In 2008 I was a graduate student with almost no understanding of the financial system–I couldn’t even explain the difference between an interest rate and an APR!–working to launch what would become Capital Good Fund: a nonprofit lender. One day I met a progressive activist for coffee, and I’ll never forget the lesson she taught me: the way interest is charged is morally backward, for those most able to pay high interest rates–the wealthy–pay the lowest rates, and those least able to afford it–the economically disadvantaged–pay the highest rates.
To be clear, it makes sense that this is how lending works. Fundamentally, a lender does two things. First, we secure money to lend; if you’re a bank, the funds come from deposits from customers, and in the case of a non-bank entity like Capital Good Fund, we take out loans from foundations, individuals, and financial institutions. And second, we lend that money to individuals and businesses to buy a house or car, start or expand a business, construct an apartment building, and so on. The interest rate we charge our borrowers has to cover three categories of expenses: defaults (the money that we lend out that is not paid back to us); cost-of-capital (the interest we pay on the money we borrow, for instance the rate a bank pays to depositors); and, finally, our cost to make and service loans, like personnel, technology, and rent.
When considering a pool of borrowers, a lender looks to achieve a certain average “spread”, defined as the interest they charge minus the sum of cost-of-capital and losses. For instance, Capital Good Fund charges 4.2% – 6.99% on our Solar Loans, with an average rate of roughly 5%. The less likely we believe it is that a client will default, the lower the rate we charge, and vice versa. When a higher-risk borrower at 6.99% does pay us back, they are basically paying us more interest to cover the losses on those high-risk clients that did not pay us back. This is crucial, because the margins on loans are often razor-thin. In our case, we borrow at around 4% (or at least did before the Fed starting raising interest rates), and every year we lose about .25% of Solar loans due to defaults. Our gross spread, therefore, is just .75%: 5 – (.25 + 4).
That .75%, earned on an average loan size of $35,000, just barely covers the costs of customer acquisition, underwriting, origination, and servicing. A small change to any of the three inputs–say, an increase in our borrowing costs of one percentage point, or an increase in our default rate of half a percentage point–can make the entire program unsustainable. There are only a couple ways for us to offer a Solar loans at such rates. The first is to keep overall losses low, which we accomplish by lending to a mix of high and low-risk borrowers; excellent customer service, especially when it comes to loan servicing; and our unique approach to evaluating risk, which allows us to outperform what traditional metrics, like FICO score, would predict. The second is that we leverage our nonprofit status and mission focus to raise lower cost capital and grant dollars to subsidize operations. For instance, we sometimes receive grant dollars to “buy down” the interest rate–that is, the grant dollars cover the difference between what we normally charge a high-risk client and what we actually charge. These buydowns can improve project economics for lower-income customers who would otherwise be unable to afford a higher-interest solar loan. And we also receive grants for personnel, technology, and marketing, thereby reducing the need for the spread on the loan to cover all operating costs.
Nevertheless, we do, at the end of the day, charge higher rates to riskier borrowers, which often results in lower-income families paying more than others. So does that mean that I have ignored the advice of my activist friend? And what does this have to do with climate change? Sorta, and a lot!
It is very difficult to get around the fact that risk is priced into interest rates. We’ve solved for this by coming up with a unique way to assess risk; by borrowing at low rates (imagine what we’d have to charge if our cost-of-capital was 10%!); and by leveraging grant dollars to reduce risk (the aforementioned interest rate buydowns, as well as loan guarantees and grant-funded loan-loss reserves). Ultimately, however, there is only so much grant money to go around, and so if we want to push the boundaries of social impact–lending to those unable to access capital–we have to take more risk. And even our innovative, proven, non-FICO-driven underwriting model is wrong often enough that we can’t get around charging higher rates to riskier borrowers. The end result is that if you borrow $35,000 for a solar system from us at 6.99%, you’ll pay $247/ month for four years, compared to $188 / month at 4.2% for a low-risk client: a difference of $17,700 in interest over the 25-year life of the loan.
This is where the issue of borrowing costs becomes central. If our investors expected us to pay them 6% instead of 4%, then, in order to maintain our spread, we’d have to raise interest rates by two percentage points across the board. At that point, the monthly loan payment would be so high as to dissuade people from going solar for economic reasons–the loan payments would be greater than the electricity savings.
The same dynamic is at play at the level of nations. In fact, at the current COP27 climate conference in Egypt, the issue of borrowing costs for clean energy, as well as debt relief, is central to the negotiations. A recent article in Bloomberg, Climate Debt Trap Risks Pushing Emerging Markets to the Brink, highlights the link between interest rates and climate change:
Rising global borrowing costs are denting the finances of some of the most climate-vulnerable countries right when they most need money to fight the devastating impacts of global warming.
It’s a convergence of events that risks pushing developing nations into a “debt trap,” according to Prime Minister Shehbaz Sharif of Pakistan, who addressed world leaders at the COP27 climate talks in Egypt last week. Countries that borrowed heavily when interest rates were low are now struggling to fund projects that would make them more resilient to extreme weather, leaving them vulnerable to even higher borrowing costs in the future.
Just as a poor American family may have to pay exorbitant rates because of a low credit score resulting from something out of their control–an illness or divorce, perhaps–a poor nation may also see its borrowing costs soar as a result of a climate change-fueled natural disaster. The cruel irony is that these nations have contributed almost nothing to the climate crisis and yet are both more impacted by it and least able to adapt.
According to a report by the Brookings Institution, “Developing countries’ average interest cost on external borrowing is three times higher than that of developed countries” and they also “dedicate an average of 14 percent of their domestic revenue to interest payments, compared to only around 3.5 percent in developed countries…” This is the same phenomenon that low-income Americans experience: the average family making $25,000 / year spends as much on financial services (interest, fees, etc.) as it does on food, about 10% of income. In both cases, the dynamic is driven by risk, both real and perceived; the operating cost of making loans to low-income individuals or nations; and the lender’s borrowing cost.
To tackle the climate crisis, developing nations are going to need trillions of dollars in capital to finance solar arrays, wind turbines, transmission infrastructure, electric vehicle charging stations, battery storage, geothermal and hydrothermal power plants, and more. But they will also need money to harden their infrastructure against increasing natural disasters and rising seas; build more resilient housing, schools, and agriculture; and to continue to grow their economies and lift people out of poverty.
Whether a nation or an individual, borrowing costs and terms can mean the difference between clean energy being economically feasible and infeasible. Consider a homeowner who pays $220 / month in electricity. If it costs $35,000 to install a solar system that will eliminate her electricity bill, then she needs a loan with a 25-year term and an APR of 5.99% or less. If either the term is shorter or the APR is higher, she will pay more on the loan than she was paying on electricity–a non starter for many cash-strapped families.
In the case of a nation, the dynamics are a little different. For instance, in places where there is no or unreliable power, the economics of solar and wind are almost always better than fossil fuels, regardless of the borrowing cost. Nevertheless, at some point the bottom line is the same: given low enough rates and long enough terms, individuals and nations can make the investments needed to mitigate and adapt to challenges, be they a car breaking down or a lack of access to energy.
To get those trillions of dollars to flow to the people and countries most in need of them, we must bring down borrowing costs, ease collateral requirements, and offer long terms. There are a couple of ways to do that, such as:
- Investors can lower their return expectations. Whether the investor is the International Monetary Fund, a bank, a foundation, or a high-net-worth individual, they are always free to say, “I care about climate change. As long as you use my money to reduce emissions, I will offer you a reduced interest rate.” This is often called concessonary or below-market-rate capital, and it forms the basis of a lot of impact investing: lower return and higher risk tolerance in exchange for social and / or environmental impact. There is, unfortunately, a very popular movement which says, “Actually, impact investing can and should deliver market-rate returns. So, I want you to both reduce emissions and pay me the same interest I would get by lending to a fossil fuel project.” This Do well by doing good notion is bullshit, philosophically and mathematically. I wrote about this in an essay titled The Problem With Most Impact Investing.
- Third parties can reduce risk. “De-risking” can happen in a variety of ways. A large foundation might put up a loan guarantee or provide a loan-loss reserve. Or an impact-oriented investor might take a first-loss position, saying that, in the event of a default, they’ll be the first to absorb losses. The less likely it is that the primary investors will lose their money, the lower the interest rate they have to charge.
- Public policy can combine with grant dollars to reduce operating costs. The Inflation Reduction Act has improved clean energy economics by increasing the incentives for wind, solar, and similar projects. The bill also includes billions of dollars in grants that will be distributed in ways that will further lower the cost of reducing emissions: grants for job-training programs, pre-development work (such as project design and development), community education and outreach, etc. Philanthropic dollars can also build capacity in emerging markets, for instance by subsidizing infrastructure development, providing funding to indigenous organizations, and helping governments hire regulators and engineers.
- Nations impacted by climate change can have their debts reduced, restructured, or forgiven. Lower-income nations are asking for debt relief so that, instead of spending their limited tax revenue on debt service, they can instead invest in clean energy and sustainable economic growth. Now that so-called attribution science can quickly estimate how likely it is that a particular natural disaster was caused or made worse by climate change, we have a mathematical means of determining what debt forgiveness should look like; the question now is whether we have the political and moral will. And lastly, in addition to debt relief, these countries are also asking for grant dollars for “loss and damage”: they want climate reparations, for those most responsible for global emissions to pay for the harm they’ve caused to those least responsible.
When we think about tackling the climate crisis, we often focus on individual actions like recycling or purchasing solar panels. Yet as important as these are, they are rarely feasible for the non-wealthy absent an intentional regulatory and economic paradigm. As we’ve seen, borrowing costs are fundamental to climate justice. We are in a strange moment: high inflation disproportionately impacts the low-income, yet we must be careful not to make the medicine–higher interest rates–worse than the illness. What’s more, 40% of inflation is due to rising fossil fuel prices. The faster we transition to a renewable economy, the less beholden we’ll be to price volatility and petro-dictatorships like Russia and Saudi Arabia, and the less we’ll spend on cleaning up after floods, wildfires, and heat waves.
So while it’s necessary that interest rates go up, at least temporarily, to combat inflation, it is imperative that we make an exception for those areas that can directly address the primary causes of inflation. In other words, making it harder to buy a home will cool off the housing market, which we have to do. But making it harder to finance a residential or utility-scale solar farm is bad for inflation, bad for people, and bad for the climate. Nor do we have time to lose: global emissions are rising, putting us at risk of exceeding 2 degrees of warming. Governments, central banks, individual and institutional investors, and grantmakers all have a role to play to ensure that we continue to unlock the potential of clean energy to benefit both people and planet.