Equity Financing and the Future of Greenovation
As debates mount in the U.S. over how best to regulate the financial sector to address climate change, the potential harm from banking sector exposures to climate change has attracted considerable attention, while the potential benefits of equity markets seem largely ignored. In what follows, I discuss why those debating over how to regulate the financial sector to address climate change should acknowledge two facts. First, debt, especially bank lending, plays a less important role in U.S. nonfinancial corporate funding than equity. Second, equity funding, generally plays a more important role in encouraging innovation, including green innovation, or “greenovation”, than debt.
Fact #1: There’s Much More US Nonfinancial Corporate Equity Than Nonfinancial Corporate Bank Loans
To see why, concerning the first fact nonfinancial corporate loans from banks in the U.S. most recently reached an all-time high of about $1.3 trillion; while not an all-time high, nonfinancial corporate mortgages have recently equaled almost $650 billion. However, those values pale in comparison with total nonfinancial corporate assets. Also, corporate bonds make up a larger and growing fraction of nonfinancial corporate funding. I show this in the figure below, which depicts Flow of Funds series for nonfinancial corporate bank loans, total mortgages and corporate bonds, each relative to total assets (to understand how the entries relate in the Flow of Funds data, see here).
The numbers in the figure above do not usually sum to one. The median ratio since 2001 equals 12.5 percent (9.9 percent since Q4 1951) for corporate bonds, 2.4 percent (4.6 percent since Q4 1951) for bank loans and 1.9 percent (2.6 percent since Q4 1951) for mortgages. For comparison, the median market value of equity to asset ratio for nonfinancial corporations since 2001 equals 56 percent (46 percent since Q4 1951). Overall, the figure shows that equity plays a more important role than bank lending as a source of external financing of nonfinancial corporate activity. It also plays a more important role in funding innovative activity, including greenovation.
Fact #2: Equity Markets Are Usually Better Suited to Funding Innovation/Greenovation Than Debt
To understand this second fact, a recent European Central Bank working paper (summarized here and here) suggests the future of climate change financing lies with equity markets rather than debt. The prediction arises from tying together several literatures. One highlights how higher income countries tend to have more equity market capitalization and less bank financing. Another finds that as economies transition from a more agricultural base to a heavy industrial base, pollution tends to rise, while as economies later shift toward more service activity pollution tends to stabilize or even decline. A third shows that debt, including bank loans, best funds tangible assets like factories, while equity best funds intangible assets, like ideas. Put together, these ideas suggest that equity will provide a better way to fund greenovation that could be used to address climate change. But why does funding type matter at all?
Intuitively, for those with ideas but no funding, equity investors take on the risk of funding a project knowing they could lose everything. In the case of debt financing, including bank loans, however, for those with ideas but no funding, if the idea winds up generating no income, then the borrower might not repay the loan. Patents are an exception to the rule here since some banks, like Bank of America and JP Morgan, do offer loans backed by the patent as collateral. But lots of innovation happens without patents.
Conclusion
During a keynote address at the Southern Economic Association meetings in November 2019, based on a paper written with Joseph Aldy, Richard Zeckhauser suggested that mitigating greenhouse gas emissions alone will not suffice in preventing global average temperature rises beyond 1.5° or 2° C. Rather than a so-called “one prong” approach, Zeckhauser suggests adding amelioration through solar radiation management and adaptation to form a “three prong” approach to climate change. The discussion (including Figure 6) in their paper also suggests that innovation will influence each prong. If that’s the case, then ensuring equity markets, and certain markets for debt, effectively fund that innovation happening at each prong seems an important policy objective to focus on in debates over financial regulation.
