Investments that are growth-enhancing, that generate employment and that improve the sustainability of the economy are good and desirable. However, even before the crisis hit, the European Union suffered form a lack of optimal levels of investments in infrastructure, green energy and energy efficiency measures and small and medium sized enterprises. This was driven by a number of factors inherent to these kinds of desirable investments for example high upfront costs and long payoff periods in the case of infrastructure investments and a lack of policy certainty on carbon price for green investments. An additional problem was misallocation of resources by the financial sector because of excessive short-termism and crowding out by speculative investments.
The crisis exacerbated the paucity of investments flowing to these desirable categories. However, policy makers have been handed a unique opportunity to address many of these deficiencies for example through a more informed reform of the financial system and through the introduction of new and innovative sources of financing. This Policy Brief for the European Parliament identifies the main obstacles that impede desirable investments in the real econmomy and puts forward a set of concrete suggestions on how to tackle these and stimulate more investments in infrastructure, energy effeciency, green energy and SMEs.
All economies need investments in order to grow and prosper. Investments come in all shapes and sizes and include large scale investments in public infrastructure on the one hand and small investments by Small and Medium sized Enterprises (SMEs) on the other. Investments range across 'dirty' sectors of the economy such as coal fired plans etc. to clean energy sectors such as wind turbines. What is clear is that the growth, productivity and sustainability of an economy all depend on the size and nature of investments made.
In general, investments in good quality public infrastructure help increase productivity, solid investments in high real return projects by SMEs in particular drives growth and job creation and investments in energy efficiency measures and green projects increase the sustainability of economies. Given the importance of these and the short nature of this paper, it makes sense to focus this paper on 'options for better financing of infrastructure, green and SME investments' which we collectively call 'desirable investments' for the purpose of this paper.
Even before the crisis hit, too little money has flowed into these three categories of investments discussed. Some of the factors behind this, such as the malfunctioning of the financial sector, were common while others differ across the three categories. These factors need to be tackled if financing to these desirable sectors is to increase.
The ongoing financial and economic crisis in the EU has had a substantial impact on the availability of financing for investments. While the impact is wide-ranging, the most relevant impacts have been
1) the overall availability of private sector investment funds has shrunk;
2) the accompanying austerity measures means that the pool of public sources of funds for investment has also shrunk;
3) investors are much more reluctant to make longer-term fund commitments so the availability of long-term funds has shrunk in particular;
4) the availability of bank finance has also shrunk as banks deleverage to restore capital ratios;
5) the average cost of financing has increased in particular because investors are more risk averse; and
6) the availability of funds for more investments seen to be more uncertain, untried and risky such as those in the green sectors of the economy and in the SME sector.
Clearly any negative effects of the crisis and subsequent regulatory changes on the availability of finances for desirable investments need to be addressed with urgency.
In this section we briefly look at a number of long term obstacles that these three categories of investments face. Some are common across the three categories and some are specific to their particular characteristics.
Raising large sums of money for investments is always hard so funding of capital intensive projects such as in the transport, energy and other infrastructure projects is difficult. This challenge is pertinent for normal infrastructure projects and even more so for trans-border infrastructure projects well as for many green investment projects.
The absolute size of funds involved, the long gestation periods and high construction risk all mean that raising funds for infrastructure projects is hard. Trans-border projects that may be even more ambitious in scale but almost always also carry higher construction and operational risk are even more difficult to mobilise investments for. While the funds required for green energy projects such as the installation of solar panels or wind turbines are not that large, the riskiness associated with these projects is higher so upfront funds for construction are difficult to mobilise. For investments in energy savings such as through the installation of better home insulation the outlay amounts to a significant percentage of household incomes even though the absolute sums of money involved may be small.
As in most other markets, financial markets too have their conventions. Transactions that are of a size and kind that fall within the range of normal market practice are easier to finance and entail lower costs. That is why transactions that are very large, for example trans-border infrastructure projects, are harder to raise funds for than normal mid-sized corporate investments. The problem is also acute at the smaller end of the spectrum where directing money towards the relatively small investment needs of SMEs may be uneconomic for several investors. Similarly, the funding requirements for carbon reducing investments such as better home insulation are too small to be of much interest to any major investor.
The vast majority of large infrastructure projects, especially in the transport and energy infrastructure sectors, have a large public element. Some are fully owned and operated by the public sector but often and increasingly so there is private sector involvement in the funding, ownership and operational side of these projects, the so called public-private partnership arrangement.
The construction of roads, railway lines, transmission grids etc. all deliver a significant benefit to the wider economy that is hard to capture fully in terms of private compensation even with the increasing use of practices such as user fees by using tolled roads etc. The full benefits of infrastructure projects are very difficult to capture privately so the incentives for private investors who only look the profitability that can accrue to them are different from those for the country or region as a whole since the relevant parameter in that case is the economy-wide benefits that such projects might generate.
A similar problem applies to green investments where the private profits generated for investors do not fully capture the positive externalities generated by the project in terms of contribution to tackling global warming at least as long as carbon emissions remain under-priced.
To a lesser extent, there also exists a positive externality that comes from the intensive employment generation in the form of SME investments that may not be fully reflected in the profits that accrue to SME owners.
The general debate about investments almost always underestimates the potential impact that policy changes can have on the profitability of investments. This is particularly true in the case of infrastructure projects which have long complex construction cycles and even longer payback periods wherein many policy parameters such as land acquisition practices, price caps, obligation of providing universal access can change with a significant impact on the bottom-line of the project.
The single biggest source of risk and uncertainty in green investments is the evolution of public subsidies, if any, and of carbon price. No other parameter determines the profitability of green projects more than the prevailing and expected price of carbon which in turn is largely the result of public policy.
Information problems, where investors are uncertain about how to invest and/or about the details including the risk return dynamics of the underlying investment, are especially acute both in the SME sector as well as in the case of green investments. For the SME sector, the information problems arise because most of the SME’s are not listed and have little public information on their businesses. In this situation, it is very costly for investors to acquire detailed information in particular because the investment itself is rather small in size.
For green investments, the biggest problems arise at two levels. First, many investors who want to go green are uncertain where or how to invest and also whether the investments that claim to be green are actually so in practice. Second, there is also a clear uncertainty and lack of knowledge about nascent and evolving green technologies and about the longer term risk return profile of investments in technologies that are still evolving.
Infrastructure projects, once they have been built, are considered to be relatively safe investments. Energy generators, airports, toll roads and water projects all generate steady and relatively stable cash flows. Attracting reasonable cost funding for such projects is not that difficult but in the construction phase that is typically complex, expensive and takes a number of years, these projects find hard to attract the right mix of investments. A number of things can go wrong during the long drawn out building phase so the real and perceived riskiness of these investments is high.
Investing in green projects that lack a long history of established technology and a track record of life cycle cash flows for similar projects is naturally perceived to be risky by investors.
SME investments are also typically perceived to be less safe than investments in corporations that are larger and in particular also have brand recognition. This is so despite the fact that the cash flows and business models of many SMEs are in actual fact safer than those of larger more well-known businesses.
The profitability of large infrastructure projects, especially those that are unable to capture positive externalities or those that are designed primarily to deliver services to the public is relatively modest. Green investments lie across a whole range of spectrum from the highly profitable investments in energy efficiency to more marginal investments in solar panels that would not even be profitable without public subsidies. Without a doubt they would all be much more profitable if there were a proper price attached to carbon emissions but this is not the case yet. While SME investments may be highly profitable, the large information acquisition and monitoring costs means that profit margins on SME investments may still be low.
In addition to the problems that afflict ‘desirable’ investments that have already been discussed, there are also additional friction costs that make such investments less attractive to investors. The non-existence of appropriate financial instruments that match the right risk/return characteristics required by investors with the cost, duration and nature of funds needed for desirable investments is a major friction cost.
As discussed above, the ‘desirable investments’ often yield modest profits but offer significant real value added to an economy. As the nature of the financial industry has changed and as financial innovation driven primarily by the sell-side seeking to maximise short-term profits started dominating the financial system, speculative investments that often offer high profitability but with little real benefit to the wider economy crowded out investments that added real value to the economy.
This happened both at an aggregate level with large investors but also at the level of individuals. Faced with booming real estate markets many investors particularly in countries such as the UK, Ireland and Spain chose to put money into speculative purchase of houses that promised large (primarily because of leverage) safe returns rather than putting money into SME, green or infrastructure funds.
A parallel development to the increased innovation in financial markets has been an increasing degree of short-termism. At the level of large investors it means that the average holding periods for stocks and many other investments are now measured in months not years. Both bankers and fund managers are compensated on the basis of a quarterly or annual performance which significantly increases their incentives to maximise short-term profits. Retail investors too have become increasingly impatient and everyone wants quick profits with patience having become a very scarce commodity amongst investors.
In this section we look at how the crisis, which is still ongoing, has altered the investment landscape in the European Union.
The crisis inflicted significant losses on many investors both in the fixed income and equity segments of which only some have been recovered as a result of the partial economic recovery. Banks too saw their reported loan losses increase significantly. This has resulted in a shortage of investible funds particularly in certain markets.
At the same time that these losses have been registered, governments in the EU and internationally particularly amongst the developed economies have increased their borrowing to record levels. This has possibly exacerbated the impact of the shrinkage of funds so investments in the desirable categories have undoubtedly suffered.
The crisis resulted first in an expansion of government stimulus programs in most EU countries. This partly made up for the initial shock to investments that resulted from the eruption of the crisis. However, since the euro area sovereign debt crisis erupted last year governments throughout the EU have embarked on the sharpest austerity programs in recent history. This has not only reduced government expenditure on procurements, an important source of revenue for SMEs, but has also resulted in sharp cut backs on government support provided to the green investment sector and expenditure on infrastructure projects. The withdrawal of subsidies provided to the solar energy industry in Spain, for example, has thrown the industry into disarray.
After having been burnt by the crisis, many investors are sensibly cautious about making long term commitments especially as long as the European Union fails to draw a clear line under the crisis. This is an individually sensible response for investors but collectively it has a negative impact on the economy. Finding the long term market shut down or very expensive many borrowers have turned to borrowing over a shorter term. This reduced funding predictability, is unsuitable for certain kinds of investments and simply stores up problems for when the borrowing falls due.
An additional aspect of the crisis has been the drying up of equity markets (new issues) in the EU and a sharp fall in the amount of funds available in the form of venture capital, already a weak feature of the EU financial system.
Faced with increasing losses, an urgent need to protect capital and new regulations that require them to build up capital, banks throughout the EU have shrunk the amount of credit they make available. Some have put this down to being a demand rather than a supply problem. Both are two sides of the same coin. There is a widespread tightening of qualitative and quantitative credit standards which has reduced the supply of bank credit at any set of loan terms. Since bank credit is a very major source of finance, especially in the EU, for SMEs and for infrastructure and green investments particularly in the construction phase, this has had a disproportionately negative impact on our set of desirable investments.
At every level, the cost of funds has increased for the same nature and duration of financial contracts. This has altered the risk return characteristics and projected cash flows for a number of projects so that under the scenario of higher costs of funds some of the desirable investments are no longer commercially feasible despite the fact that their overall returns to the society in terms of impacts on growth, sustainability and employment is substantially positive.
Even though interest rates are very low, there has been a re-pricing of risk so the rise in credit spreads charged by banks and other investors has been greater than the decrease in headline interest rates. Moreover, as sovereign spreads have increased substantially especially in the weaker Member States, this too is contributing to a rising cost of credit.
The previous two sections have highlighted a series of problems that exist in the current investment landscape in the European Union. Some of these are structural and have grown over time and some others are a direct result of the crisis though they may be with us for many years to come. In this section we briefly discuss why these sets of problems have a disproportionately negative impact on our category of desirable investments.
Projects with large upfront costs and long payoff periods are already hard to finance even under normal market conditions but this has been exacerbated both by an overall shrinkage of available funds and an increased reluctance on behalf of investors to make longer term investments. Large scale infrastructure projects as well as smaller green investment projects that require relatively smaller but still multi-year funding commitments have both been disproportionately affected.
At the other end of the spectrum the small but fragmented nature of SME financing needs and energy efficiency enhancing household investments mean that these fall outside of the normal scale of market financing and are chronically underfunded. As the cost of credit has increased as a result of the crisis these micro investments have come to be seen to be more risky and are being disproportionately penalised by a reduction in bank credit in particular.
The split incentive problem, discussed briefly in a previous section of this paper, seriously afflicts all three categories of desirable investments disproportionately as the full socio-economic benefits of these investments are not reflected in the risk/return landscape faced by private investors so investment levels are suboptimal.
Out of a large category of investments our subset of desirable investments in particular are highly depended on public policy. As the crisis has forced governments to embark on large scale and often unexpected changes to policy, the resultant policy uncertainty has depressed investments in desirable areas. As public subsidies are withdrawn from the green investment sector and as public authorities withdraw some of the commitments made on infrastructure, total investment levels are shrinking.
Even though many investors express a desire to make green investments they face several information and friction hurdles to doing so. If there were more easily available investment products that were vetted to be quality a lot more money would flow into green investments.
The modest profitability and perceived higher riskiness (at least in the construction phase) of infrastructure, green and SME investments penalizes them disproportionately as speculative and short term investments crowd them out.
Austerity measures as a result of the crisis have had a disproportionate impact on our categories of desirable investments since these sectors depend disproportionately on partial public investments. The decline in the terms and volume of bank credit and a secular increase in the cost of funds have affected the desirable sectors more than others.
In general, anything investments seen to be unfamiliar, or more risky or requiring a longer term commitment of funds have been shunned by investors and this in turn has had a large impact on the investments in the desirable sectors in the European Union.
While there is a huge set of micro, macro and financial sector reforms the EU could undertake to encourage what we have called desirable investments, this policy brief does not allow for discussion of most of these ideas. Instead we highlight some of the major themes that capture a large proportion of these ideas.
We are undergoing the biggest overhaul in the regulation of the financial system in a generation. Most of the regulations being enacted are merely looking at a financial stability perspective. This is wrong. The problems in the financial system ranging from a general misallocation of resources to excessive short-termism and incentives for speculative over real investments are much larger. These other incentivising real, growth-enhancing, employment-generating, and sustainability perspectives should be factored in while revising and devising regulatory reforms.
For example, an introduction of financial transaction taxes and reforms to compensation of bankers and investment managers can help induce a
longer-term perspective into finance. Mandatory carbon stress tests for fund managers and banks can induce more green investments. Reducing the risk factors for SME lending and encouraging the securitisation and pooling of SME and household energy efficiency lending will also promote desirable investments. Steps to penalise speculative investments such as by introducing tighter loan to value ratios for housing markets etc would also push the financial sector in the right direction.
As we discussed above, our category of desirable investments is disproportionately dependent on public funds. So efforts to 1) increase dedicated funds for public investments, 2) promote investments in trans-border infrastructure, 3) support green investments, and 4) catalyse support to SMEs would also be very helpful in promoting desirable investments.
Funds that the pan-EU level in particular can be used to promote much needed pan EU infrastructure as well as green investments and the priority direction of cohesion funds in the direction of desirable investments holds great promise. Expansion of the European Investment Bank's size and scope of operation as well as an expansion of its concessional lending facility could also provide a significant boost to good investments.
Stressed governments budgets means that new and innovative sources of financing, in particular financial transaction taxes, other forms of financial sector taxation, carbon and other environmental taxes, the use of EU-wide lotteries, a possible use of dormant bank accounts and renewed efforts to claw back untaxed EU citizen funds deposited in tax havens would all be very promising sources of additional public revenue particularly at the pan EU level.
Project linked Eurobonds and project-bond purchases by the EIB for infrastructure projects are both good ideas though these could only be
used to finance that are at or close to commercial levels of profitability.
At the same time as EU investor power is declining, the funds being built up by non-EU investors, particularly in Asia and Norway are increasing. The stock of commodity related sovereign wealth funds and reserves held by emerging economies easily exceed USD 10 trillion now and hundreds of billions of dollars of funds are being added every year. Attracting even a fraction of these funds to the EU, particularly into the infrastructure and green sectors that can be made attractive to these investors can help make a substantial difference in the EU.
Providing tools for credit enhancements could and making special marketing offers to large sovereign owned funds is a good way of attracting them to EU infrastructure investments. Oil related funds in particular will find pooled portfolios of green investment as well as appropriate green venture capital funds very attractive because they provide serious green diversification potential for their carbon exposed flows of new money. In fact, such funds would be willing to invest in more marginal green investments than other non commodity investors who do not enjoy the diversification potential.
Often investments that would otherwise have happened in perfect and well-functioning financial markets do not materialise in markets that are somewhat dysfunctional and lack the right financial instruments for risk sharing and for connecting the right projects to the right investors.
The EU is widely regarded to have an underdeveloped venture capital industry and an excessive reliance on bank finance. Projects need different kinds of financial instruments at different stages of financing and these instruments need to have different risk sharing characteristics and time horizons.
In particular the EU needs to better develop instruments for credit enhancements and risk sharing, securitisation of green and SME investments, venture capital investments and public private partnerships on infrastructure. Where the private sector is able to step in to complete the market, it should be encouraged but in its absence the EIB and other public financial institutions should be tasked with developing product portfolios that best complete the requirements targeted in particular at financing desirable investments.
As long as impact of the crisis on public revenues is not purged, it may make sense for EU governments to explore the use of public private partnerships (PPPs) that until now have mostly take place in the UK. The experience of the UK has been rather mixed but appropriate lessons can be learnt and a selectively increased use of PPPs in the EU may be no bad thing particularly when the private sector can supply financing needs that governments at this point may have a harder time mobilising. Sometimes the choice may be between no public investment in infrastructure and investment in the form of PPPs.
The introduction and expansion of vetted infrastructure and green bond and equity indices, climate awareness bonds and green deposit accounts etc would be very helpful to attract investments into these sectors.
Private equity in the EU refers mostly to leveraged buy out (LBO) kind of deals that are not very useful for our preferred category of investments. Venture capital is very different from LBO transactions and should be put under a separate and more favourable regulatory framework. Within private equity, the public utility of public to private deals is rather limited whereas deals involving SMEs that can help create exits for entrepreneurs and retiring businessmen can be highly beneficial.
The EU is still working on tightening green legislation, launched a Small Business Act in 2008 to remove bottlenecks for and encourage investments to the SME sector, has prioritised our categories of desirable investments in its EU 2020 strategy and has ambitious plans for
trans-border infrastructure. Within these initiatives there are several plans that will, for example, 1) increase the price of carbon, 2) improve the operating and financing landscape for SMEs, 3) facilitate trans-border infrastructure investments, etc. These should be pursued in earnest and will significantly increase the investments flowing to growth and employment enhancing and green friendly sectors.
Preferential tax and regulatory treatments are very useful and powerful additional tools that can help stimulate additional desirable investments in the European Union.
Reducing other friction costs, such as those of pooling information, would also help encourage investment to flow to our desirable categories of investments. SMEs would benefit significantly if their liabilities could be pooled and securitised, if they had access to equity in specialised mini equity markets with less stringent listing requirements that standard exchanges. A credit registry for SMEs would also be very useful and could bring down their borrowing costs significantly.
Pooling arrangements for household energy efficiency loans and flexible billing arrangements that can help directly recoup some of the lower energy bills for investors can help stimulate a much needed expansion of micro investments in energy efficiency.
Similarly, approved green indices and vetted green deposit accounts can help many well-intentioned investors to translate their intentions into action by giving them easy access to making green investments.
When Lehman Brothers collapsed, no one knew which bank would be next. Counterparties lost faith in all measures of the soundness of banks. Under such a scenario, the only course of action that made sense was to hold one's money close to the chest. The uncertainty around the size and distribution of potential losses led to systemic collapse. Something similar has been unfolding in the euro area banking and sovereign debt crisis albeit in slow motion. The failure to draw a line under the crisis has meant that the continuing uncertainty around the size and distribution of losses in the Eurozone has been haemorrhaging our economy. Political dithering and mixed messages have ensured that no one knows how, when or where these losses will materialise (Source: http://euobserver.com/7/31752).
Under these circumstances, it ihas been rational for investors to keep their distance. They are penalising both sovereigns exposed to weak financial institutions and financial institutions exposed to troubled sovereigns. They assume the worst for both but this collective fear is far in excess of the worst possible realistic economic outcome. States and banks with healthier balance sheets have got caught in the crossfire.
Instead of reacting decisively to reduce uncertainty, our political leaders have done the exact opposite. Their continuing dithering has increased the absolute cost of the crisis and the resultant 'crisis overhang' has been one of the main drivers for depressed levels of investments. As discussed earlier, the uncertainty has affected our category of desirable investments more than proportionately as they have been shunned by investors under the present economic and political situation in the euro area.
EU leaders meeting on the 25th can help stimulate investments in the real economy by agreering to draw a line under the crisis and restoring confidence in the EU capital markets. they can do this by tackling the Greek, Irish and Portuguese debt overhang, restablishing market confidence by expanding the EFSF and putting in place an effective ESM and annoucing rigorous bank stress tests accompanied by an urgent bank recapitalization plan.
· European Commission; "Think Small First", A "Small Business Act for Europe, 2008.
· European Commission; Europe 2020, A European strategy for smart, sustainable and inclusive growth, 2010.
· European PPP Expertise Centre; A Guide to Guidance, Sourcebook for PPPs, 2011.
· Kapoor, Sony; Financial Transaction Taxes: Tools for Progressive Taxation and Improving Market Behaviour, Re-Define, 2010.
· Kapoor, Sony, Hogarth Ryan, Oksnes Linda, Gibson Anna, Narciso Thais; Tackling Climate Change: Tools to Fund Adaptation and Mitigation Initiatives, Re-Define, 2010.