Increasing yield spreads

Economics doesn’t prepare you for the financial system. An degree in environmental economics is another step away again. If you read enough financial literature, you can start to pick up the lingo but until you are in the middle of the financial system, you can’t see the critical role of incentives.

A thoughtful person asked me  about how my perspective on sustainability had changed after I returned from finance in New York. My reply was that I had never previously considered the impact of incentives and that sustainability, as a whole, rarely discusses why people do what they on a day to day basis. Much of sustainability stresses the moral imperative but I saw how incentives can warp and morph morality, making even small sustainability goals less achievable.

So my own education was a crash course in why incentives shape financial flows. For instance, yield spreads, the difference between interest rates of different fixed income assets, are critical signal and incentive for investors. Sovereign yield spreads change currency values. Spreads are highly affected by credit ratings. Changing spreads can change the attractiveness of investing in equities. Spreads are a major form of revenue generation for banks by borrowing in a low interest product and lending in a higher product. They can affect how much a company or project developer can borrow and at what rate.  They can also decimate the global financial system, and the wider economy, if they blow out (i.e. 2008-09).

Credit spreads also affect sustainability projects.Renewable energy depends on up-front capital to fund deployment and then generally delivers fixed repayments to investors so an increasing yield spread that increases the cost of debt can reduce the attractiveness of renewable energy for investors. Lazard provides analysis on the impacts of rising cost of debt.

Source: Lazard

The analysis shows that increasing cost of debt from 5% to 10%, increases the cost of rooftop solar by 37% and 46% for utility scale solar. Discussion on the ‘economics’ of solar should include a detailed discussion on the impact of yield spreads. I rarely heard it discussed. Yield spreads provide a strong signal for investors so its omission in economics and environmental is a significant oversight.