Instruments of transformation finance and their relevance for NRW

NRW The transformation of companies must be accompanied by the financial sector. The focus here is on the adjusting screws of volume, fit and risk. In order to coordinate these, the networking of companies with banks, insurance companies and investors should be strengthened. Fin.Connect.NRW supports this networking.

Companies in NRW have an immense need to invest in the digital and climate-neutral transformation. The study „Transformation in NRW: How can the digital and climate-neutral transformation of companies in NRW best be financed?“ by the Institute of the German Economy identifies annual investments of up to 70 billion euros in the coming years. However, not only do the high volumes have to be managed, but attention must also be paid to the fit of the financing and the associated risks:

– The majority of the volumes will be financed via the house banks. The banks‘ equity capital can be a potential bottleneck. It is therefore important to consider how the banks‘ equity can be used most effectively in the transformation process.
– The fit of financing always plays a role when investments in digitalisation and sustainability not only improve existing products and processes, but when it comes to technologies for which market maturity has not yet been reached. Access to equity and funding instruments with risk sharing between the bank and the funding bank can be crucial.
– Transformation also comes with risks, as certain basic innovations still need to be developed through research and development activities and brought to market maturity. Government seed funding is an option when the innovation is too risky for private investors, but brings high social and economic returns if successful.

The OECD’s Oslo Manual discusses the different forms of financing and their applicability for financing innovation. This scheme can be applied to the financing of transformation, and the relevance for NRW can be analysed and discussed.

Strengthening access to equity for companies

Equity financing has a significant role for the financing of innovations that are too risky for loan financing due to their risk structure or a lack of market maturity. These are primarily innovations that are still in a development phase. These include technologies such as carbon capture and storage, in which CO2 is skimmed off and stored in the production process. With a higher CO2 price, these investments will pay off for the companies, and then they can also switch to additional credit financing. The situation is similar with the development of new digital technologies, such as artificial intelligence (AI).

Many companies increased their equity ratios in the last few years before the pandemic began. However, companies particularly affected by the pandemic and those affected by the floods also had to record losses, which could limit financing from equity in the coming years. Companies that are particularly affected by the current sharp rise in energy prices may also have less recourse to retained earnings as a form of financing. In order to support these companies in their transformation, improved access to equity instruments is helpful. This is particularly relevant in light of the fact that companies need to build up know-how for the transformation, which they usually finance through retained earnings.

Even though many companies are reluctant to raise external equity, it is an important source of finance, especially for young companies. One challenge here is that the young and still unknown companies and the equity investors have yet to find each other. Local funds can overcome the existing information asymmetries much better than globally operating funds, which often lack regional expertise. Therefore, it makes sense and is important to make equity instruments available at the state level. Economies of scale can be achieved through cooperation between local and global funds, e.g. through participation of the European Investment Bank in a NRW fund.

Government investment and government support for innovation

State investments are often the first enabler for corporate investments. In NRW, 240 kilometres of new hydrogen pipelines are to be built by 2030, which can trigger further investments by industry. For example, the first large-scale hydrogen-based steel production plant will be built in Duisburg. By 2030, hydrogen-based plants are to be built in the glass, tile and brick industries and foundries. The mobility turnaround is also to be supported by 11,000 fuel cell trucks and 3,800 fuel cell buses for local public transport.

State innovation funding and participation in an innovation fund can be beneficial. This is especially true for the funding of basic innovations that break new technological ground, since the companies take high risks through their research activities, which are, however, also counterbalanced by high societal benefits. This is because these innovations gradually diffuse into the breadth of the corporate sector and attract follow-up investment. This would be the case in the field of AI. NRW wants to become a leading nationwide location for applied artificial intelligence. The application areas of AI and the management of data in companies are large and not just limited to large companies. For example, companies in the food manufacturing and catering sectors can also use AI and weather data to generate sales forecasts that enable them to plan better and help them avoid waste, for example.

House banks will finance the bulk of the transformation

Funding for incremental innovations, i.e. process and product improvements through new technologies that have a market maturity, can best be done through banks, as these types of innovations do not pose excessive risks due to their market maturity. Depending on the case, additional participation by equity investors or development banks may make sense. NRW.BANK also has appropriate programmes in this regard, such as the Digitalisation Loan. This was used, for example, to support a digitalisation project of the Lechtermann Pollmeier bakery for the introduction of electronic receipts to save paper.

An analysis of the equity structure of the banking sector shows that the immense investment volumes can be handled by the banking sector. However, it cannot be ruled out that an economic crisis, such as the current energy crisis, will lead to higher loan defaults, reducing the banks‘ equity and making them more risk-averse in their financing. Promotional instruments for risk sharing between banks and promotional banks can be useful here, so that the banks‘ equity is used efficiently and so that innovative companies, which also have to invest under uncertainty, are not excluded from the credit market. Strengthening the securitisation markets could also support the high credit volumes for the transformation.

New business models can contribute to balance sheet relief

While capital goods have to be newly acquired, especially for the climate-neutral transformation, digitalisation at the same time allows for capital-saving technological progress. New business models, which are summarised under the term Anything-as-a-Service (XaaS), can help companies in the transformation process to ease their balance sheet. These business models are very similar to leasing machines. Through the possibilities of cloud computing, a usage-based payment can be made for the provision of machines, as is already known from car sharing. For companies in the transformation process that have to invest in both machines and employees, balance sheet protection can make sense, as the companies can thus counteract an increase in their debt ratio and thus a drop in their credit rating.

Complementing and bundling the financing instruments and the information services

The financing instruments do not necessarily have to be reinvented for the transformation of NRW. They do, however, need to be re-bundled and supplemented in order to do justice to the opportunities and risks of the transformation:

– Companies that invest in buildings, IT and machinery at the same time often have to resort to different loans and funding instruments for which different advisors are responsible. The bureaucratic burden on companies can then be minimised through a stronger bundling of loans and funding instruments.
– Many companies are not hesitating to invest in their transformation because of uncertain financing, but are waiting for government infrastructure to be made available, which is necessary for their investments in digitalisation and sustainability.
– Improved access to equity instruments is essential for young and innovative companies. A new innovation fund involving the European Investment Bank should be explored. This fund could also provide complementary equity for bank financing.

In addition to improving the supply of financing, however, it is also necessary for companies to have access to information on transformation financing. With Fin.Connect.NRW, a central information platform for NRW is being established for this purpose in order to better connect companies, banks and investors and to create an ecosystem to support the transformation in NRW.