Low-Energy Fridays: Do higher interest rates hurt clean energy?

The adverse effects of high interest rates on clean energy have gotten a lot of attention lately. While the topic is nuanced, the simple fact is that although rate hikes may hurt clean energy investment, they are necessary to address inflation. Because higher interest rates blunt the effectiveness of conventional policy mechanisms like subsidies, they create a stronger case for politicians to pursue other energy policy ideas—including permitting reform—more thoughtfully.

First, it is important to understand how interest rates from the U.S. Federal Reserve (Fed) work. Global trade occurs via “floating” exchanges, where the value of currency is determined by global supply and demand. One of the Fed’s responsibilities is to manage the currency supply (how much is printed); another is to set interest rates. Both affect the supply and demand of dollars, which, in turn, affects their value. Since inflation occurs when too many dollars chase too few goods, the Fed plays a major role in managing it by addressing both sides of the equation.

When inflation is high, the Fed can hit the brakes by increasing the interest rate banks must pay (the federal funds rate, which directly impacts the interest rates charged on loans to conventional consumers and slows demand for new spending). For example, if the bank is paying 2 percent, consumers can expect to pay slightly higher. This reduced borrowing helps slow inflation by reducing the demand of goods relative to the supply.

There is a lot of complexity around why inflation has skyrocketed in the past couple of years, but it is reasonable to cite two major factors: 1) a reduced supply of goods due to the COVID-19 pandemic disrupting supply chains and 2) consumers’ increased buying capacity due to government stimulus.

How high interest rates will go is not yet known. While the Fed has a target inflation rate of 2 percent, the current rate is 3.7 percent (down from a high of 8.9 percent in June 2022). A rule of thumb the Fed uses is something called the “Taylor Rule,” which says rates must be 2 percent higher than inflation in order to bring inflation down. Because the current federal funds rate is 5.33 percent—with the Taylor Rule suggesting a rate of at least 5.7 percent—interest rates may rise even further.

All of this affects clean energy because it comprises most new energy investment. Rate hikes hurt clean energy more than fossil fuel because much of fossil fuel’s infrastructure already exists. Increased interest rates charged on loans are good for people who already have low-interest loans and bad for people taking out new loans—and the same is true for energy investments.    

In terms of energy policy, the situation is complicated by the fact that the Inflation Reduction Act (IRA) is subsidizing clean energy at a higher rate than initially expected. Higher spending means more demand for goods, which, as we recall, worsens inflation. In this sense, the IRA is in a catch-22: The more money it pumps into clean energy, the worse its effect on inflation and the higher rates must go, which then hurts clean energy investment.

In practice, the impact of the subsidies on incentivizing clean energy investment will overtake the effect of higher interest rates because the benefits are concentrated in specific industries while the costs are dispersed more broadly across the economy. But from a policy perspective, this illustrates why a heavy reliance on subsidies is problematic.

More practically, there is mounting evidence for the notion that capital investment in clean energy is pent up by restrictions on permitting. Conventional wisdom suggests that permitting reform would result in more clean energy investment without contributing to inflation or raising costs for the public. In this dynamic, we see exactly why pragmatic, economically sound environmental policy is far superior for improving overall economic welfare and clean energy investment than the IRA’s tax-and-spend approach.