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Weekly data: Interest rate modelling risks overestimating decarbonising costs

The EU's future interest rate of 10% risks over-inflating the estimated cost of decarbonising, potentially putting more ambitious future carbon targets at risk.

By Nick Ferris

EU modelling is potentially overestimating the costs of decarbonising by making low-carbon technologies like electric vehicles (EVs) and wind turbines seem more expensive than they actually are.

The 10% interest rate used by the EU in its macroeconomic modelling is “too high in the current context”, says a new report from global economics consultancy Cambridge Econometrics. The projected rate risks making initial capital costs more expensive than would be the case if the current era of prolonged low interest rates were to continue in the coming years.

Such modelling biases cost scenarios against low-carbon technologies, as these have higher capital costs but lower operational costs – where borrowing is less likely to be involved – than high-carbon alternatives.

Data shows that capital costs represent 70% of overall costs for onshore wind versus 18% of costs for gas turbines. An over-inflated interest rate projection would accordingly have a more significant impact on the cost of wind turbines.

“Having accurate assumptions for discount rates in economic modelling of transitioning to low-carbon energy in Europe is pivotal,” says Harry Verhaar, chair of green business lobby the European Corporate Leaders Group, which commissioned the report. “A too-high cost of finance assumptions can undermine the scale and pace needed to achieve EU emission reduction targets.”

The EU upped its 2030 emissions reductions goals from 40% to 55% last December, after gruelling overnight talks between member-state leaders in Brussels.

The new target will require huge changes across all sectors of the economy. In June, the European Commission will propose the first part of its ‘Fit for 55%’ package, which will update everything from the EU Emissions Trading Scheme and Renewable Energy Directive, to new CO2 standards for vehicles, forestry and land use.

“In the same way as products won’t sell if they are not correctly priced, the Commission must use up-to-date methodology when estimating the investment needs of the EU’s 2030 climate and energy policies,” says Mirella Vitale from green construction company Rockwool Group. “Otherwise – if the Commission keeps on using a 10% interest rate – cost estimates will be too high and it will be harder to convince member states to support more ambitious goals.”

As well as not reflecting current low interest rates, the blanket 10% rate fails to account for the fact that borrowing costs differ across different countries and sectors. Borrowing also tends to be much cheaper when governments cover the costs.

In a recent bond issuance to finance the €750bn ($891.74bn) Next Generation EU recovery fund, the Commission secured a negative rate for seven-year bonds and a 0.134% rate for 30-year bonds, highlights Brook Riley, head of EU affairs at Rockwool, in a recent article for Energy Monitor.

Specific modelling on vehicle costs from Cambridge Econometrics – as illustrated in Energy Monitor’s weekly data – illustrates how different interest rates can affect the cost of technologies.

With a 10% interest rate, the projected cost of an EV is modelled at €80,829 versus €87,146 for an internal combustion engine vehicle. Were the interest rate to fall to 5%, the costs would fall to €63,596 and €73,496, respectively – a €10,000 rather than €7,500 price difference between the two.

“We have now been in a low interest rate for 12 years, and even before then it wasn’t particularly high,” says Philip Summerton, CEO of Cambridge Econometrics. “Because of Covid we are likely to stay in a low interest rate world for even longer.”

Summerton believes the Commission “does a good job” and its modelling is “probably among the best”.

However, he encourages the EU executive to encompass different scenarios in its modelling to better reflect uncertainties that lie ahead.

“It is about having a bit more humility about what these models are capable of,” he says. “We can look at what the outcome would be with a 10% rate, but it is worth also understanding what would happen with 5%. I think modelling that is more flexible and looks at different scenarios would be more accurate.”

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