Resources Article

Commentary: Loan Guarantees Reconsidered

Feb 16, 2012 | Joel Darmstadter, Joshua Linn

Early in September 2011, Solyndra, which manufactured a new type of solar photo- voltaic module, declared bankruptcy, and about 1,100 workers lost their jobs. The company had been awarded a $535 million loan guarantee from the U.S. Department of Energy’s (DOE) Loan Programs Office (LPO), and many politicians and industry advo- cates had previously touted Solyndra as a positive example of the “green economy.” DOE’s press release announcing the award in September 2009 predicted that Solyndra would “accelerate job creation and ... intro- duce into large-scale commercial operation a new and highly innovative process for manufacturing a breakthrough design for photovoltaic panels.”

Solyndra’s collapse and the resulting cost to taxpayers have generated a flurry of media coverage. While some of that coverage delved into issues related to loan guarantees in general or Solyndra in particular, most of the media attention has focused rather narrowly on the loan approval process, largely ignoring the bigger policy questions. As the quote above reflects, loan guarantee programs such as DOE’s have rather broad aims: encouraging commercialization of brand-new technol- ogy, promoting U.S. manufacturing of green technologies, and stimulating the stagnant economy. Are loan guarantee programs a good way to achieve these objectives, and how can this approach be improved?

Three Loan Guarantee Programs in One Office

The basic workings of a loan guarantee are fairly simple. A private company borrows money for a project, and the government agrees to repay all or most of the loan if the project fails and the company has to default. By reducing the risk to the lender, the guarantee reduces the cost to the company of obtaining the loan. Effectively, the government is subsidizing the cost of the project.

DOE’s LPO oversees three programs that have overlapping objectives. The first program aims to encourage the commer- cialization of significantly new or improved technologies that reduce carbon dioxide emissions. The second program aims to create jobs in the current weak economy and includes, in particular, projects that began construction before the end of 2011. The third program specifically focuses on vehicle technologies. All told, the programs have guaranteed almost $40 billion in loans for 42 projects. The expected federal liability depends on the projects’ successes and will almost surely be less than $40 billion.

Common Rationales for Loan Guarantees

Three primary arguments commonly support the goals of loan guarantees.

Bridging the “valley of death.” Investment in new technologies tends to be highest in the earliest stages (think venture capital or public funding of basic R&D) and in the latest stages (private funding after commercialization); in the “valley” between these stages, new technology has trouble attracting private investment. Investors may not want to back a start-up because there is too much uncertainty about the quality of its product, for example, or because the time horizon required for payback is too long.

Providing immediate economic stimulus. Because of poor and presumably transitory economic conditions like the current economic downturn, many otherwise successful businesses—particularly environmentally innovative ones—may fail; loan guarantees would help support such businesses.

Supporting green industry in the long term. Many supporters of loan guarantees argue that because of either future carbon policy or depletion of exhaustible resources, the United States will have to transition to low-carbon technologies sometime in the future. U.S. citizens would be better off developing and manufacturing these technologies rather than importing them from China and elsewhere.

Some Important Economic Considerations

Using loan guarantees to meet the stated objectives, particularly regarding the commercialization of new technology, means facing several challenges. We turn to those now.

Risk. Investing in new technology is inherently risky—moving from the pilot-project stage to commercialization is extremely difficult, and there is always uncertainty over finding sufficient customers. That doesn’t necessarily mean that the projects shouldn’t receive subsidies, but it does mean that loan guarantees for new technologies should be recognized as risky. Projects may fail because technologies turn out not to perform as expected, because demand drops unexpectedly, or for a number of other reasons. If few of the projects fail, they might not have been risky enough to justify a loan guarantee.

Learning-by-doing and market failures. Loan guarantees and other investment subsidies are often justified based on a learning-by-doing argument: basic economic theory says that firms invest in learning less than is socially optimal when others profit from it. The important lesson for the government is that subsidies are only justified when there are learning spillovers. If learning stays within the firm, the firm profits from it privately, and subsidies are not justified.

"It is not clear why loan guarantees are the best form of investment subsidy, much less the best policy for meeting the broader objectives of promoting new technology, green industry, and employment."

Information. In a successful loan guarantee program, the government supports projects that private investors have decided not to back, but that nonetheless are beneficial to society. In other words, the government needs to figure out why the private market isn’t financing the project. Is it because the project is a bad idea? Or because the social benefits of the project outweigh the private benefits? The LPO addresses this information problem by conducting a detailed review of each proposed project, a policy that places a large burden on the government.

Is a Loan Guarantee Program the Best Policy for the Job?

One detail that sets apart loan guarantee programs from other federal subsidies, such as tax credits, is that loan guarantees directly promote the commercialization of new technologies. (Imposition of a carbon dioxide emissions price might be an important complementary policy, reinforcing the loan guarantee promotion of new technologies.) Even so, it is not clear why loan guarantees are the best form of investment subsidy, much less the best policy for meeting the broader objectives of promoting new technology, green industry, and employment. A particularly challenging task for the government is to acquire enough information to identify the projects that have the greatest social value and that the private sector would not invest in otherwise. Identifying learning spillovers is very difficult, as is gathering sufficient information to evaluate a project’s risk and societal benefit.

If loan guarantees are to continue despite their shortcomings, they should be subject to ex post evaluation of their effectiveness. The programs are advocated for correcting market failures related to the commercialization of new green technologies, and it should be possible to assess the extent to which the programs achieve that goal.

Other options include an innovation or commercialization prize offered to a project that successfully meets certain criteria, or a production subsidy offered for each unit of output. In both cases, the subsidy can depend on the social value of the project, so the government no longer has to identify the best projects. Instead, private investors can consider the value of the subsidy and any additional profits they may earn from selling the resulting products—and then choose accordingly.