The pace of global transition to low-carbon technologies could be adversely impacted with the ‘zero era’ for interest rates ending, a Wood Mackenzie report has said.

Higher interest-rate scenarios have increased the cost of capital and raised the cost and pace of the transition to net zero, which will likely require $75 trillion in investments by 2050.

The report recommends that policymakers should focus on efficient subsidies (targeted and non-discriminatory) that can minimize nationalistic subsidy battles that are counterproductive to global emissions targets.

Mobilization of climate finance is critical for green investments. The report outlines a need for greater use of financial mechanisms and instruments to maximize private-sector investment. Loans offered by central banks to commercial banks at preferential rates can help finance low-carbon investments.

Higher cost of borrowing

On average, major economies will likely experience nominal and real interest rates at two percentage points higher than in the ‘zero era.’ This higher cost of borrowing has disproportionately impacted the energy and natural resources sectors.

High capital-intensive, low-carbon energy and nascent green technologies rely heavily on subsidies. Further, debt also accounts for a higher share of the capital structure for low-carbon energy sectors. Hence, the impact of higher interest rates has translated sharply to an increasing share of capital expenditure.

While the energy transition will stimulate demand, Wood Mackenzie estimates this might also inflict upward pressure on inflation by shifting to higher-cost, low-carbon technologies.

Renewables bear the burden

While companies in the oil, gas, metals, and mining sectors remain relatively unaffected by higher interest rates, their counterparts in the renewables sector bear the unequal burden of higher borrowing costs. The high capital intensity of renewables and nuclear power has exposed these sectors to interest rates.

Debt from bonds and project finance, secured against long-term power purchasing agreements, has been leveraged to fund rapid growth in renewables.

Due to power and renewables having high gearing, the recent rise in interest rates has a larger proportional impact on their cost of debt.

With this threatening future projects, the renewables and green technology sector is worried.

According to Wood Mackenzie, while subsidized renewable investments can access cheaper finance, the low cost of debt and low required returns make projects sensitive to interest rates. These rates affect required returns and the cost of capital more than other power generation projects that need higher returns in the first place.

Nascent technologies, such as low-carbon hydrogen, carbon capture, utilization and storage, and direct air capture, need large-scale development and incentives to transform them into commercially viable, large-scale options for decarbonizing the economy.

As a result, they will be directly impacted by higher interest rates. This affects smaller development companies struggling to access debt and larger, credit-worthy emitters relying on low-interest leverage to render projects attractive for shareholders.

For instance, the capital intensity for hydrogen varies based on the project. At higher capital intensities, a 2% point increase in interest rates lifts the levelized cost of hydrogen by nearly 10%. The lack of economic incentives to capture carbon and the absence of a hydrogen market is thwarting investment in these sectors.

In contrast to renewables, the oil and gas sectors have a low gearing (smaller debt compared to equity). The net debt for 25 of the largest international and national oil companies assessed by Wood Mackenzie fell from $390 billion in 2020 to $150 billion in 2023.

As higher interest rates will impact investment sentiment, the cost of capital is worked into the 15%-plus return targets the industry’s biggest players expect from oil projects.

Global market structures contract

The policy rates in most developed economies touched their highest levels in decades after the most aggressive hiking cycle in 40 years.

With renewables competing against the market price in the U.S. and Australia, this will likely curb investments. In Europe, however, investments are still expected to advance, but they will result in higher prices due to the mandate to achieve decarbonization targets.

In the U.S., Wood Mackenzie’s analysis shows that a mere 2-percentage point increase in the risk-free interest rate will increase the levelized cost of electricity (LCOE) by as much as 20% for renewables. The LCOE increase for a combined-cycle gas turbine plant is 11%.

As these higher rates also risk the government’s efforts to subsidize energy transition, the transition efforts are restricted by reducing supportive subsidies and tax incentives or cutting direct public capital investment in a low-carbon economy.

Despite public debt in China having doubled in the past decade and the government stopping the subsidies for new renewable power capacity in 2022, the legacy subsidy payments to the renewables sector are climbing swiftly. As eligible projects outstripped the available funding, the report predicts that the country is likely to struggle to support subsidies in the future.

Despite the high interest rates, Mercom Capital group’s Annual and Q4 2023 Solar Funding and M&A Report showed that the solar industry received $34.3 billion in corporate funding in 2023, the largest amount raised over a decade.