Climate Policy with the Chequebook - An Economic Analysis of Climate Investment Support

Abstract

Across the globe, climate policy is increasingly using investment support instruments, such as grants, concessional loans, and guarantees-whereas carbon prices are losing importance. This development substantially increases the risk of inefficient public spending. In this paper, we examine the ability of finance instruments to effectively and efficiently address market failures related to clean energy investments. We characterise these market imperfections-emission externalities, knowledge spillovers and capital market imperfections-and identify their negative impacts on the investor-relevant risk-return characteristics. We argue that finance instruments are able to address the effects of these market failures. However, a carbon price is superior in internalising the emission externalities. With respect to the latter two inefficiencies, investment support instruments can effectively compensate the market failures if designed appropriately. We further provide policy recommendations on the choice of finance instruments to address the various market failures and guidance on how to use these instruments avoiding inefficient government spending.

Full text

Climate Policy with the Chequebook Accepted Manuscript
1
Karol Kempaa,c and Ulf Moslenerb
Climate Policy with the Chequebook – An Economic Analysis of Climate Investment
Support
a. Corresponding author: FS-UNEP Collaborating Centre for Climate and Sustainable Energy Finance,
Frankfurt School of Finance and Management
Sonnemannstrasse 9-11, 60314 Frankfurt, Germany
Phone: +49 (0)69 154008 645, Fax: +49 (0)69 154008 4645, E-Mail: K.Kempa@fs.de
b. FS-UNEP Collaborating Centre for Climate and Sustainable Energy Finance,
Frankfurt School of Finance and Management
c. Justus Liebig University Giessen, Department of Economics and Business Studies
This article first appeared in Economics of Energy & Environmental Policy, Vol. 6, No. 1,
pages 111-129, 2017, DOI: http://dx.doi.org/10.5547/2160-5890.6.1.kkem
– Reproduced by permission of the International Association for Energy Economics
(IAEE).
This is the accepted manuscript version of the article. For citing purposes please use:
Kempa, K. and U. Moslener (2017). Climate Policy with the Chequebook – An Economic
Analysis of Climate Investment Support, Economics of Energy & Environmental Policy
6(1): 111–129. DOI: 10.5547/2160-5890.6.1.kkem
ABSTRACT
Across the globe, climate policy is increasingly using investment support instruments, such
as grants, concessional loans, and guarantees – whereas carbon prices are losing
importance. This development substantially increases the risk of inefficient public
spending. In this paper, we examine the ability of finance instruments to effectively and
efficiently address market failures related to clean energy investments. We characterise
these market imperfections – emission externalities, knowledge spillovers and capital
market imperfections – and identify their negative impacts on the investor-relevant risk-
return characteristics. We argue that finance instruments are able to address the effects of
these market failures. However, a carbon price! is superior in internalising the emission
externalities. With respect to the latter two inefficiencies, investment support instruments
can effectively compensate the market failures if designed appropriately. We further
provide policy recommendations on the choice of finance instruments to address the
various market failures and guidance on how to use these instruments avoiding inefficient
government spending.
Keywords: climate finance, investment support, market failures, policy instruments.

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1 INTRODUCTION – IS CLIMATE POLICY STILL ON TRACK?
Over the past few years, climate related policy intervention has witnessed a stark increase
in the use of government subsidised financing. The corresponding instruments are neither
directly tied to the emissions abated nor do they make carbon emissions more costly, but
rather decrease the financing costs of certain projects and thereby increase the
attractiveness of the corresponding investment. Essentially, the government moves away
from its role as regulator determining the market rules and tackling externalities at their
origin by introducing prices through carbon taxes or permit trading schemes. Governments
take on the role of an actor on financial markets by providing financing to specific projects
or programmes, often through their public finance institutions.
Environmental regulation and in particular climate policy has been through a dynamic
history. Traditional command and control instruments dominated early policies
characterised by government-defined technological standards such as “best available
technologies” or direct input or output controls (Harrington & Morgenstern, 2007). The
economic literature following the work of Pigou (1920) powerfully demonstrated the
superiority of market-based instruments – at least in terms of their ability to implement a
given level of emissions at least cost.
1
One key issue is the decentralised nature of those
market-based instruments that allows for cost efficient implementation without requiring
detailed knowledge at the government level of technologies and individual firms’
abatement cost structures. Rather than giving explicit directives on pollution levels,
market-based instruments provide incentives through market signals to encourage the
behaviour. These instruments – if designed and applied appropriately – realise a desired
level of pollution abatement at least cost to society (Baumol & Oates, 1988; Montgomery,
1
See Sumner, Bird, and Dobos (2011) for a review of carbon tax policies.

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1972; Tietenberg, 1995). The price signal induces an equalisation of marginal abatement
costs across firms such that the pollution abatement burden is allocated efficiently among
polluters, where firms with the lowest abatement cost will be the first to abate.
Furthermore, market-based instruments perform better in terms of incentivising the
development of new technologies which has led to a rapid increase in the use of these
instruments since the 1970s across OECD countries (Hahn & Stavins, 1992; Jaffe &
Stavins, 1995; Stavins, 2003; OECD, 1999). The most prominent economic instruments in
climate policy are the CO2 emissions trading scheme introduced by the European Union
(EU) and the state-level emissions trading foreseen in the Kyoto Protocol to the United
Nations Framework Convention on Climate Change in 2005 or 2009, respectively. Other
policy schemes were introduced in parallel that mainly target the promotion of renewable
energy (Menanteau, Finon, & Lamy, 2003).
In very recent years the trend of increased climate related government investment subsidy
appeared, mainly through grants, interest subsidised loans or (less often) guarantees. Even
the use of more complex so-called structured investment vehicles can be observed.
2
The
EU recently set regulations on the use of financial instruments of various European funds
for, among other goals, reducing pollution.
3
The International Development Finance Club
(IDFC) – consisting of 20 national development banks operating nationally and
internationally, inside and outside the OECD – reports total green financing by 18
reporting institutions of USD 99 billion in 2013 (Khosla, Eggink, & Gilbert, 2014).
Multilateral Development Banks – not included in the figures above – report USD 28
billion of climate finance in 2014 compared to USD 27 billion in 2011 (World Bank,
2015). In addition to these financial institutions, 22 multilateral and 6 bilateral funds are
2
An example is the Global Climate Partnership Fund, structured similarly to a credit default obligation
(CDO) where the riskiest tranche is held by the government and serves as a risk buffer to attract private
investment for the less risky tranches.
3
See EU Regulations No 1303/2013 and No 480/2014 as well as the Commission Implementing Regulation
No 821/2014.

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dedicated to financing climate related investments.
4
According to the IEA/IRENA Global
Renewable Energy Policies and Measures database, currently 208 support policies (subsidy
and loan programmes) for renewable energy are in force worldwide.
5
Consistent with this development, the international climate policy debate drifted from
“emission targets” towards “financing commitments”. A major element of the United
Nations (UN) climate process is the promise of the industrialised countries to mobilise
climate financing of USD 100 billion per year from 2020 on, to finance mitigation and
adaptation in developing countries (UNFCCC, 2012) and the establishment of the UN
Green Climate Fund (GCF) by the Conference of the Parties (COP) in Durban (2011).
Thus, policy seems to move away from the explicit internalisation of externalities, it
requires technology-specific information to formulate the investment subsidy programmes,
and, by subsidising individual projects, it moves away from a decentralised approach.
Considerations from a political economy perspective might explain parts of this trend. For
a policy maker it is more attractive to offer support for climate friendly investments than to
introduce additional costs for established conventional technologies (Bowen, 2011; Green
& Yatchew, 2012). Green and Yatchew (2012) provide an economic analysis of support
schemes focusing on the difference between programmes focusing on prices, e.g. feed-in
tariffs, and quantities, e.g. renewable portfolio standards. We complement this work by
examining to what extent these instruments can efficiently correct market failures caused
by the emission externality, innovation spillovers, and capital market failures as well as
providing guidance on how to use them appropriately. We argue that finance instruments
are in general inferior to economic instruments in compensating for environmental
externalities. However, these instruments seem suitable to effectively address knowledge
4
See Climate Funds Update, available at http://www.climatefundsupdate.org/ (last accessed 22 March 2016).
5
The database is available at http://www.iea.org/policiesandmeasures/renewableenergy/ (last accessed 22
March 2016).

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spillovers and, in particular, capital market failures. Both aspects can be expected to be
increasingly relevant as the world is trying to speed-up the structural change towards a low
carbon economy as decided in the Paris Agreement under the United Nations Framework
Convention on Climate Change.
6
The remainder of this paper is structured as follows. The following Section 2 presents three
major instruments for investment support (grants, interest subsidised loans, and
guarantees). In Section 3, we characterise three main market failures relevant to clean
energy investments and illustrate their effects from an investor’s perspective. In Section 4,
we examine whether finance instruments are suitable to address the respective market
failure and provide policy recommendations. The final Section 5 concludes.
2 INSTRUMENTS FOR CLIMATE RELATED INVESTMENT SUPPORT
Subsidies to financing renewable energy or energy efficiency investments occur in a
variety of instruments.
7
In this analysis, (i) simple grants, (ii) interest-subsidised loans, and
(iii) loan guarantees are considered. While this set of instruments is not exhaustive, it still
covers the majority of the subsidised financing volume and represents the main elements
more complex instruments, such as structured funds, are composed of. Table 1 provides an
overview of the major design parameters of a grant programme compared with
concessional loans and loan guarantees. These design parameters largely determine the
value of an instrument to the recipient (subsidy element) and the cost to the government.
6
According to the Paris Agreement, parties to the convention agree to “undertake rapid reductions […], so as
to achieve a balance between anthropogenic emissions by sources and removals by sinks of greenhouse gases
in the second half of this century”.
7
See Mclean, Tan, Tirpak, Sonntag-O'Brien, and Usher (2008) for an overview. A comprehensive
comparison between the different instruments for government-intervention would be complex, since the
different instruments imply different rights and obligations on the side of the investor (in our case sometimes
the government). While the right of a debt-provider is merely restricted to receiving information and interest,
the right of an equity provider may be different and involve decisions of the respective company. Similarly,
the risks taken on by the institution providing the instrument are different according to the instrument. In our
analysis, we concentrate on debt.

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2.1 Grants
A grant is typically a simple payment that is tied to a specific investment. As a support
instrument used by a government or a public finance institution, the grant provision as such
and its volume can be flexibly coupled to any politically justified parameters. In the field
of clean energy, these parameters may be a list of technologies or activities that are eligible
for support. It may also be a more abstract description of activities (e.g. by their goal or
purpose) in order to keep the instrument flexible. In general, one may also link the grant
provision to parameters such as emissions saved. This is, however, rarely the case, since it
is often difficult to determine the emissions saved through an investment. If at all, expected
savings for standardised technologies, which may be estimated up-front, are used.
The parameters may not be limited to climate related political goals. Typical examples of
additional requirements are a certain maximum income of the supported household in order
to focus the support on low-income households, or so-called local content rules that require
part of the investment to be spent on technologies produced in the country that is funding
the support scheme to support the regional economy. Grants are mainly used for two
different purposes: (i) to fund early-stage clean technologies in their pre-maturity phase
(research, development, and demonstration) and (ii) to subsidise the deployment of small-
scale renewable energy.
In any case, the support scheme needs rules to determine whether support is granted, the
volume of the support, as well as the timeframe. The latter has strong implications on
dynamic incentives. A credible long-term commitment of a government to subsidise, e.g.,
certain energy efficiency improvements in residential buildings or renewable energy
heating systems, might incentivise innovations in these technologies that could lead to cost
reductions. A very limited subsidy scheme might not be able to trigger innovation
activities.

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2.2 Concessional Loans
Concessional loans use public money to extend loans for politically desired projects at
more favourable conditions (maturity, interest, seniority) compared to commercial loans
available on the market. If a concessional loan programme is used as a support policy, the
conditions for the loan provision can – similar to the case of grants – be coupled to any
parameters.
A number of reasons make the efficiency analysis for concessional loans fundamentally
more complicated than the case for grants. One reason is that a concessional loan is
characterised by more variables than a grant. While a grant is largely determined by
volume and time of payment, a concessional loan needs to be further specified with respect
to maturity, interest rate, including potential interest-free years at the beginning plus the
seniority relative to other loans. A so-called senior loan will have to be paid back with
priority while a “junior”-ranked loan might leave the priority to other loans, perhaps
commercial lenders, who would find themselves in a more secure situation.
A second complexity relative to grants stems from the fact that the subsidy element of a
concessional loan is not completely determined by the characteristics of the offered loan,
but also by the risk profile of the recipient: At market prices, a high-risk borrower will
normally be charged a higher interest rate than a low-risk borrower. Therefore, a
concessional loan programme with a standardised interest rate will effectively mean a
higher support for the high-risk- borrower than for the low-risk borrower.
8
This support-
bias may give rise to standard adverse selection problems. Further, it is obvious that the
absolute value of support increases with the volume to be financed.
8
This may be different if the interest rate is formulated relative to some interest rate that the borrower would
have been offered on the market.

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An alternative to direct public lending are interest subsidies. In this case, the government
does not directly provide loans, but rather offers a subsidy on the interest paid by the
borrower. In such an interest softening mechanism, the borrower receives a loan at market
conditions from a bank, but the interest repayment is party taken over by the government
such that the effective interest rate for the borrower is reduced.
2.3 Guarantees
Public guarantees to loans are typically used in order to lower the financing costs for a
specific project. If a lender (e.g. a bank) receives a guarantee for some risks or part of a
loan by a credible public institution, he is confronted with less risk and consequently may
ask for a lower risk-premium on the interest rate, provide a higher loan amount or provide
a loan at all.
A potential investment support programme structured as guarantees needs to specify the
type of loans (often loan purpose) which are eligible for a guarantee. Hence, implicitly
most characteristics of the loan are part of the support scheme (maturity, seniority, volume,
etc.). The added complexity of guarantees versus concessional loans comes from defining
the trigger of the guarantee, the covered risks, and its pricing. While the pricing is often
very similar to loan pricing (as a percentage of the covered loan volume), guarantees
usually do not cover the full loan, but rather a certain fraction of the full amount – typically
between 70-80% in practice (Honohan, 2010). One main reason is that coverage of (close
to) 100% would induce moral hazard, as it would weaken the monitoring incentives of the
lender (Anginer, de la Torre, & Ize, 2014).
9
A major complexity – also when it comes to
implementation – is the specification of risks to be taken by the public guarantor. In the
9
Green (2003) provides an analysis and examples on this moral hazard effect. One case is the Lithuanian
Rural Credit Guarantee Fund that offered 100% coverage for loans for purchasing agricultural equipment
and resulted in a huge amount of defaulted loans. When the Canadian Small Business Loans Act increased its
guarantee coverage from 85% to 90%, lenders awarded loans to riskier clients resulting in a drastic increase
in defaults.

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event of default, it might be difficult to determine the drivers for this default ex-post.
Depending on the risks covered by the guarantee, the value (or the subsidy embedded in
the guarantee) may be higher for high-risk borrowers/projects.
Table 1: Variables characterising the three major instruments for investment support
which need to be determined designing a corresponding support programme.
{Insert Table 1 around here}
3 MARKET FAILURES AND THE INVESTOR PERSPECTIVE
Two main market failures that are related to climate investments frequently used to justify
the promotion of climate investments are the negative externality caused by greenhouse
gas emissions and the positive innovation externality (spillover).
10
One class of market
imperfections, which is typically disregarded in analyses of instruments for environmental
policy are potential imperfections on the capital markets. We argue, however, that it is
essential to consider these market imperfections for at least two reasons. Firstly, climate
related investments highly depend on services provided by capital markets, as renewable
energy investments, e.g., are typically characterised by high up-front investment and low
operating costs, which means that the cost structure is dominated by capital costs (Evans,
Strezov, & Evans, 2009; Painuly, 2001; Wiser, Pickle, & Goldman, 1997). For
photovoltaics, the capital costs can account for more than 95% of total life cycle costs
compared to a share of only 11% in the case of an oil power plant (Kannan, Leong, Osman,
10
Other reasons frequently used to justify policy intervention include clean energy investments’ contribution
to energy security or strategic considerations of industrial policy aimed at establishing competitive
advantages for local clean technology firms.

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& Ho, 2007). Secondly, climate policy increasingly acts through capital markets, as
demonstrated above.
We therefore examine three major economic market failures related to low-carbon
investments – (i) environmental emission externality, (ii) innovation spillovers and (iii)
capital market failures (Stern and Rydge, 2012) – and, following Dinica (2006), translate
these externalities into the investor perspective to illustrate their effects on the risk-return
profile of climate investments.
3.1 Environmental Externalities & Innovation Spillovers
Emission externalities are characterised by a (negative) impact of one agent’s emissions on
the well-being of others. If this market failure is not corrected, e.g., through a price on
emissions via taxes or a tradable permit scheme, then renewable energy or energy
efficiency projects are commercially less attractive compared to otherwise similar projects
based on conventional thermal power generation. There is a cost differential in favour of
conventional technologies as long as the external costs of, e.g., fossil-based energy
generation are not internalised.
11
Innovation spillovers refer to the positive effect of inventions or innovations on other
market actors. Technological change can be roughly divided into three stages: (i)
invention: the creation of ideas, (ii) innovation: creation of new products or processes
based on ideas, and (iii) deployment and diffusion: the actual penetration of the relevant
market by the new technology (Popp, 2010). A firm invests in innovation activities if the
expected returns of these activities exceed the costs. A successful technology innovation or
deployment activity, however, usually leads to increased general knowledge due to its
11
Renewable energy, however, might also be associated with negative externalities as negative impacts of
visual and noise pollution from wind turbines on neighbouring properties’ prices (Jensen, Panduro, and
Lundhede, 2014) or changes in the landscape and impoverishment of natural diversity caused by hydropower
(Kataria, 2009). Ladenburg and Lutzeyer (2012) provide a review on visual impacts of offshore wind.

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public goods nature. It is difficult to exclude others from these benefits. Even if intellectual
property rights are in place, patents cannot entirely exclude other firms from profiting, as
they can modify the patented innovation and utilise it (Levin et al., 1987). Hence, the
social returns of innovation and deployment activities exceed the private returns of the
innovator and result in an under-provision of such activities (Arrow, 1962; Griliches, 1992;
Jaffe, 1987; Jones and Williams, 1998). Private actors invest too little, or possibly not at
all, in certain socially beneficial innovation activities, as they cannot fully exploit the
resulting benefits. Dechezlepretre, Martin, and Mohnen (2014) and Braun, Schmidt-
Ehmcke, and Zloczysti (2010) provide evidence for knowledge spillovers in the clean-
technology sector.
Environmental externalities and innovation spillovers may also interact. Successful
innovation and diffusion of clean technologies reduce the marginal costs of achieving a
desired pollution level. Policies targeting one of these externalities might also indirectly
affect the other. Acemoglu et al. (2012) and Fischer (2008) show that it is inefficient if
only one of both externalities is addressed by policy.
12
Hence, a portfolio of public policy
instruments might be better suited to address both externalities (Bennear and Stavins,
2007; Jaffe, Newell, and Stavins, 2005).
3.2 Capital Market Failures
Less specific to renewable energy or energy efficiency, but relevant for the discussion of
the government acting through the capital market, are imperfections on the capital market
itself. This refers to cases where – despite a hypothetical absence of other market failures –
the market does not allocate capital such that it is used most productively from a social
point of view (See, e.g., Akerlof (1970), Stiglitz & Weiss (1981), and Stiglitz (1993)). In
12
There are also interactions between externalities and capital market imperfections (see, e.g. Hoffmann,
Inderst, and Moslener, 2016). They may lead to optimal emission taxes deviating from a linear pigouvian tax.

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this context, we consider two types of capital market failures that systematically affect
investment decisions on clean energy projects. These are (i) the lack of a liquid market for
long-term debt (credit rationing) and (ii) imperfect credit markets.
These market failures are caused by information asymmetries between the lender
(principal) and the potential borrower (agent) that knows the expected return and risk of his
project. Expenditures to reduce this asymmetry might be sufficiently high such that
transactions are limited or deterred. This credit rationing particularly affects long-term
contracts, where information asymmetries and hence the risks for the lender are
particularly large, and result in a lack of a market for long-term debt (Stiglitz, 1993).
However, even in successful transactions, imperfections on credit markets might result in
interest rate rationing, i.e. a borrower receives a loan, but at unfavourable conditions
(Jaffee & Stiglitz, 1990). We focus on two major externalities on capital markets that are
particularly relevant for climate related projects. The first imperfection, relationship
banking, refers to the relationship of the lender (bank) and the potential borrower. As the
costs of screening a borrower, i.e. reducing information asymmetry, are sunk, a lender has
an incentive for multiple transactions with the same borrower. A continuing relationship
with a borrower results in cost savings, as the private information the bank obtained in
previous transactions can be used for future deals. Hence, borrowers with a certain
relationship with a bank are offered loans at more favourable conditions compared to
unknown potential borrowers.
13
Another imperfection is caused by externalities of monitoring, selection, and lending
(Stiglitz, 1993). One main task of banks is the selection of projects and subsequent
monitoring. Other lenders interpret a positive lending decision by a bank as a signal that
13
A number of studies have shown empirical support for the positive effect of lending relationships on loan
conditions (Bharath et al., 2011; Bräuning & Fecht, 2012; Jiménez & Saurina, 2004; Petersen & Rajan,
1995). Boot (2000) provides a survey on relationship banking.

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the project was deemed as attractive after thorough screening, which informs part of their
financing decision. Consequently, it will be easier for the project to raise additional
financing. Furthermore, similar projects (e.g. using the same technology) will receive loans
more easily or at better terms. Banks do not account for this positive externality on
subsequent (other) lenders for the project or similar projects. Hence, there might be an
under-provision of loans (or a provision of loans with bad conditions) for projects using
novel technologies or project developers or technology firms with a limited track record.
These capital market failures are not exclusive for innovative clean technology, but are
particularly present in this sector due to the following reason. Carpenter and Petersen
(2002) show that particularly young high-tech firms have issues obtaining debt financing
as high-tech investments are associated with higher uncertainty compared to conventional
projects using established technologies. The fact that young firms do not have an
established relationship with a lender further fosters credit rationing (Berger & Udell,
2002). The clean-technology sector plays an important role among small high-tech firms
and attracts a large amount of venture capital investments.
14
Substantial information
asymmetry between these firms and potential lenders aggravates the aforementioned
capital market failures.
Capital market failures in this sector may be reinforced by the corresponding project
finance characteristics. Due to the high up-front costs of renewable energy generation
investments only utilities and large project developers are sufficiently capitalised to use on-
balance sheet (corporate) finance (Kann, 2009). More typically, project finance structures
14
In 2011, the US clean-tech sector attracted more than one quarter of the total venture investments (Pernick,
Wilder, & Belcher, 2014). This indicates the importance of small high-tech firms in the sector and might give
an indication for credit rationing in the clean-tech sector as equity financing, e.g. through venture capital,
seems to be an option chosen in the case of credit rationing (Carpenter & Petersen, 2002).

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are used.
15
These project finance structures are often long-term and characterised by a large
share of debt, typically 70 to 80 % (Pollio, 1998), but do not involve any collateral as the
lending is based on the project cash-flow. Collateral, however, is an important signalling
device that can otherwise reduce the information asymmetry between lender and
borrower.
16
Consequently, a limited capability to provide collateral can result in credit
rationing (Bester, 1987).
The role of capital market failures for energy efficiency investments is similar, as they
have a similar structure compared to renewable energy projects: high initial capital costs
and lower energy costs in the future (Gillingham, Newell, & Palmer, 2009). Credit
rationing for energy efficiency can be caused by limited information of the lender on the
(certainty) of potential payoff of the energy efficiency investment and future energy prices
(Golove & Eto, 1996; Gillingham & Palmer, 2014). Furthermore, energy efficiency loans
are typically not secured as energy efficiency investments can typically not be used as
collateral. However, capital market constraints seem to be less severe for energy efficiency
compared to other clean technology investments. In developed countries, lenders can rely
on credit ratings/histories of firms and households such that the lender does not have to
rely on returns from energy savings for the repayment of a loan. An overview of recent
empirical studies on industrial energy efficiency investments by Trianni, Cagno, and Farné
(2016) shows that, in developing countries, alternative options for investing scarce capital
play a more important role in deterring energy efficiency investments than a limited access
to capital. Hence, credit constraints are more relevant in developing countries and for
15
In a project finance structure, the project is developed and financed off-balance sheet. This means that
financing is based upon the future cash flows of the project and only secured by the project assets (rather than
the general assets of the sponsor). In 2014, project finance accounted for almost 32% of worldwide
investments in utility-scale renewable energy (McCrone et al., 2015).
16
Collateral can be used by the lender to induce a self-selection among borrowers. A high-risk borrower,
knowing that his project has a high probability to default, is less likely to accept collateral requirements set
by the lender. In contrast, low-risk investors will reveal themselves by accepting the collateral requirement
(Bester, 1987).

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borrowers with a poor credit rating (Palmer, Walls, & Gerarden, 2012).
17
Although varying
in magnitude, capital market failures therefore affect all types of clean energy related
investments.
3.3 The Investor Perspective
When discussing market failures and policy measures in clean energy, it is helpful to
complement the policy-maker perspective by an investor perspective through translating
the market failures relating to clean energy investments into consequences for the risk-
return profile of these projects.
18
A potential investor decides on a certain investment
opportunity based on the risk-return characteristics of the underlying project. Hence, an
investor’s decision on whether or not to move forward with a certain project is indirectly
affected by market failures through their effect on the (perceived) risk-return of the
underlying project. Furthermore, instruments of public investment support directly
influence this risk-return profile. Those instruments may provide financing below market
interest rates (concessional loans) or take risk (guarantees), which can directly increase an
investment’s attractiveness by counteracting the symptoms of market failures.
Environmental externalities affect the risk-profitability of a climate investment, but rather
indirectly: If the negative environmental externalities are not internalised, alternatives to
clean energy projects – e.g. fossil fuel based electricity or less energy efficient production
technology in case of industrial energy efficiency – have higher returns than they should
have from a social perspective. Hence, the relative risk-return profile of an emission
17
Apeaning and Thollander (2013) and Kostka, Moslener, and Andreas (2013) provide empirical evidence
for the relevance of credit constraints for energy efficiency investments. However, overall, other market
failures as imperfect information, principal-agent issues, differences between private and social discount
rates, or bounded rationality seem to be at least as important in deterring energy efficiency investments (for a
review, see Gillingham and Palmer (2014) and Linares and Labandeira (2009)).
18
Wiser, Pickle, and Goldman (1997) provided an early contribution focussing on barriers for renewable
energy financing from an investor perspective. Dinica (2006) analyses the risk characteristics of support
instruments might affect investor behaviour and hence the deployment of renewable energy technologies.

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mitigation project is negatively affected. Knowledge spillovers affect the risk-return
characteristics of the clean energy project itself. As not all benefits are exclusive to the
investor, the private return is below the social return of an innovative investment.
Furthermore, innovative activities, e.g. the deployment of a new technology, have higher
risks compared to using established dirty technologies. Finally, capital market
imperfections have a direct impact on the financial characteristics of a project. As argued
above, capital market imperfections result in worse loan conditions – e.g. higher interest
rates – and hence negatively affect the profitability of a project. Hence, all these market
imperfections – if uncorrected – decrease the attractiveness of a clean energy investment
relative to other investments.
4 ECONOMIC ANALYSIS OF FINANCE INSTRUMENTS
After characterising main market failures associated with clean energy investments and
their effects from the investors’ perspective above, we now turn to examining the ability of
finance instruments to compensate those market failures. For this evaluation, it is important
to consider how much value is transferred through such investment support, i.e., the
subsidy element of such an instrument, as characterised in Section 2. In this section, we
first examine to what extent finance instruments are capable of correcting each of these
market failures (in comparison to alternative policies) and the information requirements to
design those instruments cost-efficiently. Finally, we provide some brief policy
recommendations on designing and applying public finance instruments, particularly in
cases where alternative first-best policies are unavailable. Table 2 summarises the results
of the analysis and the policy recommendations.

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17
4.1 Environmental Externalities & Innovation Spillovers
Both for environmental externalities and innovation spillovers, instruments of investment
support do not directly correct the respective market failure, as, e.g., an emission trading
scheme or emission tax do in case of the environmental externality, but rather address their
symptoms, namely their negative impact on the risk-return profile of a clean energy
investment. Thereby, the incentive to realise the project would be increased, compensating
its disadvantage relative to other projects emitting CO2 or profiting from knowledge
spillovers (see Table 2). In order to achieve the internalisation of both externalities through
investment support efficiently, the value / cost of the respective finance instrument must
not exceed the social value of the avoided emission externality and the knowledge
spillover.
Determining the value of the environmental externality requires the amount of avoided
emissions and a (hypothetical) price per unit of emissions. In the absence of a CO2 price,
assumptions on a price are required, potentially based on other areas/sectors where CO2
prices exist.
19
Overall, market-based instruments are more suitable to correct the emission
externality at least cost due to two main advantages. Firstly, these instruments provide
incentives through markets signals that encourage emission abatement where it can be
achieved at least cost (Stavins, 2003). Hence, these instruments do not require detailed
information of firms’ or technologies’ marginal abatement costs. In order to apply financial
instruments efficiently, the policy maker would require this information in order to target
financial support at the most cost-efficient investments. Secondly, revenues from market-
based instruments – revenues from emission taxes or from auctioned permits in emission
trading schemes – might be used to reduce other distortionary taxes resulting in the
19
Note that in general one might argue that the socially optimal CO2 price should be based on some global
cost benefit considerations. We abstract from the issue of a globally optimal emission level but rather look at
the question of cost-efficient abatement.

Climate Policy with the Chequebook Accepted Manuscript
18
beneficial “revenue-recycling effect” (Goulder & Parry, 2008; Goulder, Parry, & Burtraw,
1997) or to support climate investments in developing economies, where a carbon price
might not be feasible (Bowen, Campiglio, and Tavoni, 2014).
Overall, finance instruments seem to be suitable for targeting this market failure. Evidence
suggests that, even in the presence of economic instruments that provide incentives for
innovation and deployment of clean technologies, the market failures associated with
knowledge spillover cannot be compensated entirely (Jaffe, Newell, and Stavins, 2005;
Popp, Newell, Jaffe, 2010). Johnstone, Hascic, and Popp (2010) find that direct investment
incentives, e.g. grants, concessional loans, and guarantees, effectively support innovation
in clean technology, particularly in the case of less mature technologies. Olmos, Ruester,
and Liong (2012) provide a comprehensive analysis on the suitability of different finance
instruments for supporting innovation and deployment of clean technologies based on
features of innovation that vary across clean technologies, e.g. the maturity of the
respective technology. Public (concessional) loans and loan guarantees seem particularly
suitable for close-to-maturity technologies that are expected to be profitable large-scale
deployments in the future. By providing a concessional loan or a loan guarantee that
improves the loan conditions, the government subsidises the investor conducting the
innovative project by compensating for the knowledge spillovers other actors benefit from.
This subsidy lowers the financing costs and hence increases the private return (and lowers
the risk) and reduces / closes the gap between the private and the social return of
innovative activities with knowledge spillovers. Grants can, in principle, be used for any
clean innovation activity. Considering the higher costs of this instrument – in contrast to
loans, grants are not paid back – it seems particularly suitable to support early-stage clean
technology innovation which is commercially the least attractive. For concessional loans or
guarantees, the value of the support is determined relative to the same instrument at market

Climate Policy with the Chequebook Accepted Manuscript
19
prices. Note, however, that this does not solve the issue of determining the appropriate
level of support (which exists for clean energy technologies as well as for all other
innovations) that should not supersede the benefits, i.e. the social value of knowledge
spillovers that is challenging to quantify (Hall, 1996).
20
4.2 Capital Market Failures
Providing public finance instruments means that the government acts as player on the
capital market. In contrast to compensating emission externalities or knowledge spillovers,
here the public intervention is aimed at the market where the failure actually occurs.
According to previous studies, public intervention on financial markets can effectively
correct market imperfections (See, e.g., Arping, Lóránth, & Morrison, 2010; Gale, 1990;
Honohan, 2010; Janda, 2011; Philippon & Skreta, 2012).
Policy interventions on capital markets have the ability to remedy the negative effects of
market failures on climate related investments. The provision of (concessional) public
loans is the most direct instrument: the regulator provides debt for climate related
investments that is underprovided, or offered at unfavourable conditions, by private lenders
due to asymmetric information. This instrument seems particularly suitable for the case of
the lack of a market for long-term debt for climate related investments (credit rationing).
As a loan guarantee partly takes over the risk of default, the lender can improve the loan
conditions, e.g. reduce the interest rate, of loans for clean energy investments. In the
absence of a guarantee, the private lender charges a higher interest to account for the risk,
while the interest payments of the borrower can be reduced through interest subsidies.
In spite of the differences of both instruments, interest rate subsidies and loan guarantees
generally have the same effect: they diminish the unfavourable loan conditions induced by
20
See Kaiser (2002) and Nelson (2009) for an overview of alternative approaches of approximating
knowledge spillovers.

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20
information asymmetries. Minelli and Modica (2009) show that both subsidised loans and
loan guarantees are optimal to correct market failures on credit markets and imply similar
costs to the regulator.
21
As guarantees are only paid in the case of failure, the costs of this
instrument increase with the guaranteed loan’s risk of default and maturity (Honohan,
2010). The costs of interest subsidies (also the subsidy component) occur even in the case
of a successful project and rise with difference to the market interest, volume, and
maturity. Hence, for both instruments the costs increase with the magnitude of market
failure. Grants also have the ability to remedy capital market failures, but, as they are
normally not paid back, grants are in general the more expensive instrument and hence
inferior to loans and guarantees in addressing capital market failures (Minelli & Modica,
2009). With respect to costs, direct concessional lending by the state combines the
attributes of interest subsidies and guarantees. If government budget is used to subsidise
interest, the costs are similar to paying an interest subsidy on a loan provided by a private
lender. The amount of the subsidy, however, is likely to be smaller in case of public loans,
as government institutions – at least in developed countries –usually have lower
refinancing costs than private institutions. In case of a default, the government has costs
amounting to the defaulted loan, which is similar to the cost attributes of guarantees. The
latter, however, are potentially lower as they typically do not cover the whole loan amount.
In addition to the static effects, capital market interventions also have a dynamic effect by
reducing information asymmetries over time. When projects supported by public finance
instruments materialise, private lenders acquire information on those projects. Hence,
lenders have better information on the profitability of investments in, e.g. certain clean
technologies. The same applies to clean technology firms or project developers that might
21
Janda (2011) argues that the costs of guarantees and interest subsidies depend on the diversity of projects,
i.e. the difference in the success probability of high-risk and low-risk projects. The author shows that
guarantees are less costly in case of high project diversity, while interest subsidies are less costly in case of
low project diversity.

Climate Policy with the Chequebook Accepted Manuscript
21
build up a track record that can reduce the information asymmetry between them and
lenders. Overall, finance instruments seem to be the instruments of choice to correct capital
market failures related to clean energy investments.
4.3 Policy Considerations
Climate related investments, as renewable energy and energy efficiency projects in the real
world, are subject to more than one market imperfection and frequently a number of policy
instruments and incentives coexist. Designing appropriate support policy schemes in such a
context is challenging (Fischer & Preonas, 2010; Sijm, 2005, Sorrell & Sijm, 2003).
Nevertheless, their design will benefit from a clear understanding of the individual market
imperfections. Note that in order to implement the first-best optimum, theoretically each
externality needs to be internalised and this could be achieved with one instrument per
externality. If we assume, however, that this design of multiple internalisation policies is
not possible, then one approach could be the following: In general, and if all the
externalities could be quantified, one would be able to aggregate them with respect to their
effect on risk and return. These aggregate effects could then be compensated through
support policies.
As market-based instruments are the first-best choice to internalise the emission
externality, other policies, such as finance instruments, should only be considered if an
emission price is (politically) not feasible. When using finance instruments to correct the
emission externality, government support should aim to achieve a certain benefit at least
cost, which requires some estimate of the benefit of saved emissions. In the case of a
renewable energy project, e.g., expected emission savings can be estimated based on
assumptions about: the technology, the capacity, the expected lifetime and some reference
generation technology. In the case of an energy efficiency investment, emission savings

Climate Policy with the Chequebook Accepted Manuscript
22
estimations have to be based on the lifetime and usage of the technology. Quantifying the
value of the externality requires an emission (shadow) price assumption to value the
avoided emissions. A potential approach for such a quantification of emissions avoided by
renewable energy projects could be the use of standardised baselines as suggested by
Spalding-Fecher and Michaelowa (2013) for the Clean Development Mechanism. A
corresponding estimation for an energy efficiency project (e.g. a new technology) might be
less straightforward.
22
The costs of the applied finance instrument, i.e. the subsidy element,
should not exceed the benefit of the avoided emission externality. Even under these
considerations, investment support for clean energy might induce additional inefficiencies.
Consider subsidies to an energy efficiency investment that illustrates the non-equivalence
of an emission price on the one hand and subsidising carbon free technology on the other.
Inefficiencies particularly result if the (subsidised) investment also raises the emission
baseline. An example would be the provision of low-interest loans for cars with relatively
low emissions. On top of making relatively efficient cars more attractive, the low-interest
loan may have two additional effects: (i) it subsidises the use of cars in general (leading to
additional emissions, especially if clean / cleaner means of transportation are substituted)
and (ii) the subsidy element increases with the price of the vehicle, which typically means
a higher subsidy to bigger (more expensive) cars often emitting more carbon than smaller
(cheaper) ones.
In contrast to the emission externality, finance instruments are suitable to address market
failures due to knowledge spillovers and, in particular, market failures on capital markets.
In case of knowledge spillovers, a main guideline for using financial support is that grants
should be used for early-stage, far-from-maturity clean-tech innovation investments,
22
With some assumptions, it might be possible to estimate the expected emissions saved, but the business-as-
usual reference is less obvious if the investment in a new cleaner technology was due to other reasons than
just increased energy efficiency.

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23
whereas the support of more mature technologies, in particular their deployment, can be
more cost efficiently supported by subsidised loans or even guarantees. In order to avoid
crowding out, particularly loans and guarantees should be only employed for innovation
and deployment projects, where (i) the investors have difficulties receiving private finance
due to the gap between social and private returns or (ii) the public sector is more
knowledgeable / experienced with the respective technology than the private sector
(Olmos, Ruester, & Liong, 2012).
Within the group of finance instruments, loan guarantees and interest subsidies are the
most appropriate policies to address capital market failures as they are generally more cost
efficient compared to (investment) grants. However, direct government lending bears the
risk of crowding out private lending. Whether direct (concessional) lending is an
appropriate instrument also depends on the development of the financial sector and its
liquidity.
23
In case of limited liquidity, direct public lending might be the only instrument
to provide finance to clean energy projects. This could be the case in emerging and
developing countries as well as in developed countries in periods of credit crunches during,
e.g., a financial crisis.
24
Furthermore, when the financial sector development is low, the
public sector lender might have an advantage in assessing projects of potential borrowers
(lower information asymmetry) due to better screening skills based on previous experience
and knowledge. Hence, concessional lending by, e.g. bilateral or multilateral development
banks, are particularly suitable to finance clean energy investments in emerging and
23
Lending by governments or mandated public finance institutions in fact may either happen directly or
through other commercial banks which are for these projects refinanced by public finance institutions (so-
called on-lending). Inter alia this is used to limit crowding out or to use specific strengths of the commercial
bank such as an established client base.
24
Due to the current expansionary monetary policy in a majority of OECD countries and the resulting low
interest rates, liquidity seems, at least currently, not to be a major issue on credit markets in developed
economies.

Climate Policy with the Chequebook Accepted Manuscript
24
developing countries, where financial sectors are less developed.
25
In this case, direct
public lending might be an effective tool to reduce the information asymmetry by
providing finance to pilot projects. The learning effect for private lenders might be
increased by public and private co-financing of clean energy projects.
Table 2: Summary of market imperfections, their effect on the investor perspective, and
the analysis of investment support instruments.
{Insert Table 2 around here}
5 CONCLUSIONS
In this paper, we raise the issue of whether the intensified use of public finance instruments
to support climate related investments is compatible with facilitating the structural change
at least cost to society, or whether they run the risk of being overly expensive or
extensively using scarce public funds, therefore impeding the transition towards a low
carbon economy.
In general, finance instruments are capable of compensating for the main market
imperfections associated with clean energy investments. From an investor’s perspective, all
market failures analysed here negatively affect the risk-return characteristics of the
underlying clean energy investment. As public finance instruments for investment support
are able to directly influence risk and capital cost (i.e. return), they can be flexibly
designed to compensate where climate related investments are less attractive from the
investors’ perspective than they should be – based on societal / economic considerations.
Whether these instruments are the first-best choice, however, largely differs across market
failures and investment environments.
25
Brunnschweiler (2010) provides empirical evidence for the importance of financial sector development for
the deployment of renewable energy in emerging and developing countries.

Climate Policy with the Chequebook Accepted Manuscript
25
With respect to emission externalities, policies of finance support are economically inferior
to market-based instruments. Whenever economic instruments are not politically possible,
e.g. in emerging and developing countries, finance instruments might be second-best
choice. When applying these instruments, however, the design of public investment
support programmes – e.g. the magnitude of an interest subsidy or the proportion of a loan
that is covered by a guarantee – should be based on cost benefit considerations. The cost of
a finance instrument and the subsidy element should not exceed the value of abated
emissions.
An additional advantage of market-based instruments, if designed appropriately, is their
ability to provide incentives to innovate and deploy clean technologies (Bennear and
Stavins, 2007; Jaffe, Newell, and Stavins, 2005). Although these policies cannot fully
compensate for the market failures related to innovation and deployment, they can reduce
the social cost of innovation policies, as, with a carbon price in place, clean technology
innovation investments require less financial support. As economic instruments cannot
fully overcome the innovation market failures, a combination of this policy with financial
support innovation and deployment can compensate both market failures at least cost.
Finally, finance instruments are optimal policies to address capital market failures.
Given the global consensus of limiting global warming, a substantial structural change in
the energy infrastructure is required. Based on our examination, this speaks strongly in
favour of (i) introducing carbon-price-based regulation to cope with the corresponding
externality and (ii) focusing on understanding the non-emission market imperfections when
designing investment support policies in order to avoid inefficient government spending.
While it can be technically challenging to quantify all market imperfections, understanding
them provides a reliable foundation when designing policy to moderate structural change.

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26
ACKNOWLEDGEMENTS
We thank Christine Grüning, Andreas Löschel, and two anonymous referees for their
valuable input and are grateful for comments from the participants of the 12th European
Energy Conference of the International Association for Energy Economics, where an early
version of this article was presented.
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Annex
Table 1: Variables characterising the three major instruments for investment support
which need to be determined when designing a corresponding support programme.
Grant
Concessional Loan
Guarantee
 volume
 timing
 volume
 timing
 interest (& risk free
years)
 seniority
 (implicit: loan
characteristics.)
 loan fraction covered
 risks covered
 trigger event
 pricing

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Table 2: Summary of market imperfections, their effect on the investor perspective, and the analysis of investment support instruments.
Market
Imperfection
Economic Mechanism
Mapping to Investor’s
Perspective
Ability of investment support
instruments to compensate
Policy Considerations
Emission
Externality
A missing emission
price leads to socially
inefficient high return
for conventional / non-
clean investments.
Relative return below
social optimum (as
compared to
conventional
alternative).
Finance instruments for clean energy
projects reduce financing costs and
hence increase their relative return. If
the subsidy element is appropriately
sized, negative effects of externality on
risk-return profile can be compensated.
Market-based instruments are superior policy.
If not available, investment support can be
considered. To avoid inefficiency, subsidy
element of finance instrument should not
exceed the (estimated) value of avoided
externality.
Innovation
Spillover
Innovative projects
bear higher risk and
provide social benefits
through knowledge
spillovers that are not
reflected in the return.
Increased risk not
adequately rewarded
and return below
social optimum.
Investment support instruments can
reduce financing costs and hence (i)
mitigate the risk-premium that has to
be paid to private lenders and (ii)
increase the return to decrease /
mitigate the gap between private and
social return.
Investment support instruments are suitable to
compensate for spillovers. Grants should be
applied to early-stage innovation, while
subsidised loans and guarantees are best suited
to support the deployment of (close to
maturity) clean innovations.
Capital
Market
Failure
Due to information
asymmetries between
investor and lender,
financing is
inefficiently expensive
(or not available at
all).
Return below social
optimum (or equal to
zero in case of the
project not being
implemented).
Instruments of investment support
directly target the capital market
failure. By improving financing costs
(through grants, interest subsidies, or
guarantees) or direct concessional
lending, investment returns can be
increased.
Policy interventions through finance
instruments are optimal. Interest rate subsidies
and guarantees are preferred to investment
grants due to lower costs. Direct subsidised
lending should be used if (i) government (or
public bank) has a better ability to screen and
monitor or (ii) a market for (long-term) debt is
absent.