Master Thesis in Economics
DISPUTED ADDED VALUE OF THE
EUROPEAN INVESTMENT BANK
The relevance of a Regional Investment Bank in a developed region
University of Amsterdam
Faculty of Economics and Business
Master in Economics, specialisation International Economics and Globalisation
Student:
B.C.F. Houterman BSc., 5899230
Supervisor:
dr. D.J.M. Veestraeten
Second reader:
drs. N.J. Leefmans
22 April 2014
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Abstract
In this thesis, the economic relevance of the European Investment Bank (EIB) is
discussed. The EIB is a Multilateral Development Bank (MDB) funded by Member States of the European Union (EU). The majority of the loans are allocated to projects in the EU; this paper presents the way in which this process matches the framework – consisting of four elements – of an economically sound MDB. It is argued that an economically sound MDB must focus on externalities, public goods and conditionality, missing markets and governmental failures.
In the way EIB currently operates, the economic potential is not maximized. Often, projects are granted loans despite the fact that the bank’s involvement in that project has little added value with regard to the economic framework. Although externalities are internalized in the loan application phase, the focus on positive externalities is not a policy goal. At most, the EIB provides merely half of the required loan, whereas EIB’s conditionality must apply to the full project. Therefore, the EIB can effectively utilize its funds to claim for conditionality, so as to stimulate the supply of public goods. The conditions that loans must fulfill, however, do not optimally stimulate the production of public goods. Although missing markets can be opened as a result of EIB’s involvement, the EIB requires the involvement and cooperation of other parties. Hence, the EIB cannot invest in sectors in which other lenders are not willing to provide loans. Next, policy failures by governments cannot be corrected for by the EIB because the bank does not lend to governments. Underinvestment by governments can be corrected for though, because of the project focus of the bank.
Changes in the operational structure of the bank are proposed in order to maximize the economic impact of the bank. Improvements entail changing the lending policies of the bank, increasing innovative lending and changing operational procedures. Such
proposals support the argument that in order for the EIB to increase its economic relevance in the EU, it must adapt its operations.
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Index
1. Introduction ... 5
2. The EIB ... 7
2.1. Organization of the EIB ... 7
2.1.1. Founding of EIB ... 7
2.1.2. Capital and funding ... 8
2.1.3. Appraisal process ... 9
2.2. Goals of the EIB ... 11
2.2.1. Current operational goals ... 11
2.2.2. Evolution ... 12
2.2.3. Field of operation, and relation with respect to the EBRD ... 14
3. The economic case for a Multilateral Development Bank ... 16
3.1. Definition of the MDB ... 16
3.2. Market failures ... 17
3.2.1. Missing markets ... 18
3.2.2. Public Goods ... 20
3.2.3. Economic Rate of Return and externalities ... 22
3.3. Governmental failures ... 24
3.3.1. Failure in policy ... 24
3.3.2. Failure in investment ... 26
3.4. Framework to support the economic case for an MDB ... 27
4. The economic case for the EIB ... 28
4.1. The EIB as a Multilateral Development Bank ... 28
4.2 The economic case for an EIB ... 28
4.2.1. Externalities ... 29
4.2.2. Conditionality / public goods ... 33
4.2.3. Missing market ... 35
4.2.4. Correct governmental failures ... 37
4.3 The conclusion on the economic case for the EIB ... 38
5. Heading towards an EIB of the 21st century ... 40
5.1. Lending policies ... 40
5.1.1. Increase volume of lending ... 40
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5.2 Innovative lending ... 44
5.2.1. Expanding the use of existing new products ... 44
5.2.2. Focusing on diverse investment types ... 45
5.2.3. Offering innovative financial tools ... 46
5.3. Operational changes ... 48
6. Conclusions ... 50
7. Reference list ... 52
8. Appendix... 56
8.1. Shareholder structure of EIB from 1958 to 2007 ... 56
Note:
When in this thesis a ‘bank’ is mentioned without any other context, one can interpret this as the European Investment Bank.
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1. Introduction
Multilateral Development Banks (MDBs) are international organisations that provide financial services, typically in the form of loans and grants, for investment projects and policy-based loans. The operation MDBs is especially relevant in developing countries. As opportunities for borrowing from the domestic and international capital market may be limited or non-existent, ‘missing markets’ arise; this is where MDBs come in. Lending facilities can be offered in fields where other parties are not active. MDB’s investments can have a large impact on society in general. This applies to those that receive financial benefits (e.g.: people who have been hired due to the investment). However the benefits or costs of certain investments may affect those parties not directly linked to the
investment; these effects are referred to as ‘externalities’. MDBs have the ability to account for such externalities during their lending operation. Given their unique
shareholder structure and alternative way of setting goals, MDBs are capable of moving beyond the private-market profit focus. Investing in schooling facilities, for example, generates a solid knowledge base in a country. Such knowledge may spill over, resulting in increased productivity in numerous economic sectors. Given that MDBs generally serve to increase welfare in the developing parts of the world, it is interesting to
investigate whether MDBs are able to have a similar impact in an already developed area of operation.
The European Investment Bank (EIB) was established in 1958; it was set up as a
financial institution that would contribute towards the integration, balanced development and economic and social cohesion of the EEC Member States (European Investment Bank, Annual Report, 1999). Today, the EIB fulfils this role within the European Union (EU); it provides over € 240bn predominantly long-term financing for projects that align with the goals of the EU as “we support projects that make a significant contribution to growth, employment, economic and social cohesion and environmental sustainability in Europe and beyond”0 F
1. The EIB is funded by the Member States, who have all have committed a
certain amount of capital to the bank. Due to its clear and solid policy approach, the EIB may be considered an MDB as will be argued in this thesis.
The EIB is mainly active in developed economies that are characterized by a wide variety of investors, including regional or national governments, European funds, private banks and national public banks. Is it therefore necessary for the EU Member States to possess
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Development Banks that operate in countries that already have a diversified supply of loans, and where the missing market argument is not relevant or at least not large? How does this bank differ from the EBRD (European Bank for Reconstruction and
Development), which also partially operates in the EIB’s area? In this thesis, the relevance of regional investment banks in developed regions, with the EIB as central focus point, is analysed. The main research question is as follows: To what extent is the European Investment Bank, as a Multilateral Development Bank, relevant in a financially mature region such as the European Union?
In answering this question, a clear focus is maintained on the European operation of the bank. Other (smaller) areas of operation, such as in Africa, will be excluded from the analysis, as such market conditions are too diverse from and hence incomparable to those in Europe. Moreover, the EIB will be analysed from a development banking literature perspective. Given the scope of this thesis, the analysis will be restricted to incorporate only the economic rationale of development banking.
In order to answer the research question, the EIB – including its general organization and the bank’s operational goals – will be described in chapter 2. In chapter 3, the theoretical aspects of the economic rationale for Multilateral Development Banking are presented. The question pertaining to which type of lending is considered to be effective and to which extent it will increase welfare, are discussed. Theories on additionally, imperfect markets, capital market failures and externalities are also addressed. In chapter 4, these topics are linked to the EIB’s current practices in order to assess as to what extent the EIB’s current operation relevant within the EU? Following a description of the economic case for the current operation of the EIB, in chapter 5 several
suggestions for improvement are presented, including propositions on how the bank could alter its operations to become more relevant from an economic point of view. In the final chapter, conclusions are drawn and recommendations for further research are discussed.
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2. The EIB
Prior to the analysis, it is necessary to establish and discuss the EIB’s main
characteristics. First, the organization of the bank is described. What was the leading rationale of the six initial shareholders in establishing the bank? The position of the bank – with respect to other European institutions – and details on its capital structure are elaborated upon. Next, the main goals of the bank are described. The general
operational goals and the action areas (EIB’s own term for describing specific lending fields) are mentioned, including the ways in which they have evolved over time. Finally, a brief overview is provided of comparable institutions within the European Union (EU).
2.1. Organization of the EIB
2.1.1. Founding of EIB
The EIB was founded in the process of intensifying relations between various European countries. The founding of the European Coal and Steel Community in 1951
institutionalized the integration of European States after the Second World War. The treaty established a common market for coal and steel amongst the six participating European nations (Luxembourg, Belgium, the Netherlands, Italy, France and West Germany). This spurred the development of numerous supranational and
intergovernmental institutions. In 1955, the six countries formulated a strategy to achieve greater economic cooperation, resulting, for example, in the creation of a
common investment fund in 1956. Merely one year later, negotiations were held on what later became known as The Treaty of Rome. In the process of designing the framework of The European Economic Community (EEC), the differences in the level of economic development became noticeable between the six countries. A mechanism for tackling these differences was included in the Treaty and replaced the two-year old investment fund. In fact, the European Investment Bank was created in 1958, serving to provide funds that were to reduce the developmental gap between the ECC members (Bussière, Dumoulin, & Willaert, 2008).
The treaty negotiation sought to establish the bank as both a European policy institution and a financial institution with the ‘greatest possible freedom from any political influence’ (Bussière, Dumoulin, & Willaert, 2008, p. 42). The decisions have led the EIB’s legal position to differ significantly from that of most other European Institutions. It operates with great autonomy, given that it is not a so-called ‘Community Institution’. EIB’s legal personality and administrative structure are separate from that of the Community Institutions (European Parliament, 2013). Consequently, the EIB has sole authority to decide on lending operations within the EU, and does not necessarily adhere to the
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European Commission’s directives. The autonomy is additionally supported by the role of the capital of the bank, which is provided by the Member States rather than by the EU itself.
2.1.2. Capital and funding
The current operational model entails financing eligible projects by utilizing its own borrowing from the capital market. In order to issue debt, e.g. to start borrowing from the capital market, the EIB requires equity as collateral. The equity of the EIB is provided by the Member States of the EU in the form of subscribed capital, which is comprised of uncalled capital and called capital. The amount of a country’s subscribed capital relates to factors such as its population size and economy size. It is also dependent on the levels paid-in by countries that are roughly equal in size (e.g.
Germany, France, Spain and the United Kingdom have the same amount of subscribed capital, although their economies and population may vary). This policy ensures that no single Member State becomes the largest paid-in shareholder of the bank with the ability to obtain the greatest voting power in the board of directors. All shareholders delegate one director; his or her voting power is related to the share of that country in the bank.
This subscribed amount is primarily uncalled, in that it is not paid-in by the Member States and does not belong to the bank’s own funds. The bank may call upon these funds, e.g. when the bank requires the funds to meet its obligations. The bank’s statutes do not disclose the specific conditions required for calling on the capital. The ‘uncalled’ capital amounts to roughly 95% of the total of € 243,3bn subscribed capital (2013 figure). Despite the uncalled capital not belonging to the bank’s own funds by financial reporting standards, credit rating agencies account for it1F
2 in their assessment of the
quality of these bonds that are issued by the EIB.
The largest part of resources is generated by EIB borrowing activities from the capital market. The bank issues various types of bonds, in different currencies and with different maturity dates. According to the 2012 financial report, the bank raised a total of €
71.3bn from the capital market (European Investment Bank, 2013c). The AAA credit rating of the bank allows it to borrow money from the capital market at a relatively low cost, in turn enabling it to ‘multiply’ paid-in funds by the Member States. The exact
2See e.g. this report of Moody’s on the credit rating of the EIB, where the quality of the callable
capital of the bank is assessed. https://www.moodys.com/research/Moodys-Strength-of-European-Investment-Banks-asset-quality-liquidity-and--PR_279268
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amount is calculated by dividing the total pool of outstanding lending by the EIB amount of equity. The lower the interest rate on borrowing activities, the higher this multiplier will be.
Having described the liabilities side of the balance sheet, the following section details the asset side of operation. Here, the loan appraisal and evaluation will be discussed.
2.1.3. Appraisal process
The ‘promoter’ of the loan is the party that approaches the bank with a funding request. In formulating such a request, the bank greatly assists the promoter and meticulously evaluates the proposal4F
3. The lending request proceeds through the application and
appraisal process. During the former phase, the bank initially establishes whether the borrower meets several basic conditions (size of required funds, country of operation, willingness to share information with the bank etc.). Moreover, EIB teams
simultaneously analyse the environmental and social impact of the project. If the impact of the project does not comply with the EIB’s terms the project will be directly denied any form of investment.
During the appraisal phase, EIB staff conduct research on the project, investigating the overall quality and soundness of the project in the implementation and operation phase of the project. Moreover, the market conditions, environmental impact and the
investment costs are studied in great detail in order to calculate the returns that the project will yield, i.e. calculation of the Economic Rate of Return (ERR). Here, the “expected future cash flows will be taken into account, next to possible shifts in tax and income, externalities, non-monetary revenues and other effects” (Ministry of Finance (Netherlands), 2013, p. 8). The ERR calculation has a clear ‘society focus’, considering that it calculates the total costs and revenues on an aggregate societal level. The minimal ERR is 5%, entailing that a project with a lower ERR value will not proceed to the final phase of the appraisal process: voting by the board of directors. Figure 1 presents a general overview of the decision-making process during the loan application phase, voting phase and monitoring procedure. The board of directors, consisting of delegates from each shareholder country, makes the final decision on whether to approve or deny funding of the project.
3An overview of EIB’s appraisal process is provided on the bank’s website:
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Figure 1: Decision-making and supervision by the bank5F
4
Once the funding has been granted and the contract signed, the project is monitored and evaluated in terms of its ‘added value’. The following three criteria are used to evaluate the level of added value (European Investment Bank, Evaluation Criteria, 2013b);
i. Consistency with the Priority Objectives of the EU ii. Quality and Soundness of the Underlying Project iii. Financial added value
The first criterion describes the relevance of the financed project with respect to the current relevant EU policies. The fact that the EU is not a single institution makes it difficult to determine if and when exactly a project properly complies with EU policies. The bank states that the projects is analysed on consistency with EU policies “as defined by the Treaty, Directives, Council Decisions, Mandates, etc., the decisions of the EIB Governors, as well as the beneficiaries’ requirements, country needs, global priorities and partners’ policies” (European Investment Bank, Evaluation Criteria, 2013b). These EU objectives are also reflected in the bank’s sectors with specific focus, referred to by the EIB as ‘action areas’. Each of these areas is elaborated on at a later stage.
The second criterion refers to the performance of the projects, measured in four ways. First, the effectiveness of the project is determined by analysing whether or not the expectations of the realized objectives of the projects have been met. have the project’s concrete goals been met (e.g. a decrease in traffic jams)? Second, the efficiency is measured: how is the project’s outcome related to the inputs made at the
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moment of investment and during the project’s lifespan? Third, sustainability is
measured, whereby the probability of long-term benefits being yielded by the project, is explored. The fourth and last measurement relates to the environmental impact of the project, based on compliance with the “EU and/or national as well as Bank guidelines”6F
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and the general performance of the project within the environmental field.
The third and final criterion for evaluating the project’s added value is calculating the added financial value (for the bank) of granting the loan, compared to if alternatively a third party would grant the loan. The financial details of the EIB’s loan – including the interest rate, the maturity and the grace period – are realistically compared with the loans that could have been provided by other parties. Additionally, the possibilities of co-financing are considered and explored. The question is whether the EIB’s role in the loan may in fact stimulate other parties to become involved in the total loan provision.
2.2. Goals of the EIB
In this section, the primary goals of the EIB are discussed, in part by comparing EIB’s goals to those of similar institutions within the area of operation.
2.2.1. Current operational goals
The EIB’s main current goal is to promote sustainable growth and job creation. This goal is strived for by providing loans to projects in six specific action areas7F
6, all of which
comply with the economic policy objectives of the EU:
- Small and medium sized enterprises: SMEs account for 80% of new jobs; - Regional development: to address economic and social imbalances between
regions;
- Environmental sustainability: including both climate action and investment in the urban and natural environment;
- Innovation: promoting skills and innovation at each level
- Trans-European Networks: linking Europe’s infrastructure, particularly in the transportation sector;
- Energy: building a competitive and secure supply.
The bank provides only loans in the EU within these action areas. The majority of the bank’s loans are project loans, given that 93% of the activity is dedicated to providing direct or intermediated (via another financial institution) project loans. Loans are only
5 http://eib.europa.eu/projects/evaluation/methodology/criteria/index.htm
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directly provided to individual projects when the total investment cost exceeds € 25m. Smaller loans, for SMEs for example, are provided via local banks. The EIB will never provide the full amount needed for the investment; the loans “can cover up 50% of the total cost for both public and private sector promoters, but on average this share is about one-third”8F
7.
For the remaining 7% of total outstanding funds, the bank provides “a wide variety of sophisticated tools to help clients blend the bank’s financing with additional sources of investment”9F
8. These range from guarantees for private investors in high-risk investment
fields to special products designed for investing in specific fields, such as Green
Technology. The EIB invests in all EU countries: “The EIB has no pre-set country limits, but the EIB’s lending distribution broadly reflects the economic weight of various
countries within the EU, as well as the competitiveness of the EIB’s lending and the availability of other sources of financing” (European Investment Bank, 2013c, p. 8). This statement is of interest, as the EIB maintains no unique focus on the marginal returns of the funding it provides. One may in fact presume that the bank’s loans will have a
greater impact and marginal return in a developing region than in a richer area of operation. As such, focusing on both the economic weight and the competitiveness of funding may prove problematic; if the former does not align with the availability of other sources, the operational plan becomes difficult to carry out
2.2.2. Evolution
Since the bank’s founding 55 years ago, its operations have been reformed as a result of the following three factors: the inclusion of new Member States in the EU, an increase in subscribed capital and changing economic conditions.
First, in line with the expansion of the European Community (EEC), the number of shareholding nations of the bank increased to 28 Member States of the EU in 2013. The new Member States expanded the bank’s operations in terms of the total lending volume and the geographical scope of operation. The share of the initial Member States was decreased in order to accommodate the new shareholders in the bank’s ownership structure; between the bank’s founding and 2007, the initial members’ share decreased by 46% (Bussière, Dumoulin, & Willaert, 2008, p. 348). A detailed scheme describing the alterations in shareholder’s structure during the first 50 years of operation can be found
7 http://www.eib.org/products/loans/index.htm
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in Appendix 8.1. The accession of the new Member States created a larger geographical area of operation, allowing the bank to grant loans in more countries.
Second, the amount of capital that Member States subscribe to the bank has gradually increased. Naturally, with each new Member State allocating new resources to the bank, the amount increases. Next, existing shareholders increased their amount of subscribed capital to the bank. Overall, the total amount of subscribed capital has increased from € 1bn in 1958 to € 243,3bn in 2013.
The increase of capital has enabled the sum of loans – granted by the EIB – to increase, as well. In the bank’s operating plan, a ‘ceiling’ amount of maximum outstanding loans is stated. The board of directors have often increased this maximum. As illustrated by Figure 2, the ceiling amount was reached only after several years.
Figure 2: Development of EIB Loans outstanding (Bussière, Dumoulin, & Willaert, 2008, p. 347)
The third factor that influences and alters the bank’s operations is the development of the European and global economy. Two example will be provided to illustrate the concept: the 1970’s oil crisis caused significant operational change within the EIB. The crisis
commenced in 1973, causing massive economic distress in many parts of the world, including Europe. In the years preceding the crisis, the EIB did not have a clear focus on a certain policy area within the Union. In order to adjust to the new economic conditions, the board members agreed to alter the operational targets to focus more directly on ‘reemployment’. Subsequently, the bank restricted its loans to projects that would stimulate employment (rather than efficiency). (Bussière, Dumoulin, & Willaert, 2008).
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In the recent financial crisis, the bank responded by increasing lending volumes by 30% in 2009 and 2010. The EIB additionally started offering new lending products, such as proving high-risk financial guarantees (Hakket, 2009, p. 6). These policy responses confirm that the bank has adjusted strategies in direct accordance with economic reality.
2.2.3. Field of operation, and relation with respect to the EBRD
Given that the mission of the bank is to strengthen and support EU policy, it is mostly active (for 90%) within the 28 Member States (European Investment Bank, 2013c). For the remaining 10%, it operates in neighbouring countries (European Free Trade
Association countries, potential future EU countries such as Turkey, and other neighbouring countries), the ‘ACP’ region (African, Caribbean and Pacific Group of countries) and other Asian and Latin American countries.
The EIB is not the only development bank active within the EU. The European Bank for Reconstruction and Development (EBRD) acts as the other main player. The EBRD was established in 1991 for the Central European and Asian region. Initially, the bank’s main focus was on transition countries. The EBRD was established to build infrastructure for a transition towards a flourishing market economy. In short, then, the institution’s main goal is to support an economy in transition to an open market by crowding in private parties. The EBRD has no focus on specific policy areas or field of investment. The main way in which transition is achieved is through the financing of ‘banks, industries and businesses, both new ventures and investment in existing companies’ in transitional economies (European Bank for Reconstruction and Development, 2012).
The EBRD finances projects of all sizes, both directly and through intermediaries. Its financial instruments comprise loans, equity investments and guarantees. In 2012, the number of projects amounted to 393, with a total sum of signed outstanding loans of € 8,9bn. Considering that the bank receives an average share of 36% for each project, the total project value amounted to € 24,9bn (European Bank for Reconstruction and
Development, 2013, p. 7).
The EBRD is owned by its 64 shareholders, for the most part constituting non-EU countries; the largest shareholder is the United States. The EU and the EIB are also significant institutional shareholders of the bank. The bank’s goal is to turn these
‘recipient shareholders’ into regular shareholders, following successful completion of the transition. In the history of the bank, this has been accomplished merely once: “the Czech Republic is the only member to have ‘graduated’ from the EBRD and no longer
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receives loans from the Bank” (European Bank for Reconstruction and Development, 2012).
The primary focus on transition is what mostly sets apart the EBRD from the EIB. The EIB lacks a solid and clear transition strategy, focussing rather on a (EU directed) policy approach. This does not imply, however, that both institutions are not linked in any way. As both banks operate partially in the same geographical area, it occurs that both
institutions invest in the same project, e.g. in a power plant project in Slovenia11F
9. Their
connection is furthermore confirmed by the EIB’s share in the ownership structure of the EBRD.
Besides the EIB and EBRD, the Council of Europe Bank (CEB) is further development bank active within the EU. The way in which CEB operates coincides largely with that of the EIB and EBRD, i.e. by providing projects with loans. In 2012, the total sum of outstanding loans amounted to € 12,1bn, with € 1,6bn disbursed in that year alone (Council of Europe Bank, 2013, p. 3). The bank’s loans are allocated to projects
“contributing to the improvement of living conditions in the least advantaged regions of Europe” (Council of Europe Bank, 2013, p. 2). In focussing on social integration, in 2012, 63% of the bank’s funds financed social integration projects, 23% was allocated to environmental projects, and the remaining 14% was invested in public infrastructure with a social vocation. One could conclude that the CEB operates with a narrower focus than the EIB and EBRD.
This chapter provided an overview of the EIB’s operations and goals, as well as its evolution over time. Comparable institutions within the EU have also been introduced. In the following chapter, the economic case for an MDB will be discussed. Here, the EIB will not form the core of the analysis, but rather the theoretical concept of the MDB, such that chapter 4 then can apply this to the EIB.
9 This is an example of a project in which both banks cooperate. The EBRD committed €200m to
the project, the EIB €550m. For an overview of the project, see:
http://www.eib.org/infocentre/press/news/all/eib-and-ebrd-to-support-completion-of-tes-thermal-power-plant-sostanj-project.htm
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3. The economic case for a Multilateral Development Bank
In this chapter, literature from various perspectives on the role of Multilateral
Development Bank (MDB) is discussed. First, the characteristics of the MDB are listed and a definition of an MDB is formulated. Next, the issue of market failure is discussed in terms of missing markets, public goods, externalities, and solutions to these failures as provided by MDBs. Governmental failures are also mentioned. In the last part of the chapter, a summary of the economic case for an MDB will be presented.
3.1. Definition of the MDB
Banks have a generally crucial and widespread role in both the economy and society. Various types of banks can be identified, such as commercial banks and investment banks. Typically, most are privately owned and not driven by governmental policy. Public banks often dominate a significant share of the total banking spectrum; in Germany, for example, they hold 40% of the total banking assets (Hüfner, 2010).
In this thesis Development Banks are described, these banks are often considered multilateral institutions. Not all Development Banks are multilateral institutions though, for example the French national public investment bank ‘the Bpifrance’12F
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operates only in
France. The Development Bank defined in here is a multilateral one, as this thesis
studies the effects of cross-border operations and multinational shareholders. Hence, the Multilateral Development Bank (MDB) forms the subject of analysis. Buiter and Fries (2001) argue that two general characteristics distinguish MDBs from private financial institutions, namely “the multilateral shareholder structure and preferred creditor status” and ”subsidised capital base and access to other subsidies” (Buiter & Fries, 2001, pp. 4,5). These characteristics of MDBs distinguish MDBs from other financial institutions in terms of goals and the operational strategy.
MDBs’ goals are different from private institutions’ goals, as MDBs “provide financial assistance to developing countries, typically in the form of loans and grants, for investment projects and policy-based loans” (Nelson, 2012, p. 1). Deducing from this definition, MDBs grant two types of loans: project loans and policy-based loans. MDBs that provide the latter “provide loans primarily to governments” (Buiter & Fries, 2001, p. 4), with an earmarked element, i.e. the funds must be spent within a certain field of policy, to be determined and established by the MDB. Moreover, MDBs often offer a
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grant element as part of the loan provision, therefore MDBs directly subsidise the country to a certain extent. The World Bank is a prominent example of an MDB that lends to governments with grant elements. Project loans are different, and are not transferred through government bodies. Private sector involvement forms a key element in the investment strategy of such a typical MDB. The ultimate goal of such investments is to “strengthen the functioning of markets, transfer and diffuse new technologies and skills, or improve corporate governance and business practices” (Buiter & Fries, 2001, p. 4).
MDBs operate differently when compared with private banks. It is interesting to discover what distinguishes the operation of MDBs from ‘normal commercial and investment banking’. First, MDBs are not privately owned, as Member States are shareholders and or donors of the banks and thus have voting power over the decisions made. Vastly different incentives apply for the shareholders of the MDBs, compared to the
shareholders of commercial banks. MDBs operate with goals that differ from private markets’ profit focus: “We need to understand that they are not [normal, BH] banks” (Castro, 2002, p. 388). Second, the MDBs’ conditions for lending differ from the private banks’ conditions (Humphrey, 2012). MDBs are attractive due to the interest rates that they offer; these are often lower than the ‘commercial’ market rate. Third, the funding provided by MDBs has a longer lifespan, or maturity. Projects with a greater maturity are considered more risky (the time-span in which non-performance of loans may occur is greater). Private banks typically have limited capacities for supplying long-term loans. In their funding, MDBs tend to focus on long-term projects. MDBs may only finance projects for which private funding is not available at reasonable terms. Fourth, technical
assistance can be provided in order to support the projects (Humphrey, 2012).
In conclusion, the role of the MDB extends far beyond merely achieving maximum (financial) return on the loan portfolio. Based on the lower interest rate, the longer maturity and assistance provided, MDBs loans may be regarded as subsidised loans. Within the scope of this research, the study is restricted to one type of MDB: the financial institution that provides mostly project loans rather than earmarked financing for governments. Hence, considered are public financial institutions with a multilateral shareholder base that invest in projects and also aim for private sector involvement in their areas of operation. An MDB is considered a bank that operates with principles of sound investing, rather than being a mere tool supporting governmental policy.
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What is the added value of MDBs offering subsidized loans? A difference exists between the optimal private and societal allocation of resources, and MDBs can bridge this gap. Private institutions may simply not “exploit economic opportunities as fully as would MDBs” (Goldman, 1984, p. 276). In case the actions of private agents fail to reach the desired efficiency level – from a societal point of view – a market failure is said to exist. In this case, the efficiency of the private agents to allocate resources does not align with societal efficiency. From a societal point of view, the allocation of resources (by private agents) should then be altered in order to maximise the benefits yielded by the activity. However, if the private agents feel no incentive to do so, the market failure remains intact.
Institutions play a role in the correction of market failures. They may correct for “the failure of a more or less idealized system of price-market institutions to sustain
‘desirable’ activities or to stop ‘undesirable’ activities” (Bator, 1958, p. 351). To label an activity as ‘desirable’ is arguable, as it is highly disputable to formulate the maximised efficiency level of allocation of resources within society. Here three different types of market failures will be discussed; missing markets, public goods and externalities. 3.2.1. Missing markets
Markets can fail to deliver optimal outcomes in different levels. Grave cases, i.e.
complete market failures, embody a lack of activity within a certain area of production or consumption. When economic activity is dormant in fields that are desirable from a societal perspective, a missing market arises. Missing markets are therefore sectors in the economy in which no supply and demand exists, while this would have been
beneficial from societal point of view. Three types of obstructions, described below, are responsible for missing markets.
First, a lack of profit prevents private parties from entering a market; “Private agents will establish a market in a particular good only if the costs of doing so are more than met by gains” (Heller, 1999, p. 235). If private calculations indicate that no profits are feasible within a certain field of the economy, private parties are likely to refrain from initiating activities in that field. If social calculations indicate a societal gain in that field, the market may be deemed a missing market. This type of missing market is brought on by a lack of supply. Governmental action can alleviate this by making the actions within this field profitable for the private party (Heller, 1999); they could, for instance, offer a subsidy to potential private sector supplies. Another option is for the government to exercise complete control over the market. This field of missing markets is often related to the concept of public goods, which will be explained below.
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Second, the missing market may be caused by overly high transaction costs. “Transaction costs refer to the costs involved in market exchange”13F
11, the costs that
parties must make to be able to participate in the market. These costs may be “so high that the existence of the market is no longer worthwhile” (Arrow, 1969, p. 70). This ‘transaction costs argument’ can be used in various elements of an economic activity, such as the high costs of selling products (e.g. the marketplace may be costly) or high costs of enforcing a contract. The basic notion is that economic activity is inherently beneficial in terms of private calculations, but the high costs associated with participation in the market prevent the economic activity from taking place. An example may be the amount of legal fees that are required for entering a new market. Despite potential profits from selling products in the new market, the legal fees (e.g. for claiming property rights or complying with the tax law) may refrain a company from entering a new
market.
The third obstruction responsible for missing markets is poor infrastructure, such as facilities for learning and borrowing, which may inhibit economic activity. This
argument may be regarded as part of the second of obstruction, as costs related to acquiring knowledge about the market (e.g. price setting) constitute a transaction cost. Knowledge extends beyond transaction costs, however. For example, knowledge about production processes may be difficult to acquire and to use exclusively in competing with other firms. Firms produce knowledge at huge costs, and the benefits could afterwards easily spread to other firms. Therefore firms cannot be (fully) compensated for the initial investment, in terms of competitive gain, and refrain from undertaking that investment. Moreover, the lack of borrowing opportunities in the market may prevent crucial
investments necessary to enter a market. The lack of ‘market infrastructure’, which is essential for doing business, may prevent participants from entering a missing market.
MDBs can open up missing markets in different ways. First, MDBs can provide necessary loans in areas that suffer from a lack of funding because of mismanagement of
governments. Several countries, often those less-developed, have limited access to international financial markets or a poorly developed national capital market. In such countries, “a party is unable to borrow as much, and/or on the terms that it wants, even though such borrowing was justified by the existence of economic opportunities within the country” (Goldman, 1984, p. 277). This is where an MDB may play a fundamental role, by providing funds, given the lack of funding by international and national
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commercial banks or other creditors. It is debatable whether the lack of adequate
funding provided by commercial banks constitutes a true market imperfection. In several countries, private financial institutions provide no loans, or at the most, short-term loans; “Shorter-term loans serve to give an early indication of debt difficulties” (Goldman, 1984, p. 278). The limited supply of long-term loans may be resultant from mismanagement and could pressure governments into legitimizing their creditworthiness. This may also be the case when funding is not supplied by commercial banks at all. The supply of favourable MDB loans may postpone the process of governmental modernization (Goldman, 1984). Where an insufficient supply of loans is often regarded as a market failure, it may in fact indicate a governmental failure.
Second, and less debatable, MDBs can open up missing markets by investing in specific areas of the economy that lack funding because (private) investors consider the areas too risky or non-profitable. MDBs can provide the crucial loans in order to open up the market and in order to pave the way for other investors. MDBs have incentives to do so, as the impact of loans on society is of greater importance than the financial return. MDBs’ action in missing markets may crowd in private parties in several ways. The first steps of entering a new market may be costly, but could enable other (private) parties to enter at lower costs when the market is further developed. Moreover, MDBs can set a (positive) benchmark in areas that have been unknown for investors before. MDBs can also mitigate some of the risk for other investors, by providing guarantees to private parties and to transfer knowledge to the missing market in order for funds to be allocated efficiently into the missing market.
3.2.2. Public Goods
The market fails to provide an adequate amount of public goods, despite their positive impact on the society. Public goods contain two distinct features: they are non-rivalrous of supply and non-excludable in consumption (Olson, 1971, p. 14). A good is ‘non-rivalrous’ when many people can consume it simultaneously with no extra costs, i.e. the cost remains the same, regardless of the number of users. Furthermore, the
consumption of one individual does not reduce the consumption of others. A classic example is the streetlamp. The use of a streetlamp of a person walking down the street does not affect the use for another person in that same street. The non-excludable element indicates that one cannot be prevented from using the good, i.e. one can never be denied benefits from streetlights on a publically accessible street. The goods that comply with these two conditions are considered public, because individuals cannot be effectively excluded. Public goods can still be ‘produced’ by the private market parties. For example, investing in research by a private company strengthens the supply of the public good ‘stock of knowledge’ when this research would be publically available.
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Public goods are under-supplied by private parties, due to the lack of private returns, Considering the market’s inability to control or limit who benefits from public goods, consumers naturally feel little incentive to pay for the good: “The consumer who has access to the good anyhow has little reason to vote the taxes, or pay his or her
appropriate share” (Kindleberger, 1986, p. 2). This lack of incentive subsequently results in ‘free riding’ behaviour, i.e. individuals enjoy the benefits without paying for the costs. This free riding behaviour can also occur when a company invests in research with public good features; other firms may benefit from the knowledge acquired without paying for the investment costs.
Unarguably, public goods could benefit the society, a street lamp prevents accidents and research could improve efficiency. There is a discrepancy between the supplied public goods by private parties and the demanded public good in society. Governments can reduce this gap by executing their power to collect and impose taxes. These funds can in turn be used to pay for the production of public goods. This would prevent free-riding behaviour, as all citizens pay via taxes for the use of public goods. This can happen in various layers of government, for example from local governments to the European Union Institutions.
The supply of public goods becomes increasingly problematic when the goods are
international, which is realistic given that their effects are not always confined to national borders. International public goods are goods whose benefits extend well beyond
national borders, reaching a potentially global level. Examples are economic coordination, environment, knowledge, international security, and humanitarian assistance. National governments, however, lack the incentive to fund such goods, as the returns are not solely for their enjoyment. This problem can be solved through international cooperation; “Various international institutions have been created to facilitate collective action”
(Stiglitz, 1999b, p. 597).
The provision of (international) public goods may also be promoted by MDBs, this can be accomplished in two ways. First, MDB may invest in the supply of public goods, for example by stimulating investments in research. The key goal of these investments would therefore be to stimulate the public goods. Second, more implicitly, the supply of public goods can be supported by conditionality on loans. By granting loans, MDBs may legitimately demand certain elements of conditionality that will benefit the international public goods. To illustrate: an MDB may require a company to share all its knowledge acquired from a project with competitors. Public goods can also be provided in an
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international sphere, as some public goods (such as knowledge) has an impact beyond nation’s borders. MDBs have capacities to consider cross-border effects of public goods because of their international orientation.
Extensive research has been conducted on the public goods that MDBs account for, for example: in the field of environmental issues (Dreher & Ramada-Sarasola, 2006). It has been found that in many countries in which MDBs operate, policies for tackling
environmental problems are developed within the institutions. MDBs are only marginally successful in achieving environmental impact; they do not succeed, for example, in the emission of greenhouse gasses. Transparency is another type of public good. MDBs focus specifically on fighting corruption by providing loans, as “Regional Development Banks are leading voices in the donor’s transparency chorus” (Nelson, 2001, p. 1834). Therefore, the current actions of MDBs have a limited positive impact on supporting public goods.
Besides the lack of the supply of public goods, economic agents may not take all their actions’ outcomes into account. Below, the calculation of the Economic Rate of Return (ERR) and the related concept of externalities are explained.
3.2.3. Economic Rate of Return and externalities
By its capacities to provide or demand for additionally, MDBs can internalize externalities. The concept of additionally can be understood as an action that promotes adding
something to the ‘baseline’ situation (Gillenwater, 2012). Through an act of additionally, baseline conditions are improved. Within the economy, economic agents can alter baseline condition in various ways, for example: by reducing greenhouse gas emissions, increasing the number of jobs offered, or achieving economic growth. An economic variable (e.g. the number of jobs) has a baseline condition (e.g. X amount of jobs) that can be increased by an economic agent (e.g. N more jobs are created). The outcome of the economic agent’s action (X+N) exceeds the baseline (X).
An MDB has the ability to supply the baseline condition with various improvements. The concept Rate of Return is helpful in understanding this concept. Returns on investments can be calculated in various ways. The Internal Rate of Return (IRR) can be considered an ‘internal economic performance’ and additions the total costs and benefits of a certain investment, for all parties involved. According to Feenstra and Wang (2000), this rate can be calculated by adding up “all cash outlays and receipts expressed in monetary units of equivalent purchasing power” (Feenstra & Wang, 2000, p. 3). It must be
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disclaimed that this calculation does not account for all effects. In order to grasp the full impact of a project, a more extensive and comprehensive rate of return must be used.
An extension of the rate of return is the so-called ‘Economic Rate of Return’ (ERR), which is not an internal rate, but rather a rate that focuses on the effects on the aggregate level of society. “ERR calculations take into account all stakeholders of a project – the project financiers (whose return is captured in the private return, or financial rate of return (FRR)), the financiers’ employees, the project’s suppliers & customers, producers of complementary goods, competitors of the project (and new entrants into that market), neighbouring residents affected by the implementation of the project, and the rest of society” (Harvey, 2006, p. 1). From this definition, it is apparent that if one seeks to evaluate the overall effect of a project, the impact of the project on a societal level must be well understood. By focussing on the FRR only, one evaluates only the ‘internal’ outcomes of the investment. The FRR can simultaneously be understood as the Internal Rate of Return (IRR). The ‘baseline condition’ addressed earlier can be understood as a focus on the IRR of project investment by commercial banks. This condition is altered by MDB’s focus on the ERR; as such, they also consider the external effects of investments for their investment decisions.
In calculating the ERR of a project, it is difficult to assign a monetary value to all relevant outcomes. The externalities of a project, for example, may be difficult to calculate. Externalities, consequences of an economic activity, are experienced by unrelated third parties (Greenwald & Stiglitz, 1986). When externalities are present, neither the revenues not the costs are fully allocated to the parties involved. Examples of this phenomenon include knowledge spill-over (knowledge is generated in society due to a certain economic activity) and pollution. Therefore, the total sum of costs or benefits for society may differ from the sum of private costs and benefits calculated by the actors directly involved. As such, externalities are central to the argument about the MDB’s external focus.
Externalities can be both positive and negative. Investing in the training of employees is likely to generate various externalities, such as increased productivity in the employee’s future career in potentially other (economic) sectors and a decreased probability of unemployment. The employer making the investment will not reap (all) the benefits. Externalities may also be negative, such as pollution as a result of product production, i.e. greenhouse gasses. These gasses damage the natural environment. As has become clear, externalities are indirect effects. Given that externalities have an impact on society, it is rational – from an economic point of view – to assess them during an investment
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appraisal process. In the following section, MDB’s solutions to the aforementioned issues are discussed.
Externalities are taken into account by MDBs. Given that MDBs have a different role in the financial system, their incentives are not solely based on the maximization of shareholder profit; instead, they aim to maximise social profit. Due to more diffuse operational goals, MDBs aim to maximise not the IRR, but the ERR. In doing so, an MDB can incorporate the externalities created by the investment. By financing only those projects that yield a social profit, an MDB can limit negative externalities and stimulate positive ones. “There is clear evidence that externalities or market failures justify the use of MDB resources” (Upton, 2000, p. 18). MDBs can internalize the externalities in their operation in two ways, by investing in areas of the economy that stimulate positive externalities and by demanding conditionality for all loans. The former strategy describes a situation in which an MDBs seeks for investments that specifically internalize certain externalities. An example is investing in renewable energy. Generating power by using fossil fuels, results in the production of negative externalities. Investments in renewable sources of energy production reduce these negative externalities, which has a positive impact on the society (reduction in greenhouse gasses). A different strategy is to
demand for certain conditionality for all loans that are provided, e.g. that the project has to comply with certain standards of low emission of greenhouse gases. This could for example result in requiring the use of certain renewable construction materials, or office buildings to be heated with solar power.
3.3. Governmental failures
The market is not the only sector in society that fails to produce the most efficient outcome, governmental failures can also negatively affect welfare in society. The government can be involved in social and economic activities by “the provision of a commodity, subsidize the commodity or regulate the production and distribution of the commodity” (Le Grand, 1991, p. 431). A governmental failure is defined as an inefficient distribution of scarce goods due to the (lack of) intervention of the government in the economy. There are two forms of governmental failure: failures in policy and failures in investments. Here these failures and the involvement of MDBs to correct for the failures are mentioned.
3.3.1. Failure in policy
To deem something a governmental failure is a normative assessment. Some people for example argue that governments should correct only for market failures. The
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a product (Le Grand, 1991, p. 438). Others argue that the role of the government in society is more extensive, and that it should include focus on policy fields such as reducing income inequality. Here, three forms of policy failure will be discussed that prevent the (private) market from functioning in an effective manner. To limit the analysis here, governmental failures are discussed that comply with the first (minimal) view on the role of governments in society.
The first element of policy failure constitutes the availability of information on the policy environment. What can investors expect from the government during the investment period? Often, governments lack a clear flow of information with regard to their policy environment, despite this information being of great value for individual investors. Without valuable information, investors might refrain from entering the market. When one investor collects the information, he or she may not have the incentive or intention to share it. An MDB can take on this task, by sharing information about governmental policy. This role reflects the MDB’s public good function described earlier, in that
information on governmental policy-making can essentially be regarded a public good. In case the government fails to disclose adequate information about its policies, MDBs can “carry out intensive consultation with the governments to determine the state of the economy and its future, as well as the cataloguing in detail prevailing government policies” (Rodrik, 1995, p. 8). Knowing this, national governments may feel more pressured to improve their governmental policies; MDBs can approve the policy with a ‘stamp of approval’ (Rodrik, 1995, p. 8). Although the MDB’s informational role is not directly related to the lending operation, it allows the MDBs to improve the market structure.
The second policy failure deals with effective conditionality. Conditionality assigned to loan provision allows MDBs to repair governmental failures. For loan
conditionality, it is important to distinguish between direct lending to governments and project lending. In case of the former, conditionality could be aimed at desirable actions that a government should take. According to Rodrik (1995), multilateral institutions (such as World Bank, IMF and Regional Development Banks) are more effective in enforcing conditionality rules than other debtors (such as countries), given the former’s non-political operation. When MDBs “retain some degree of autonomy from the
governments that own them, their interaction with the recipient countries, while official in nature, can remain less politicized than intergovernmental links” (Rodrik, 1995, p. 2). This may advance and promote conditionality. Here, conditionality is denoted as the set of conditions assigned to the loan that will result in “changes in government policies” (Rodrik, 1995, p. 2). Conditionality may in fact improve the function of the market
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conditions for businesses, e.g. by reducing the impact of corruption or improving the predictability of the legal processes.
The third policy failure constitutes the investor support. Due to (the lack of) government’s action, the market may be not attractive for private investors. For example, certain crucial technologies may be unavailable or unknown in the market. MDB can mitigate this governmental failures by granting loans directly to private sector projects, which may “strengthen the functioning of markets, transfers and diffuses new technologies and skills, or improves corporate governance and business practices” (Buiter & Fries, 2001, p. 4). With this type of loan provision, MDBs can correct for the government’s failure to adequately form a market that is welcoming to investors and businesses. This could stimulate economic activity in general, and may benefit the entire society.
3.3.2. Failure in investment
This part of governmental failure pertains to the government’s role of providing certain goods. The rationale behind the government’s intervention in the economy has been extensively described by previous research, distinguishing a range of market failures. In short, the government’s involvement in the economy may at times be justified. This does not imply that the governments should bear the sole weight of exploiting economic activity to correct for the lack of investments; through subsidies, governments can correct for the imperfect investments made by the private market. Governments are also often not permitted to initiate significant investments, for example to safeguard
sufficient competition in the economy.
A failure of governments to either provide or subsidise significant investments could lead to an under-investment in the economy. ”In the longer run, government investment may become productive public capital, promoting economic growth” (Leeper, Walker, & Yang, 2010, p. 1000). A lack of sufficient investments by the government prevents this public capital from being established. This can be caused by several factors, such as insufficient available funds or political preferences that do not match principles of economic
efficiency.
MDBs’ intervention in this type of failure may be appropriate in order to stimulate necessary investments. MDBs can invest in specific fields that are neglected by the government. The transaction costs described in section 3.2.1, for example, indicate that a lack of infrastructural investments may hinder economic activity. MDBs can serve to facilitate such investments in order to ease and stimulate economic activity of private parties, and hence correct for what the government has failed to deliver.
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3.4. Framework to support the economic case for an MDB
Several interventions of MDBs have been discussed that would correct for market and governmental failures. These interventions are very relevant in the present time. As mentioned by the International Financial Cooperation (2012), two conflicting conditions are noticeable in the world of MDB finance today. First, “governments, seeking greater impact from their limited resources, are now increasingly looking to approaches that leverage the capabilities, resources, innovation and efficiencies of the private sector” (International Finance Corporation, 2012, p. 10). Private sector involvement, however, is not always most efficient for replacing public sector actions, due to the market failures associated with private investment. Therefore, “the main market failure relevant to private investment is the existence of public goods or positive externalities, such that the social returns from an investment exceed the private returns expected to be captured by the investor” (International Finance Corporation, 2012, p. 16). An MDB is able to correct for an extent of the imbalances in funding. As such, it is often argued that the existence of the MDB is justified on the basis of a valid and clear economic case.
To sum up, the economic case for the MDB is that it must provide loans in fields where private parties are unable to achieve full economic benefit. This economic case can be subdivided into four (partially overlapping) arguments, all in favour of the MDB’s
operation. This forms the economic framework of this thesis and the analysis of the EIB. First, the missing markets argument deals with the lack of funding in fields generally beneficial for society to invest in. When missing markets are detected, an MDB can play an important constructive role. Second, the conditionality of projects is crucial in order for an MDB to reach higher economic potential and to correct for inefficient or incorrect market and / or governmental behaviour. This conditionality can stimulate the supply of public goods, as the MDB’s unique role allows for it to proclaim crucial conditionality elements. Third, it is essential for externalities to be taken into account during
investment decisions. As some externalities are not accounted for by private parties, the MDB must internalize them in the lending provision. Fourth, as MDBs have the capacity to influence governments and correct for (lack of) government investments, they are capable of correcting for governmental failures.
Now that the basic economic arguments (in favour of the operation of an MDB) have been discussed, the following chapter will apply this framework to the EIB.
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4. The economic case for the EIB
In the first part of this chapter, 4.1., will be argued that the EIB may be considered a Multilateral Development Bank (MDB). In part 4.2, an economic case for this proposition is made. In which way is the EIB of added value and to what extent does it comply with the conditions, identified in chapter 3, of an economically sound MDB? In part 4.3, a concluding summary on the economic case for the EIB is presented. This will serve as a link to chapter 5, in which suggestions for improvements of the workings of the EIB are made.
4.1. The EIB as a Multilateral Development Bank
The European Investment Bank (EIB) aims to facilitate economic activity in the EU. The question is whether the bank can be seen as an MDB. In EIB’s shareholder composition, characteristics of MDBs are met. The bank has a multilateral shareholder base, which consists of the Member States of the European Union. The capital base of the bank is subsided, Member States of the bank have provided capital to the bank. Moreover, the EIB loans are subsidized. The loans provided by the EIB have conditions (interest rate, maturity) that are favourable over the market conditions. Knowledge of the institution is shared in certain action areas. Therefore, the loans of the EIB have a ‘subsidized
element’ as the EIB offers conditions not offered by private financial institutions. Also in its operation, the bank can be considered an MDB. Due to its projects lending strategy, the EIB may be considered an MDB confined to providing project loans only (never policy loans).
Is there a case for an MDB is Europe? Economies seem never fully developed. The European economy can be further developed as funds are not available unlimitedly for financing all economic opportunities. No country has reached its full potential in terms of its investment opportunities, or maximised welfare to the greatest extent. Can every off-shore wind farm be financed, despite its high internal and economic rate of return? Can SMEs with steady cash flows access loans in the entire EU? Even the most developed countries have underdeveloped economies in some areas, such as in fields that rely on innovative technologies (e.g. renewable energy). Considering the fact that the EIB has a policy of granting loans in six different ‘action areas’ in order to stimulate the European Economy, it must surely be considered an MDB. Action in these areas is justified because the economic potential in the EU has not been fully reached.
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Does the EIB meet the conditions for the economic case of the MDB? This analysis will commence with a study on the externalities internalized by the EIB.
4.2.1. Externalities
Below, the externalities that are involved in the EIB’s operations are discussed. The extent to which the EIB takes externalities into account in its operation is first described, after which the bank’s fields of action are presented; here, positive externalities can be assumed to be present.
In order to account for externalities, the bank employs certain procedures during its operation. As mentioned, the bank has certain procedures for calculating the expected impact of the project during the appraisal phase of the project. The EER is calculated during this phase. Here, a minimum rate is set by the bank, often no less than 5%, which acts as a minimum condition with which all projects must comply. To calculate the ERR, the externalities of the project are explicitly analysed. In the field of environmental externalities for example, ”the Bank began to integrate a cost for environmental
externalities (carbon and local air pollutants) into project appraisal in the late 1990s” (Calthrop, 2013, p. 24). One may argue that the externalities associated with the project are internalised by the bank in the loan’s appraisal phase.
In a simplified formula used to calculate the value of the project (in order to calculate the Net Present Value (NPV)), the direct costs and benefits are listed, as well as the externalities.
Figure 3: NPV formula of EIB for project loans (Calthrop, 2013, p. 26)
In the formula above, the following items are listed: “assume a simple capital
investment in year zero (C0), leading to a stream of benefits (B) over the life of the asset
(to year T), net of fixed and variable operating costs (C) and external costs (EXT)” (Calthrop, 2013, p. 26). It is here implicitly assumed that the net calculation of
externalities will result in a cost whereby the negative externalities outweigh the positive ones. This formula derives from a study that measured the effects of the EIB’s
investment on the environment. One may assume that in alternative sectors of projection, the total externalities are positive. Attributable to a wide range of externalities such as technological spill overs, the minus sign directly preceding the externalities sum (EXT) should become a plus sign for these sectors.
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In the formula, the sum of the total costs and benefits of a project’s lifespan are added; the result is discounted. Assume a case whereby a project encompasses large benefits (B) and few costs; this will result in a high NPV outcome. However, once the project’s
externalities are taken into account by the bank, a different outcome may be reached, subsequently resulting in an ERR of <5%. Calthrop (2013) claims that for the
quantifications of externalities, various improvements have been carried out over the past year, ”Though attention is required in order to integrate this approach across all sectors in which the Bank operates, as well as to broaden the range of externalities considered” (Calthrop, 2013, p. 27).
In order to understand the types of externalities that arise with the lending operation of the bank, the action areas must be carefully studied. Projects must meet one of the six ‘action areas’ of the bank mentioned in section 2.2.1. The EIB attempts to account explicitly for the externalities in each specific field in which loans are granted. This argument will be explained by considering two ‘action areas’: energy investments and the Innovation 2010 Initiative.
The EIB has invested in projects that aim to increase the level of sustainability in energy supply. These efforts meet the action areas of ‘environmental sustainability’ and
‘sustainable, competitive and secure energy supply’. This sustainability focus has been implemented in investments in wind farm technology and construction (European Investment Bank, 2013c, pp. 9, 127). The general trend is that the bank is gradually increasing its allocation to climate action; “the Bank’s climate action target has risen from 20% in 2010 to 25% for the current three-year planning period (2012 to 2014)” (European Investment Bank, 2013d, p. 9). The goal of the bank is this field is to cut down on the emission of greenhouse gasses14 F
12.
This type of lending yields clear positive externalities (e.g. preventing pollution caused by generating energy from non-sustainable sources). Facilitating climate action is
thereby a policy that can be claimed to foster the decrease of the negative externalities, that are linked to conventional production of energy. The EIB, on the other hand, does not dedicate all its funding to the decrease of greenhouse gasses. The Bankwatch Network Report (2013) claims that between 2007 and 2011, roughly 30% of the EIB’s
