The economics and policy of energy efficiency loans

Lead partner: CIRED

Objective

Most energy efficiency investments have a high up-front cost, hence require financing facilities. Yet they also have specific characteristics which make them unconventional to finance. At least if energy savings are perfectly observable, energy efficiency measures can generate monetary savings, which increase borrower’s creditworthiness. Compared to conventional investments, this effect should drive loan interest rates down. On the other hand, some energy efficiency measures cannot be secured by a collateral, which increases borrower’s default risk. Compared to conventional investments, this effect should drive loan interest rates up.

The net effect of energy efficiency specifics on interest rates is therefore ambiguous. This has two important policy implications. First, if information asymmetries (regarding energy savings and borrower’s default risk) lead to a negative appraisal of energy efficiency loans by lenders, then some government intervention may be needed. For instance, credit enhancements can help reduce the lender’s risk. Second, reduced interest rate loans are implemented in some countries (e.g. France) to stimulate energy efficiency investment. Such a credit facility can be seen as an energy efficiency subsidy, hence a second-best solution to the externality problem (see WP1). However, the carbon dioxide abatement cost-effectiveness of this policy will be low if the above-mentioned information asymmetries exist and remain unaddressed.

In this work package, we will conduct a welfare analysis of financing facilities for energy efficiency investments. We will proceed in two steps. First, we will examine how energy efficiency loans compare to conventional loans in the absence of specific facilities. The goal here is to try and uncover the market failures that may justify specific interventions. The comparison will focus on loans for home energy retrofits (an extra-return, unsecured investment) and for a conventional automobile purchase of a comparable amount (a normal return, secured investment). Second, we will examine the efficiency of various policy options, such as: linked credit to address imperfect information about energy savings; credit enhancements to address borrower’s default risk; reduced interest rate loans to address the environmental externality. This work package will combine theoretical and empirical approaches.

Methodology

Theoretical analysis

We will express the interest rate of any project as a function of the collateral and the deterministic return on investment in a model inspired from the early work of Weiss and Stiglitz (1981). This will allow us to derive analytical conditions under which a lender offers a lower interest rate for an energy efficiency project than for a conventional project of the same size. Comparative statistics will allow us to analyse the effect of a reduced interest loan on the market for energy efficiency loans. We will also examine how credit enhancements such as a loan loss reserve can alleviate the borrower’s default risk.

When extra-returns are imperfectly observable, loans linking financing to the sale of the principal can help signal the reliability of the seller. To examine how this can apply to energy efficiency, we will consider a richer model with imperfect information on energy savings (e.g. based on Lossa and Palumbo, 2004).

Empirical analysis

We will then test the insights from the theoretical analysis and examine how, in reality, the interest rates quoted by lenders for home energy retrofits differ from those offered for a comparable investment, such as an automobile, of similar price.

We will use online simulator data collected on credit suppliers’ websites in France, Germany and the UK. These data will be recorded weekly over the full 3-year period of the project. The advantage of such data is that interest rate quotations are not conditional on credit applicant’s characteristics. Therefore, they abstract from consumer selection problems

The following explanatory and control variables will be considered:

  • Rate of return of the different investments, as approximated by external engineering data
  • Type of loan securisation: collateral, external guarantee,
  • Type of lending institution: commercial banks or consumer credit suppliers, institutions specialised in energy efficiency or non-specialized,
  • Market and Central Bank’s interest rates
  • Size of the respective markets (automobile loans and energy efficiency loans)
  • Loading factor specific to each market

In parallel to data collection, we will conduct expert interviews with bankers on their lending decisions. In the interviews we aim to understand the factors that impact lending decisions of retail bankers in the building sector in practice. In particular, we are interested to get a better understanding of the different barriers to financing energy efficiency investments and their magnitude. The interviews will allow for a meaningful interpretation of the online simulator data and help to identify differences in energy efficiency lending across France, Germany and the UK.

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