in the current context

Technically, the ECB could do this: in theory, it would simply need to resume its asset purchase program, which was halted in January 2019, and target it towards bonds issued by the climate bank (the same reasoning could apply to the EIB if the aim is to use an existing institution). It should also be noted that the ECB already purchases bonds from public investment banks such as the EIB, but in much smaller volumes. As Charlotte Gardes points out in an article in BSI Economics, a study by Michel Lepetit on the outstanding amount of bonds issued by the EIB and purchased by the ECB and the climate share of EIB operations leads to the conclusion that in 2017, the ECB would directly and indirectly refinance climate-friendly actions via the EIB to the tune of €15 billion. This includes more than €2 billion in « climate-responsible bonds » issued directly by the EIB.

However, there is no legal or institutional obligation to do so, let alone to do so on a significantly larger scale. If it did decide to do so, the issue of funding channels, mentioned at the beginning of this article, would become central. Indeed, will states be direct beneficiaries of EBCB loans, financed by the ECB, through a targeted asset purchase program in the case we are discussing? Or will only national public banks and private actors (including banks) have access to the EBCB (and therefore indirectly to the ECB)?

Legally, this is an important question, particularly in order to determine whether this program could be seen by potential critics as quasi-direct financing of governments. If the mechanism adopted resembles quasi-direct money creation for the benefit of governments too closely, we can immediately see the political difficulties that this could raise, particularly in Germany, which has already argued strongly for the asset purchase program to be halted and has taken legal action against it in the Karlsruhe Court. One could, of course, argue that this money creation would be targeted, since the climate bank would act with a single objective in mind. Indeed, according to Article 1 of the draft statute:  » The purpose of the BECB is to promote the transition to a highly energy-efficient and low-carbon economy while protecting biodiversity in the European Union, by mobilizing the funds necessary for climate change mitigation strategies. »Although they would have drawing rights equivalent to 2% of their annual GDP, Member States would not be free to use this money creation for purposes other than those specified by the climate bank.

However, in the draft « treaty » as it currently stands, this connection and assumed « complicity » between the central bank and the climate bank is not provided for or even mentioned. And for good reason: it would require difficult negotiations, or even a revision of the treaties. This was recently pointed out by Benoît Coeuré:  » We could ask the ECB to add a climate objective to its price stability objective, but in that case we would be entering into a political debate. Why climate rather than parity, rather than employment? That is a political question, we cannot decide it ourselves. » Some, such as Joseph Stiglitz, believe that the added value provided by the Central Bank would then lie in its ability to acquire large quantities of debt securities over long periods and at low cost, without this weighing on the consolidated debt of governments. Others, however, believe that this type of privileged financing would undermine the principle of independence and market neutrality of central banks and would unduly replace the fiscal responsibilities of governments. Julien Pinter points out, for example, that the money created by the central bank must bear interest if the central bank wants to retain control of its policy. However, given that this interest rate is by definition closely linked to the rate at which certain governments borrow, it is not certain that this monetary financing operation would not ultimately be as costly for governments as issuing debt at the European level.

Thus, without direct input from the central bank and with low initial capital, it seems particularly doubtful that the BECB will be able to raise nearly €300 billion each year on the markets to enable countries to exercise their drawing rights up to 2% of their GDP. The volume is also open to debate: there is no guarantee that demand for green loans will be that high, either due to a lack of projects, the BECB’s eligibility criteria, or the availability of other sources of financing. It is therefore possible that the 2% figure is more of a ceiling than a target. However, as it will only be able to refinance itself to a limited extent, which will limit its financial clout, there is a significant probability that this climate bank will not be able to develop an annual volume of activity significantly higher than that of the European Bank for Reconstruction and Development (EBRD), for example, whose statutes are similar to those provided for in the draft treaty. In this regard, it should be noted that since its creation in 1991, the EBRD has financed more than 4,000 projects with a total volume of around €90 billion. This is already significant, but it is clear that it remains incomparable with what appears to be necessary to finance the energy transition, which requires nearly €300 billion per year. Under these circumstances, the added value of this climate bank compared to the actions carried out by the EIB would lie mainly in its targeted focus on ecological transition, rather than in its financial clout.

This is in no way to question the relevance of the idea of making greater use of money creation for the benefit of the energy transition, in a targeted and responsible manner. But it would be a mistake to think that this can be achieved simply by creating new institutions, without considering the issue of refinancing. One alternative, proposed by Gaël Giraud[11], among others, would be to create a private structure benefiting from a public guarantee on its market borrowings, with the sole aim of financing the energy transition. In 2008, France created the Société de financement de l’économie française (SFEF) to refinance the major French banks without increasing the public deficit. The SFEF benefited from the public guarantee, thanks to which it was able to raise €70 billion on the markets in one year, which it lent at low rates to commercial banks. But as it was a private company, this debt was not included by Eurostat in France’s public debt in 2009. The same solution could be envisaged for investing in the energy transition.

Conclusion

The idea of a Climate Bank may be interesting in terms of the « tools » that can be added to the range of public intervention mechanisms needed to find the huge amounts of funding required for the energy transition. However, the project as formulated in the « Climate Finance Pact » unfortunately sidesteps several key questions concerning both the institutional channels and mechanisms for distributing funding and the very terms of refinancing this Climate Bank. All public investment banks face refinancing constraints that exceed those of commercial banks, which can rely on customer deposits. It is important to be aware of these limitations so as not to distort the debate and cause disillusionment about the possibilities offered by this type of tool.