Green investment and financial fragility: a Minsky ... · Green investment and financial fragility:...

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Green investment and financial fragility: a Minsky-Schumpeter ecological model

YANNIS DAFERMOS (UNIVERSITY OF THE WEST OF ENGLAND)

MARIA NIKOLAIDI (UNIVERSITY OF GREENWICH)

GIORGOS GALANIS (NEF)

19th Conference of the Research Network Macroeconomics and Macroeconomic Policy

Motivation of the paper

It has been recently argued that the synthesis of Minskyan and Schumpeterian ideas can provide a useful platform for the analysis of capital development and financial cycles (e.g. Knell, 2014; Mazzucato and Wray, 2015).

The analysis of the green investment process (see Eyrad et al., 2013 for a definition) is an important issue where this Minsky-Schumpeter synthesis could be extremely valuable.

The green investment process can be characterised by both Minskyan and Schumpeterian aspects.

Motivation of the paper

The Minskyan aspect is that green investment relies significantly on external funding. This has two implications: (a) banks and financial markets play an important role in the materialisation of green investment plans; (b) green investment expenditures can increase the leverage of firms and can thereby create problems of financial fragility.

The Schumpeterian aspect is that the innovation related to green investment is capable of generating a ‘creative destruction’ of the existing technologies that are conducive to high carbon emissions and material waste.

The aim of this paper is to develop a stock-flow consistent model of green investment and financial fragility which combines Minskyan and Schumpeterian aspects.

Background of the paper

This paper is part of the a multi-year project conducted by the New Economics Foundation in collaboration with the University of Greenwich and the University of the West of England.

In this project we have developed a new ecological macroeconomic model that combines the stock-flow consistent literature with the flow-fund model of Georgescu-Roegen and the recent modelling on climate change (see Dafermos et al., 2015).

The model presented here is a companion model to our core ecological macroeconomic model. Since our aim in this paper is to focus on the energy-finance-green investment nexus, the interactions between the macroeconomy and the ecosystem have been kept at a very minimum level.

Structure of the presentation

1. Structure of the model 2. Simulation analysis 3. Conclusion

1. Structure of the model

Drawing on Gerst et al. (2013), we consider the following types: 1. Goods production firms: They produce a good that can be used for consumption

and traditional investment purposes. 2. Energy production firms: They produce the energy that is used by all firms.

Energy is produced by using a renewable resource (e.g. wind, hydro, sunlight) or a non-renewable resource (e.g. gas, oil, coal).

3. Renewable energy technology firms: They produce renewable energy technology capital and make R&D expenditures in order to reduce their unit cost and thereby the price of renewable energy technology capital.

4. Non-renewable energy technology firms: They produce non-renewable energy technology capital.

Types of firms

Households Commercial banks

Goods production firms

Energy production firms

Renewable energy technology firms

Non-renewable energy technology firms R&D wages

Loans Wages

Balance sheet matrix

Households Goods production firms

Non-renewable energy technology firms

Commercial banks

Goods production firms' capital + K G + K G

Energy production firms' renewable capital + K R + K R

Energy production firms' non-renewable capital + K N + K N

Renewable energy technology firms' capital + K GR + K GR

Non-renewable energy technology firms' capital + K GN + K GN

Deposits +D -D 0Goods production firms' loans -L G +L G 0Energy production firms' renewable loans -L ER +L ER 0Energy production firms' non-renewable loans -L EN +L EN 0Renewable energy technology firms' loans -L R +L R 0Non-renewable energy technology firms' loans -L N +L N 0Total (net worth) +V H +V G +V E +V R +V N +K B +K G +K R +K N +K GR +K GN

9 Households Total

Current Capital Current Capital Current Capital Current Capital Current Capital Consumption -C + C 0Goods production firms' investment + I G - I G 0Energy production firms' renewable investment - I R + I R 0Energy production firms' non-renewable investment - I N + I N 0Renewable energy technology firms' investment + I GR - I GR 0Non-renewable energy technology firms' investment + I GN - I GN 0Wages +wN G +wN E +wN R +wN N -wN G -wN E -wN R -wN N 0R&D wages +w RD N RDR +w RD N RDN -w RD N RDR -w RD N RDN 0Energy bill -p E e G +p E e D -p E e R -p E e N 0Goods production firms' profits +DP G -TP G +RP G 0Energy production firms' profits +DP E -TP E +RP E 0Renewable energy technology firms' profits +DP R -TP R +RP R 0Non-renewable energy technology firms' profits +DP N -TP N +RP N 0Commercial banks' profits +DP B -TP B +RP B 0Interest on deposits +int D D -1 -int D D -1 0Interest on goods production firms' loans -int G L G-1 +int G L G-1 0Interest on energy production firms' renewable loans -int ER L ER-1 +int ER L ER-1 0Interest on energy production firms' non-renewable loans -int EN L EN-1 +int EN L EN-1 0Interest on renewable energy technology firms' loans -int R L R-1 +int R L R-1 0Interest on non-renewable energy technology firms' loans -int N L N-1 +int N L N-1 0Δdeposits -ΔD +ΔD 0Δgoods production firms' loans +ΔLG -ΔLG 0Δenergy production firms' renewable loans +ΔL ER -ΔL ER 0Δenergy production firms' non-renewable loans +ΔL EN -ΔL EN 0Δrenewable energy technology firms' loans +ΔLR -ΔLR 0Δnon-renewable energy technology firms' loans +ΔLN -ΔLN 0Default on loans +def G L G-1 +def E L ER-1 +def E L EN-1 +def R L R-1 +def N L N-1 -DEF 0Total 0 0 0 0 0 0 0 0 0 0 0 0

Goods production firms

Non-renewable energy technology firms

Commercial banks

Transactions flow matrix

It is assumed that energy production firms decide first about their overall investment in energy capital based on their profitability and demand for energy.

At a second stage, they allocate their desired investment between renewable energy technology capital and non-renewable energy technology capital :

The proportion depends on the difference between the levelised cost of the non-renewable energy technology and the levelised cost of the renewable one:

Desired investment of energy production firms

( )DEi

( )DRi

( )1110 −− −+= RN ccβββ

( )DNi

DR ii β=

( ) DE

DN ii β−= 1

The levelised costs show the (life-time) production cost per kWh (see Monnin, 2015). The levelised cost of renewable energy capital is given by:

is the price of renewable capital, is the capacity factor of the renewable energy technology capital, is the interest rate on renewable energy technology loans w is the wage rate and is the energy produced per worker.

The first term in the above equation captures the cost of capital. The second term captures the operation costs, which in our model are confined to the labour cost.

Levelised cost

wCFintpc

+= − 18760

RpERint

The levelised cost of non-renewable energy capital is given by: is the price of non-renewable capital, is the capacity factor of the non-renewable energy technology capital, is the interest rate on non-renewable energy technology capital, is the labour productivity of the extraction of the non-renewable source (Btu per worker) and h is the heat rate (Btu per kWh).

The first term in the above equation captures the cost of capital. The second term captures the operation costs, which in our model are confined to the labour cost. The third term is the cost of the extraction of the non-renewable resource.

Levelised cost

( )( )EXEN

whwCFintpc

λλχξ

− 118760 1

Np RCFENint

Energy production firms demand new loans in order to make their investment in both types of capital. Only a proportion of loans are provided by the commercial banks.

The effective amount new loans is:

The degree of credit rationing is given by:

The degree of credit rationing is assumed to be higher the higher is the leverage ratio and the default on loans .

Credit rationing and loans

( ) DERERER NLCRNL −= 1

( )DERNL

12110 −− ++= EEER deflevCR φφφ

( )Edef( )Elev

The effective investment in renewable energy technology capital is given by:

A higher amount of loans causes an increase in the renewable energy investment, leading to more profits to the renewable energy sector.

The default rate of loans is given by:

It is assumed that the default rate is a positive function of the leverage ratio. The rationale is that as the leverage ratio increases the proportion of firms that their net worth is close to zero increases.

Effective investment and default rate

110 −+= EE levdef ττ

1−++= EREERER LdefLRPI ∆β

The energy that is demanded by the energy production firms is equal to the demand for energy by goods production firms , renewable energy technology firms and non-renewable energy technology firms :

Firms use both the renewable and non-renewable resources to produce energy. When the non-renewable resource is used to produce energy, CO2 is emitted

(EMIS):

is the emissions intensity and is the non-renewable energy.

Energy demanded and emissions

enEMIS ω=

NRGD eeee ++=

( )Ne( )Re( )Ge

The number of R&D workers as a proportion of the total labour force of R&D workers is given by:

The proportion is higher the higher is the profitability of firms and the

lower is the degree of credit rationing:

Energy technology firms have an incentive to make R&D expenditures in order to reduce their costs and increase their market share .

R&D expenditures of renewable energy technology firms

LFRDRRDR NrdN =

12110 −− −+= RRR CRrdrrdrdrd

( )RDRN( )LFRDN

We have found a steady state for the macroeconomy of the model using reasonable parameter values and initial values for endogenous variables.

In the steady state economic growth is positive and the key macroeconomic and financial variables remain in a constant relationship to each other. However, CO2 emissions increase continuously and the stock of non-renewable resource constantly reduces.

At a specific point in time two types of green finance policies are introduced: (1) A decline in the interest rate on loans granted for green investment. (2) The provision of incentives to banks to reduce credit rationing on green loans, for

example by imposing green capital adequacy requirements (see Campiglio, 2015).

2. Simulation analysis 17

Interest rate on green loans ↓

Levelised cost differential ↓

Difference between the levelised cost of renewable and non-renewable energy technology capital

Credit rationing on green loans ↓

Investment in renewable energy technology capital ↑

Investment in renewable energy technology capital

Profits of renewable energy technology firms ↑

R&D expenditures of renewable energy technology firms↑

Emissions ↓

Emissions

2. Simulation analysis

Leverage ratio of energy production firms↑

Emissions ↓

Leverage ratio of energy production firms

Emissions ↓

Default rate of energy production firms↑

Default rate of energy production firms

Leverage ratio of renewable energy technology firms ↓

Emissions ↓

Leverage ratio of renewable energy technology firms

Leverage ratio of renewable energy technology firms ↓

Emissions ↓

Default rate of renewable energy technology firms ↓

Default rate of renewable energy technology firms

Leverage ratio of renewable energy technology firms

Leverage ratio of renewable energy technology firms ↑

Emissions ↓

Default rate of renewable energy technology firms ↑

2. Effects of green finance policies 37

Investment in renewable energy technology capital

Emissions

This paper develops a Minsky-Schumpeter stock-flow consistent model that analyses the interaction between green investment and financial fragility.

Simulation analysis indicated that the implementation of green finance policies (captured by the reduction in the interest rates and credit rationing on green loans) have beneficial ecological effects in the short run.

However, in the simulations credit expansion increases the financial fragility of the firms, driving up their rate of default. As a consequence, credit rationing increases gradually, reversing the initial reduction in CO2 emissions.

3. Conclusion 40

According to our preliminary results, the transition to a low-carbon economy cannot rely entirely on the private sector.

Even if the necessary financial instruments are developed to enhance the financing green projects, in the long run financial fragility can rise, outweighing the initial beneficial ecological effects.

Hence, the role of the public sector in the transition to a low-carbon economy is crucial. A significant rise in the public finance of green investment projects can ensure that such a transition will be less financially fragile and, hence, more sustainable.

3. Conclusion 41

Green investment and financial fragility: a Minsky ... · Green investment and financial fragility:...

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