The current zero-interest-rate policy of the EU, in combination with financing mechanisms such as feed-in tariffs (FiT), has contributed immensely towards cost reductions in renewables and spurred investments since 2010.
This post is a bit of a digression from our usual posts on renewables, but we believe that a more detailed grasp of the financial theory behind the renewables investment surge in recent years is interesting to some of you as well.
The EU’s zero-interest-rate policy
How are interest rates determined?
Interest rates are determined and impacted by a variety of factors, including monetary policy, inflation, and economic growth. Generally speaking, the relationship between interest rates and economic growth is inverse. Based on Keynes’ macroeconomic theory, the IS-LM model, also known as the Hicks – Hansen Model, explains this relationship, at least partially.
According to the model, lower interest rates encourage higher levels of investment (represented by the IS – curve), which raises GDP and therefore, economic growth.
The model’s LM – side explains the interest rate and real income combination of an economy and shows the equilibrium combinations of money demand and money supply. Money demand is determined by the willingness to hold and invest money, whereas the central bank determines money supply and in respect to nominal interest rates is perfectly inelastic.
Instead of being the independent variable as in the IS part of the model, the interest rate is the dependent variable in the model’s LM part. An increase in GDP should, therefore, increase the interest rate.
In the graph below, the IS-LM model is represented, where i is the abbreviation for the interest rate and Y for income.
The overall equilibrium is found when both, the IS and the LM side of the model, are in balance, meaning no more shifts are taking place.
The role of the ECB
The European Central Bank (ECB) is currently, and has been for a while, following a so-called zero interest rate policy, which means that the key interest rate is kept close to zero.
The ECB sets its key interest rate, which is used for (i) the primary refinancing operations (MRO) providing most of the liquidity to the banking system, (ii) the deposit facility used by banks for overnight deposits, and (iii) the marginal lending facility, which provides banks within the Eurosystem with overnight loans, every six weeks.
These traditional settings all include monetary policy decisions based on their primary objective of price stability.
In Figure 1 below, the trends of the most crucial Euro-Area interest rates are illustrated, where the interest rates for the facility rate, the primary refinancing operations, and the deposit facility are represented in red, purple, and orange, respectively.
Why low interest rates?
Low-interest rates are a tool to nudge banks to lend more money, and firms and individuals to invest more money by providing them with affordable access to capital.
Consequently, the ECB and its decision-makers hope to see an economic boost.
However, low-interest rates are only viable in countries with low inflation and sluggish economic growth, which is the case for most European countries.
Naturally, there are upsides and downsides to running a low-interest rate regime.
Continuous low levels of interest rates deplete the effectiveness of monetary policy measures, making it more challenging to keep inflation at a pre-set level and ensure sustainable economic growth.
On the other hand, as also demonstrated by the Euro Area, low-interest rates can help boost an economy by leading to more willingness to invest and spend money.
The origin of low interest rates
Since the global financial crisis in 2008 and the years following, stock markets have nearly tripled, housing prices have seen significant increases, and people generally invest more money than ever before.
These events can all lead to a so-called liquidity glut, which describes a situation in which too much money is looking for too few investments. Excess liquidity can pour into all sorts of markets, but most commonly into financial asset markets, caused by investors looking for higher returns.
When this happens, prices are driven up, due to increased demand, and yields down, resulting in an inverse effect of the hoped-for outcome. This was the case in the years after 2003 and resulted in the collapse of the United States’ mortgage market.
What does the US mortgage crisis have to do with renewables?
With money supply having continuously gone up in the past decade, interest rates at zero, a booming stock market, and increasing household savings, capital is in excess, and a liquidity glut exists.
Such a surplus does not only have adverse effects. Within the solar PV industry, the high liquidity and the low costs of capital have spurred investments.
This increase in assets has kickstarted production, research and development and led to dropping module prices, resulting in lower installation costs and ultimately, overall levelized costs of solar photovoltaic electricity.
The impact of low interest rates for investments in renewables
The solar photovoltaics industry has been the energy source with the most significant investments in the past decade, which is due to many factors, one of which is the amount of liquidity in the market.
Combined with cheap access to capital, investors saw attractive return possibilities, which they did not see elsewhere, and started investing heavily in PV.
This increase in investments has led to market consolidation, price pressure and hence dropping price levels.
Why we want zero interest rates to last
The increase in investments has led to market consolidation, price pressure and hence dropping price levels.
The need for clean energy combined with the security of feed-in tariffs and linked incoming cashflows has led many investors to enter the solar PV market, develop power plants, and contribute to economies of scale and decreasing price levels.
If interest rates stay as low as they are, investments in renewables will keep spurring, as higher returns usually attract more investors.
The spill over effect of zero interest rates on capital costs
Without going into too much detail, low interest rates lay the basis for low costs of capital.
Within the solar PV market, the costs of capital are in no way negligible, if reaching a certain height. It has been identified that the costs of capital play a significant part in the overall costs per kilowatt hour, in such that weighted average costs of capital of 12% make up more than half of the total levelized costs.
Table 2 shows the share and impact of different costs on the levelized costs of electricity for solar PV installations, where costs of capital can quickly make up the majority of costs.
Once again, this supports the initial statement that the zero percent interest-rate strategy the ECB follows gives investors unprecedented opportunities to invest in renewables, especially more mature technologies.
Low costs of capital help, among other things, generate higher returns on investments (ROI) and make the renewables industry attractive to invest in.
Consequently, all sources of energy, including renewable energy, benefit from the EUs zero interest rate policy.