Investment and Decarbonization: Rating Green Finance

The Biden administration has committed the United States to cutting its carbon emissions in half by 2030 and achieving net zero emissions by 2050. The International Renewable Energy Agency (IRENA) estimates that the global transition to a low-carbon future will require $131 trillion in infrastructure investment by 2050.¹ With the US share of global GDP and carbon emissions around 16 percent, a back-of-the-envelope calculation puts its gross financing needs at roughly $21 trillion—or 100 percent of GDP over the next three decades. In other words: approximately 3.3 percent of GDP per annum in investment has to be financed to achieve Biden’s commitments. But the climate-related financing promised by Biden’s twin infrastructure bills amounts to no more than $100 billion, or 0.5 percent of GDP per year over the next eight years.² How is the rest going to be financed?

In what follows, we propose that Congress should create a standalone public ratings agency that is insulated from both public and private institutions involved in green finance. The agency would be mandated to assess the economic viability and contribution towards decarbonization of project proposals. Their ratings would serve as a public signal for the state, investors, cities, and firms to back, fund, and undertake projects that are both viable and contribute significantly to decarbonization and resilience against climate change. Once there are reliable ratings, the United States can backstop private financing of green projects at scale, while conserving politically expensive tax dollars and maintaining financial stability. This strategy would unlock trillions of dollars in funding for green projects—going a long way towards closing the existing funding gap of $600 billion a year. Whatever institutional configuration emerges to fund the energy transition in the United States, an independent public ratings agency must be a pillar of green finance.

Funding and building

At the most fundamental level of analysis, we must distinguish between the financing and undertaking of green projects. A public authority may undertake a green project and finance it directly from tax revenue through a budget appropriation. Or it may finance it by borrowing the funds from private investors by issuing bonds and paying off the debt over time. Similarly, a private firm may undertake a green project and finance it directly from retained earnings, or through government subsidies, as envisioned in the “cash for clunkers” program. Or it may finance the project by raising funds from investors by issuing debt or equity. We thus have a basic typology of financing possibilities.

Given the scale of the financing needs for true decarbonization, “all of the above” is the right solution to the problem of green finance. Different models of undertaking and funding are appropriate for different projects. Projects that are socially and privately rational can be undertaken by private actors and funded by private investors. Projects that have high social net present value but are difficult to monetize require either direct public investment or public subsidies for private undertaking. In either case, they can be financed directly by tax dollars or by issuing debt to private investors to be paid off with future tax revenue.

Direct financing of public investment makes sense when the payoff from the investment is clear but only realized with a great time lag. Investments in childcare, education, and public health increase social welfare and even growth rates, but are unlikely to translate into higher revenues for fiscal authorities for decades. Replacing lead pipes, for example, will reduce health insults for children and make them into more productive adults, but the economic benefits of a generational increase in health outcomes will only show up in tax receipts decades in the future. Direct financing of public investment also makes sense when the goal is resilience, as in the case of seawalls. In fiscal terms, the investment pays off by preventing a future fall-off in revenue—seawalls prevent the collapse of property tax revenue, as storm risk and rising sea levels lower house prices. Many green projects have such properties. Many others—like smart grids, retrofitting the housing stock, public transportation, and clean energy—do not. For these, debt financing is more appropriate.

Debt finance is highly attractive at the present moment for a number of reasons. First, the real interest rate on US debt is negative. Direct funding is therefore equivalent to leaving money on the table. Even if interest rates were to rise, as long as they remain below the rate of growth of the economy, debt-financed public investment pays for itself because future revenues increase faster than debt service obligations.³ It is also more effective than directly-funded public investment in stimulating economic activity.⁴

Second, given the shortage of safe assets in the global financial system, US debt issuance tempers the risk of financial instability.⁵ Third, debt finance allows the US to bring the supermassive risk-bearing capacity of patient intermediaries—US pension funds and insurance companies alone reported $38 trillion in financial assets as of the last quarter of 2020—to bear on the problem of financing green projects. Given the high upfront costs of green investments, it makes sense to finance them with longer maturity bonds. Given their appetite for investment in fixed-income securities with long-term maturities that match their long-term liabilities, prime high-duration green bonds will be especially attractive to patient intermediaries.

Risk

The distinction between fiscal capacity and risk-bearing capacity is crucial to our argument. Fiscal capacity is the capacity of the state to collect taxes without destabilizing the economy. The median high income country raises 40 percent of GDP in tax revenue; for middle income countries, it is 28 percent; for low income countries, just 18 percent. Due to its high degree of institutional development and the fact that it has a larger economic size than any other country in the world, the United States in theory has immense fiscal capacity. In practice, it is subject to hard-to-evade political constraints and further limited by moral-intellectual commitments to fiscal discipline. However much these constraints may be bending in the current conjuncture, they are still evident in the Biden’s administration’s refusal to debt-finance the $4 trillion in public investment it has put before Congress.

The risk-bearing capacity of a state is the capacity to absorb losses—to stomach the risk that the future may turn out worse than expected. The US advantage in risk-bearing capacity is considerably larger than its fiscal capacity, due to the structure of global financial intermediation.

By a very large margin, the United States is the largest provider of safe assets in the global financial system: the dollar is the principal third-party currency of global trade invoicing; American banks dominate the global banking system; American investors are the dominant source of global FDI, and so on. The pattern of the US global investment position is such that it provides insurance to the rest of the world on which it earns a premium—risk assets featuring high returns predominate in the US portfolio of foreign assets, and safe assets featuring low returns predominate in the rest of the world’s portfolio of US assets.⁶ In times of market stress, global investors flee to the safety of US Treasuries—the effective definition of safe assets—and the dollar strengthens. The pattern is so marked that when Standard & Poor’s downgraded US debt from AAA to AA+ in 2011, US Treasuries actually rose in value. The compensation that investors demanded for holding US Treasuries fell despite the credit rating downgrade—where else could investors run? These structural features uniquely position the United States as the insurer of last resort.

US guarantees immediately turn any asset it backstops into a safe asset that commands the lowest compensation for investors. A particularly striking instance of this phenomena occurred at the height of the financial crisis. During the brutal week of the Lehman bankruptcy, the core of the secured funding flywheel tottered, but did not come to a sudden stop. Instead, it continued to spin rapidly, as cash investors lent trillions of dollars to dealers overnight not just against Treasuries but also agency residential mortgage-backed securities (RMBS)—obligations of Fannie and Freddie assumed to be backed by the US government.⁷ The remarkable episode not only revealed that the toxicity was confined to private-label RMBS, but also made plain the power of the United States as the guarantor of the global financial order.

For our purposes, the moral of the story is that US guarantees are so powerful that they can turn the debt obligations of US states, cities, and firms undertaking green projects into de facto AAA-rated safe assets and, in doing so, dramatically lower the financing costs for such projects. Our basic proposition is that you get an astronomically larger bang for your buck with public backstops: issuing guarantees is a virtually free, highly efficient mechanism to mine the unparalleled risk-bearing capacity of the US state and intermediaries in service of the energy transition. But the United States cannot simply guarantee the obligations of states, cities and firms undertaking green projects without making sure that it is backing only high-quality projects. This is the principal reason why we need a public ratings agency for green finance.

Cities and states

Local governments are at the frontlines of the climate crisis. From retrofitting the housing stock to mass transit, from electrification to seawalls—most of the work required for decarbonization will be undertaken at the level of the city and the state. But these governments face high financing costs. Despite the extraordinary compression of risk premia across the board, BBB-rated municipal bonds still command a premium of 1.2 percent per year over their duration-matched AAA-rated equivalents.⁸ This translates to roughly $150 billion in additional interest payments for every trillion dollars in state and local financing.⁹ A scheme where the US guaranteed prime municipal debt for green projects will save cities and states hundreds of billions of dollars.

Since the global financial crisis, cities and states have been living in grinding austerity. After growing rapidly until the financial crisis, municipal debt simply stopped growing in absolute terms: municipal debt hit $3.2 trillion at the end of 2010—exactly where it stood at the end of 2020. If cities and states are to undertake the projects that comprise the energy transition, they need both dramatically more funding and much lower financing costs. But in order to make guarantees work, we need a public ratings agency that can credibly ascertain which projects are economically viable, financially sound, and contribute significantly to decarbonization. The full faith and backing of the US should backstop only prime municipal debt—in the full sense of the term.

Controlling the boom

So far we have talked about public investment. But many green projects can and should be undertaken by private entities. For instance, electric vehicles have to be manufactured at scale by car manufacturers; solar panels and wind turbines have to be manufactured, installed and operated by profit-seeking firms. Many such green projects (electric vehicles, and certain solar and wind projects) may already be attractive to firms and will require little encouragement by the government. However, many will not. In such cases, the standard modus operandi is to provide public subsidies and tax credits to encourage private activity.¹⁰ The same activity can be encouraged by providing public backstops that lower financing costs—while complementary to subsidies and tax credits, our proposal is virtually free.

Despite being virtually free, such support would yield large gains for qualifying bond-issuing firms. The BAA10Y corporate spread over Treasuries stands at 1.97 percent and has averaged 2.36 percent since 1986. Under a scheme where the US guaranteed prime corporate debt for green projects, and given the prevailing yields on Treasuries, qualifying bond-issuers would save $216-263bn in interest rate payments for every trillion in financing. Using the average level Treasury yields since 1986, they would save $263-344bn instead.¹¹ Through the monetary cycle, qualifying firms’ financing costs will be drastically reduced without consuming any direct subsidies or tax expenditures.

But again: such a scheme could only work if there were a public ratings agency to ensure ratings are reliable and not manipulated. The most attractive feature of a public backstop is that it costs taxpayers virtually nothing—as long as the backstops do not generate large losses for the Treasury’s balance sheet. In order to ensure that they do not, we must be vigilant against a boom-bust cycle in green finance.

At present, the business of project assessment and ratings classification for green finance is in private hands, led by BlackRock. This is a recipe for trouble because private credit ratings are coupled to the financial cycle. For instance, during the mid-2000s, deterioration of rating standards played a crucial role in amplifying the financial boom.¹² There are already warnings of the coming catastrophe. Tariq Fancy, the former head of sustainability of BlackRock called the asset manager’s ESG scheme “little more than marketing hype, PR spin and disingenuous promises.”¹³ We can be virtually certain that, were green ratings left to “independent” ratings agencies or financial intermediaries, they would also become decoupled from fundamentals as the green boom gets underway. This is the default scenario. A public ratings agency for green finance is necessary to ensure that such a catastrophe does not obtain.

The scenario of the green boom getting out of hand is far from outlandish. Given the scale of the undertaking, it would be hard for economic policymakers to distinguish a healthy economic boom from a dangerous financial boom. In fact, we will only know for sure that the boom got out of hand if and when the bubble bursts. If it did, we would find a major misallocation of resources only after the fact—but the timescale of decarbonzation does not allow for the boom, crash, reform cycle. It calls for macroprudential authorities to be on the watch for the green boom getting out of hand. It also calls for good institutional design in green finance.

Institutions and investment

Public investment in the United States has fallen by half from 7 percent of GDP under JFK in the early-1960s to 3.5 percent in recent years. State and local government investment in fixed assets has fallen by a third from 3.0 percent of GDP in the late-1960s to 2.0 percent, while federal investment has fallen by more than two-thirds from 4.4 percent of GDP in the early-1960s to 1.5 percent.¹⁴ Treasury Secretary Janet Yellen suggested recently that the public investment gap explains the vanishing of broad-based growth:

For the past 40 years, the federal government has gradually shrunk its investment in public goods: schools, infrastructure, and research into new technologies. This slow decline has undermined broad-based growth. It has weighed-down productivity and curtailed our ability to respond to our nation’s most pressing challenges, including the threat of climate change.¹⁵

The investment dearth has prompted a variety of new proposals, each reflecting a strand of the new expansionary consensus. Prominently, Robert Hockett and Saule Omarova’s National Investment Authority (NIA) proposes to close the public investment gap by using the risk-bearing capacity of the US state to mobilize private finance to fund the energy transition. The NIA would function as a modern finance version of the New Deal-era Reconstruction Finance Corporation. This is an ambitious agenda to “lever private investment in public goods through federal grants, loans, guarantees, securitization, and large-scale private equity-style asset management.” The NIA would “directly allocate both public and private capital to clean infrastructure projects” by actively participating in financial markets “not only as a lender, guarantor, and market-maker but also as an active asset manager and venture capital investor.”¹⁶ We share this approach of leveraging the public balance sheet to underwrite private financing of public investment in green projects. As of writing, enthusiasm for a full-scale NIA is tepid on Capitol Hill, for the obvious reason that such an entity would be the dominant actor in the economic and financial system, and therefore threaten the revenues and power of private financial institutions. No political bloc currently exists to counterbalance this opposition, and Congress is instead considering institutions with more modest dimensions: in the House, the Committee on Energy and Commerce has proposed a bank capitalized with $100 billion, and Ed Markey has similarly introduced a $100 billion National Climate Bank Act in the Senate.

We support these initiatives. But there is reason to believe that the ratings agency we propose should not be folded into the climate bank or any other green finance institution at all. In addition to keeping green asset ratings out of the hands of interested private entities, we must also insulate the ratings function from the public climate finance institutions already under construction.

Banks in India and China are sitting on a vast pool of bad debt as a result of state planners directing investment into coal and real estate in a publicly driven boom-bust cycle.¹⁷ More than half of the financial system in each country consists of state-run banks that went on a lending spree, extending credit to crony capitalists, ultimately resulting in a massive misallocation of resources. The economic costs of such investment cycles are not confined to the misallocation: high ratios of nonperforming loans reduce the risk-bearing capacity of the banks, who in turn limit lending, which acts as a major headwind for economic growth. Raghuram Rajan, the governor of the Reserve Bank of India, was fired for trying to solve the problem of clogged public bank balance sheets in India.¹⁸

The problem here is not merely a banking problem or a crony capitalism problem. Where private bureaucracies are motivated by profits, public bureaucracies are interested in their own power. In the case of a climate bank, that may manifest at minimum as a desire to scale the assets under its control, creating systematic pressure for a deterioration in ratings quality. This procyclical tendency again risks creating a boom-bust cycle for the same reason that planned economies exhibit investment cycles. A boom-bust dynamic would destroy the moral economy of the energy transition. That is, a series of scandals around green-washing boondoggles, whether public or private, would undermine the legitimacy of the green project. We need tighter control over the high-pressure green economy—it cannot be plagued with cyclical excess.

Good institutional design, consistent with the philosophy behind some provisions already in the National Climate Bank bill¹⁹, requires that the ratings agency should be staffed by public servants forbidden from working for private financial institutions for, say, five years after they leave public service. It calls for a board of governors to supervise the agency, preferably appointed for life or for legally fixed terms of, say, ten years. The operating costs of the agency should be no more than a few hundred million dollars a year, paid for by revenues that are completely insulated from all cyclical factors.

Our proposal would save firms, cities, and states hundreds of billions of dollars at a minuscule cost to US taxpayers. It would go a long way towards ensuring financial stability as a green boom gets underway by restraining it from turning into a dangerous financial boom. It would prevent waste, cronyism, and a misallocation of national resources. Most importantly, it would move us a long way towards closing the glaring funding gap—the central problem of green finance.