Lies, damn lies and interest rates

In economics, the interest rate is everything. Like a butterfly flapping its wings, the merest hint of the European Central Bank or the Federal Reserve changing rates is enough to dramatically alter economic forecasts.

This makes the European Commission’s choice of interest rate in its climate and energy modelling all the more puzzling. The Commission is currently assessing how much money will be needed for the energy efficiency, renewable energy and other policies to reduce greenhouse gas emissions by 55% by 2030. And it is using a 10% interest rate to do so.

10%… As I write this the interest rate on 10-year government bonds in the Euro area is -0.1%. In the United States it is 1.7%. Of course not all capital is so cheap, but the only certain way to pay 10% these days is to max out your credit card on short-term consumer loans.

Why does this matter? The higher the interest rate in the modelling, the higher the apparent costs of climate action. And the higher the costs, the harder it will be to get backing from the member states for the upcoming ‘fit for 55%’legislative package. If the Commission were to use a more realistic interest rate, it might be able to show that the EU could achieve 60% or more emission cuts for the same cost as it currently is planning to pay for 55%.

This can literally make a world of difference. Each annual update of the United Nations Emissions Gap report highlights the alarming disconnect between the objectives of the Paris Agreement – to limit global warming to well below 2 degrees and to pursue efforts to stay within 1.5 degrees – and countries’ actual plans. Using a lower interest rate would justify steeper emission cuts and safer temperature margins.

Put all this to the Commission, however, and you get a variety of excuses. One senior official admits 10% is out of sync with real-world borrowing costs but tries to turn vice into virtue: expensive is good, he says, because countries will conclude it is easier to absorb the billions of euros of Covid recovery funds.

Another official argues that the Commission is at least taking a neutral approach, because it is modelling all scenarios and technologies with the same 10% rate.

These arguments are obviously flawed. One leading asset management fund has told the Commission’s energy directorate that it doesn’t expect anything close to a 10% return on investment over the next decade, so why are the modellers assuming such high capital costs?

As for the supposed neutrality of the 10% rate, a new report by the Corporate Leaders Group shows it is anything but. 10% makes everything look too expensive, including the all-important building renovation, wind, solar and electric vehicle policies. This discourages action and ends up favouring status quo fossil fuels.

All this can seem a little surreal. Remember we are only talking about reducing the interest rate in the Commission’s modelling forecasts, not a real-world change like a central bank decision. But the illusion of high costs can be enough to undermine the political negotiations on the fit for 55% package.

Possibly Ursula von der Leyen and her lead man on the Green Deal, Frans Timmermans, believe ambitious legislative proposals can be pushed through despite inflated cost assumptions. But when the stakes on climate change are so high, why sell your own policies short?

Note: this column is about capital cost assumptions in the European Commission’s modelling. It does not touch on technology cost assumptions or so-called decision-making discount rates, which are other important topics in the Commission’s modelling

The views expressed in this column are those of the columnist and do not necessarily reflect the views of eceee or any of its members.

Lies, damn lies and interest rates

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