Impact of financial incentives on green manufacturing: Loan guarantee vs. interest subsidy

Highlights

• We investigate the impact of interest subsidy and loan guarantee on the green production and investment, the manufacturer's profitability, and the bank's risk control.

• We compare the dominant government policy between interest subsidy and loan guarantee.

• We examine how key factors such as the environmental impact, the consumers’ green awareness, and the bank's risk aversion affect the outcomes.

Abstract

This paper studies the impact of government support on the production and green investment of a manufacturing firm with financing needs. Two financial stimulus policies are explored: loan guarantee and interest subsidy. Based on game-theoretic models that incorporate the manufacturer's operations and the bank's risk preference, we attempt to explore the implications for the economic and environmental performance of government interventions. Our results reveal that: (1) both policies are effective in scaling up production volume and economic performance, but loan guarantee policy is ineffective in boosting green investment; (2) the downside risk the bank bears under the loan guarantee policy is not less than that under an interest subsidy policy, due to limited intervention from government; (3) it is optimal for the government to intervene in the manufacturer's financing activity when the environmental value is above a certain level. Further, we demonstrate that whether loan guarantee policy outperforms interest subsidy depends on consumers’ green awareness, green investment efficiency, environmental value, as well as bank's attitude toward risk. Finally, we test the robustness of our findings by extending the base models to other scenarios and find that the main results still hold in these extensions.

Introduction

With the pressure of energy conservation and environmental protection, governments around the world have achieved numerous consistencies, such as the Paris Agreement and the UN 2030 Agenda, to promote environmental sustainability. As one important part of the economy, the manufacturing industry is naturally responsible for carrying out green transformation to mitigate environmental and energy pressure. For example, more environmentally friendly products (e.g., energy-efficient appliances and electric vehicles) are urged to be produced for substituting traditional high-energy-consuming products. At the same time, high-polluting manufacturing enterprises are being required to curb their carbon emissions via clean technology adoption. While green practices on a microeconomic level are significantly indispensable for facilitating the transition into a low-carbon economy, there are enormous challenges involved, among which securing enough finance for early-stage investments nearly ranks the top (Hafezi & Zolfagharinia, 2018). Wuester et al. (2016) pointed out that the limited access to capital is mainly due to the high risk, low return rate, and long payment period involved in green projects.

Green finance (or sustainable finance) has a particular role in addressing the challenges of financial accessibility and affordability in the environmental protection industry. According to a report published by International Finance Corporation (IFC),¹ “If we are to transition to a sustainable global economy, we need to scale up the financing of investments that provide environmental benefits, also known as green finance.” Broadly speaking, green finance refers to financial investments in projects and initiatives that contribute to enhancing environmental sustainability, such as investments in energy efficiency, industrial pollution control, and climate change mitigation.² In general, green finance helps ease the financing difficulty of environmentally friendly industries through relevant policies, which largely include two categories (Wang & Zhi, 2016). The first category is the regulatory policy on capital allocation of the banking sector. For example, some major banks such as HSBC and JPMorgan Chase have been required to scale up environmentally responsible lending and limit the loan to energy-intensive or high-pollution industries. The second category is the innovative financial incentives, including interest rate subsidies, credit guarantees, preferential tax treatment, and capital requirement lowering. For instance, China government provides interest rate subsidies and preferential tax treatment to banks to encourage more loans for green projects.³

In this paper, we focus on the effects of financial incentive policies on promoting green production and environmental investment. Two types of financial incentives are considered: green loan guarantee and green interest subsidy. In a green loan guarantee policy, the government provides partial or entire risk coverage for green loans, and lending banks can recuperate their loss from the government in the event of loan default. In a green interest subsidy policy, the interest rates granted to green enterprises are lower than the prevailing rates. The government compensates the borrowers for the difference between the prevailing rates and the subsidized rates on offer. Both policies intend to mitigate capital constraints of enterprises and improve their intentions to green production, but in different ways. More specifically, a green loan guarantee serves as a credit enhancement tool to help reduce the loss risk of lending banks, and indirectly improve the financial accessibility of enterprises. On contrary, green interest subsidy serves as a tool to help reduce the financing cost of enterprises, or namely improve the financial affordability of enterprises. The following are the real examples of the two incentive policies.

Green loan guarantee. As one example of this kind of policy, the U.S. Department of Energy's Loan Programs Office (LPO) has more than $40 billion in loans and loan guarantees available to help deploy large-scale energy infrastructure projects in the United States.⁴ LPO offers three financing programs for market innovators—-the Innovative Energy Loan Guarantee Program (Title 17), the Advanced Technology Vehicles Manufacturing (ATVM) loan program, and the Tribal Energy Loan Guarantee Program. The Title 17 Innovative Energy Loan Guarantee Program provides loan guarantees to accelerate the commercial deployment of innovative energy technology. Eligible projects for the Title 17 program must avoid, reduce, or sequester greenhouse gases. The Tribal Energy Loan Guarantee Program (TELGP) could guarantee up to 90 percent of the unpaid principal and interest due on any loan made to a federally recognized Indian tribe or Alaska Native Corporation for energy development.

Green interest subsidy. In 2016, China seven ministries jointly issued “The Guidelines for Establishing the Green Financial System” (Yinfa [2016] No.228),⁵ which proposed that projects supported by green loans were eligible to apply for fiscal subsidies on interest payments. In 2017, China launched green finance pilot zones of green finance reform and innovation in eight cities, among which some cities launched interest subsidies for small and medium-sized green firms that have access to green credit. For example, Shenzhen city, known as China's Silicon Valley and the tech hub, offered 50% interest subsidies to lower carbon emission enterprise borrowers.⁶ The local government in Huzhou, a green finance pilot city in Zhejiang province, provided interest subsidies for green loans based on the borrower's green rating.⁷ An interest subsidy of 12% of the loan prime rate would be offered to “dark green” borrowers. The subsidies for “average green” and “light green” borrowers are 9% and 6%, respectively. Likely, the Malaysia's “Green Technology Financing Scheme” (GTFS) is a special financing scheme introduced by the government to support the development of Green Technology (GT) in Malaysia.⁸ GTFS offers borrowers a 2% rebate on the total interest charged by banks for eligible green projects, as well as a guarantee of 60 percent of the total approved loan.

Theoretically, a vast amount of excellent research in the Operations Management (OM) field has investigated the role of government regulations and subsidies in sustainable development. Grounded on a specific non-financial sector, the majorities of these studies focus on market-based subsidies that target consumers or producers, while the research that studies the role of financial incentives in green finance is relatively scarce. Motivated by the research gap, we try to analyze how financial incentives can be well adopted to coordinate a manufacturer's production, green investment, as well as financing. To this end, we consider a financing system with three partners: a government, a profit-maximizing firm, as well as a bank with risk preference. The manufacturer lacks upfront capital to carry out production and green investment. To mitigate capital constraints, this manufacturer can get access to bank loans, but with credit limits due to the bank's risk control actions. The government, acting as the leader of the whole system, decides the optimal support intensities of financial incentives by maximizing environmental return on incentive expenditure.

Technically, we develop game-theoretic models to capture the features of both financial incentives. We investigate the impact of financial incentives on the manufacturer's production and green investment decisions, as well as the bank's risk control. Moreover, we derive the optimal support ratio for each incentive policy and identify the salient factors that affect the government's intervention intensity. Furthermore, we compare both incentive policies in terms of environmental benefits, the manufacturer's profitability, the bank's risk level, as well as the government's environmental return on expenditure. The analytical results are summarized as follows.

The implications of financial incentives for the manufacturer's operations and financing. Comparing with the benchmark case without intervention, both incentive policies are effective in enhancing the manufacturer's production volumes and resulting profits. In terms of green investment, interest subsidy policy is effective in stimulating green investment, while guarantee policy is ineffective. In terms of financing amount and cost, guarantee policy helps raise the credit line (also referred to as loan principal, or loan size) granted to the manufacturer by reducing the loss of the bank; interest subsidy policy can also enhance the manufacturer's credit line but by reducing his effective financing cost.

The impact of financial incentives on the bank's risk level. The downside risk level of the bank highly depends on its risk preference and pricing ability, the product market characteristics such as the consumers’ green awareness,⁹ as well as the environmental impact. The bank's downside risk is decreasing in the customers’ green awareness level. When the bank loan is priced exogenously, loan guarantee policy is ineffective in reducing the bank's downside risk, since the government only exerts a quite limited guarantee for the loan, whereas the bank's downside risk may be reduced to zero under interest subsidy policy, because the government may subsidize the entire interest payments for the manufacturer. When the bank loan is priced endogenously, the downside risk level of the bank can be reduced under both policies, and particularly loan guarantee policy may help reduce more risk for the bank in comparison with interest subsidy policy.

The optimal financial support intensity and equilibrium policy for the government. The government's optimal support ratios and the resulting policy equilibrium are critically contingent on the environmental and market characteristics. Particularly, the government is reluctant to intervene in the manufacturer's financing activity if the environmental value of the product is relatively small. In addition, the government grants partial financial support (i.e., the government covers the partial loss of the bank) under loan guarantee policy at most. On contrary, it could offer partial or entire financial support (i.e., the government subsidizes the partial or entire interest payments for the manufacturer) under interest subsidy policy. With respect to the equilibrium of incentive policy, loan guarantee policy dominates interest subsidy policy when the product and financial market are not favorable (i.e., consumers’ green awareness is low, the manufacturer's green investment efficiency is small, and the bank is highly risk averse).

The remainder of this paper is organized as follows. In the next section, the review of related literature is presented. The subsequent section introduces the model assumptions and the benchmark without government intervention. Section 4 models the manufacturer's best responses under two policies and examines the impacts of incentive policies on the performance of the manufacturer and bank. Section 5 provides the optimal support intensity of the government in each policy, compares both policies from different perspectives, and verifies the results via numerical experiments. Section 6 explores two extensions. Finally, managerial insights, action plans, and future research directions are concluded in the last section. All proofs are presented in the Appendix.