Financing the Fossil Fuel Phase-Out

Abstract

Shifting power generation from fossil fuels to renewable energy comes at a substantial additional cost, which is largely borne by companies in the power sector. We study the implications of this burden for their capital structure, the dynamics of the transition, and the design and choice of policy instruments. For this, we distinguish firms’ capital structure following the “pecking-order” theory of finance in a stylized energy sector model where firms can invest in capacities for fossil or renewable power, as well as in infrastructure that improves the elasticity of substitution between the two forms of energy. We find that endogenizing substitutability creates a technological tipping point for climate policy, after which a rapid decarbonization of the energy sector becomes possible. Carbon pricing and renewable energy subsidy affect revenues differently, which is mirrored in the resulting higher (lower) debt-to-equity ratios. Under performance-based lending the deterioration of the capital structure is associated with an increased borrowing cost, can slow down the phase-out and can result in unsustainable debt dynamics.

Keywords: endogenous elasticity of substitution, fossil fuel phase-out, Climate Policy, capital structure, economies of scale, performance-based lending, financial instability