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ECB interest rate hikes will hurt climate protection policies

On July 21, the European Central Bank decided to raise interest rates for the first time since 2011 in an effort to curb inflation. With further rate hikes potentially on the horizon, Philippe Heimberger and Leah Steininger argue that climate protection policies could be an unexpected victim of the central bank’s shift in approach.

Widespread forest fires, melting glaciers, heat waves… the effects of the climate crisis have affected large parts of Europe and the world over the summer. Due to the consequences of the climate catastrophe, half of humanity now lives in a immediate danger zone for their own life. Even in Europe, large areas may soon be barely habitable. Investments of hundreds of billions of euros in clean technology, green energy supply, climate-friendly infrastructure and mobility will be needed to phase out fossil fuels and achieve climate neutrality.

In a context of record heat, the European Central Bank decided on July 21 to raise its key rate by 0.5 percentage point. Raising key interest rates has the effect of reducing demand and employment with the main aim of curbing inflation: companies reduce their investments due to higher financing costs, unemployment increases and wages and levels income decline with a lag. Notwithstanding the intent, trying to manage inflation by cutting off demand does not address the supply-side reasons for currently high price indices. On the contrary, higher prices are imported due to the impact of the Russian invasion of Ukraine on the energy markets, the market power of the oil industry and the impact of the war and of the Covid-19 pandemic on global supply chains.

ECB interest rate hikes cannot increase Russia’s gas supply, open up alternative energy sources or solve supply chain problems for chips and semiconductors. However, they will cause collateral damage. In this process, in addition to high unemployment, which alone poses a fundamental problem for democracy and societal cohesion, the climate policy agenda will be particularly affected.

A climate-friendly transformation requires moving from technologies with high operating costs in fuels and labor to technologies with high capital expenditure. A different economic model is therefore necessary. For example, while a gas-fired power plant may use its permanent revenue to pay for new fuels, an offshore wind project uses its permanent revenue to pay off debt incurred for capital expenditures. The higher the cost of capital, the more less attractive an offshore wind farm is. Higher interest rates are therefore a problem for green transformation.

On the need for public investment

Investments should be driven by the state through reliable public investment plans and sensible regulations. Only improved infrastructure and planning security can encourage private companies to expand into climate-friendly sectors.

However, most climate investments are not profitable in the classical economic sense. For example, private companies will refrain from building emission-reducing public transport infrastructure if they then operate that infrastructure without making a profit. In addition to building infrastructure, the public sector will also have to set the direction by industrial policy. This includes, for example, the planning and co-financing of modern high-speed train production structures to reduce air traffic in the medium term, and the active promotion of renewable energies.

The ECB’s strategy

In 2021, the ECB adapted its monetary policy strategy by committing to pay particular attention to the interaction effects between its monetary policy and environmental and climate policies. In doing so, he pledged to consider a number of factors that should make him reluctant to raise interest rates. The main mandate of the ECB is price stability; its secondary mandate is to support the general economic policy of the EU. The active promotion of more ambitious climate policies is indeed a key priority for the achievement of both mandates.

On the one hand, further interest rate hikes in the autumn could again destabilize the fragmented euro area sovereign bond markets by putting individual Member States in a situation of funding and liquidity crisis, thereby forcing the ECB to intervene. The new ECB bond buying program (the “Transmission Protection Instrument”) announced on July 21 is intended to stabilize capital markets precisely for this reason. However, it is conditional on member states respecting outdated EU fiscal rules, which are temporarily suspended.

It is therefore all the more urgent to quickly reform EU fiscal rules so that the scope of climate policy measures is widened. After all, Eurozone member states now live under the constant risk of seeing their financing costs rise massively due to their exclusion from the new ECB bond-buying program (should fiscal rules be restored). . Otherwise, there will be massive but unnecessary restrictions on additional public spending to tackle climate change.

Second, the climate crisis also directly affects price stability. After all, fossil fuels are the main contributors to rising prices. Accordingly, investments in clean energy will significantly strengthen price stability. The renewable energy sectors are therefore essential. However, they require large initial investments and are sensitive to deterioration in financing conditions. If urgently needed investments were canceled today due to higher interest rates, Europe would even in the near future more vulnerable to the negative effects of the climate crisis. Only rapid socio-ecological transformation can bring deep stability.

Investments in sustainability (prices)

The ECB cannot solve the climate crisis and the problems of the energy system alone. Effective climate and energy policies are in the hands of democratically elected politicians who control fiscal policies. However, by affecting investment costs and the course of the business cycle through its actions, the central bank is a major player in the direction and options of climate and energy policy.

A series of interest rate hikes would undermine important EU goals such as energy security and decarbonisation. Moreover, interest rate hikes cannot address the root causes of inflation that we know. They work by strangling employment and will thus exacerbate the current downturn. Sound energy and climate investments at favorable financing conditions in the euro area are essential to achieve economic and social stability, and in particular price stability. It is up to the ECB to encourage these investments rather than torpedo them.

Note: This article gives the point of view of the authors, and not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: European Central Bank (CC BY-NC-ND 2.0)