The Fed’s rate cut cycle could trigger a risk-on atmosphere in the global economy. For critical sectors like clean energy, there’s fresh hope that falling interest rates would facilitate liquidity flows at a reduced rate
With global inflation moderating, major global central banks like the European Central Bank (ECB), Bank of England (BoE), and now, the United States Federal Reserve (Fed) have queued up to cut interest rates. After the ECB entered the rate cut cycle in June, the BoE in August and the Fed in September slashed interest rates by 50 basis points.
Unsurprisingly, central banks in Brazil, Indonesia, and South Africa have already begun to follow suit. Others will likely take cues from these developments to provide a breathing space for economic growth. For critical sectors like clean energy, there is fresh hope that falling interest rates would facilitate liquidity flows at a reduced rate.
The Fed’s rate cut cycle typically triggers a risk-on atmosphere in the global economy as investors seek riskier assets with higher yields. This weighs on the US dollar, boosts emerging market currencies and makes it easier for developing countries to repay debt denominated in foreign currencies.
Moreover, foreign investors can now look at investment opportunities in clean energy assets in the developing world, where yield will look more attractive. A low-interest rate regime also translates into the low probability of default of assets owing to decreased interest expenses. It can also lessen the pressure on exchange rate stability and accelerate capital flows into emerging markets.
Deploying clean energy technologies requires significant upfront capital investments compared to fossil fuels. Higher interest rates adversely affect the former. Capital-intensive industries, like clean energy, typically have elevated gearing ratios or more debt than equity in the capital structure. Hence, high interest rates discourage debt financers from investing in these industries.
Most emerging market economies have foreign debt, often denominated in the major global reserve currencies, as one of the most significant components of their international capital flows. The International Monetary Fund (IMF) suggests that such loans can account for more than 50% of the external liabilities of these economies. Thus, high interest rates in developed economies hurt the prospects of rapid energy transition for developing countries.
Like a waterfall, commercial and public-sector banks and project financing institutions will likely respond to the low interest rates and pass on the benefits to debt-seeking companies to expand their businesses. Theoretically, lower interest rates should reduce the hurdle rate for new loans and make debt servicing easy for existing borrowers. Both these conditions lead to an increase in loans available for clean energy assets. Besides, lower interest rates lead to fewer loan losses, encouraging lenders to provide more funds for projects.
However, banks do not immediately pass on the benefit of lower interest rates to the real economy. As the lower interest rate cuts their interest income, banks usually focus on non-fund-based businesses to boost their income. They also test how loan demand reacts to a low-interest-rate environment. Banks also gauge if there is a scope to reduce interest rates on deposits. Competition among banks and with other lenders also determines the cost of debt in markets. Yet, if lower interest rates persist for a long time, banks will be forced to pass on the benefits to corporations.
Decreased interest rates could address project developers’ extreme sensitivity to the cost of capital. A more than anticipated decrease in the interest rate, often a major component of the cost of capital, will unlock money and mind space for investments in low-carbon industries. Moreover, the appetite for low-cost, long-term debt capital will likely increase, thus contributing to a higher proportion of debt in the capital structure. Such developments are considered favourable for expediting the deployment of large-scale clean energy assets.
As corporates are likely to borrow more favourably, their investment in capital-intensive low-carbon businesses should grow. On the retail side, rate cuts will allow consumers to borrow for electric mobility, energy-efficient appliances, and eco-homes.
However, there is a time lag in the transmission of low interest rates in the real economy. Developers need to plan and design project timelines accordingly. They can also utilise this time to lock in long-term off-take agreements before they start new projects. Moreover, legacy projects shelved due to high capital costs will also be an option for quick repowering with a mix of new technologies and the latest project management techniques.
As global climate change can be directly held responsible for abrupt natural calamities that cause huge losses to people’s lives and property, banks can devise additional carve-outs to boost the clean energy sector in light of the rate cuts. This will relieve clean energy players, big, small, and startups, from the prospects of high-cost debt financing, which stalls new project development and impacts their growth.
(Jena is sustainable finance specialist at IEEFA, and Thakur an alumnus of IIT Bombay and IIM Ahmedabad)