High costs of capital put the brakes on "green" investments in emerging countries
Emerging countries need to power their economic growth with renewable energies, otherwise the energy turnaround will become a distant prospect. However, high costs of capital in many emerging markets are putting off investors.
The energy turnaround goes hand in hand with climate neutrality, which requires the global community to replace fossil fuels with renewable energies and to re-absorb CO2 emissions by 2050. This calls for the massive expansion of capital-intensive investments (in wind, photovoltaics, heat pumps, etc.). According to estimates by the International Energy Agency (IEA), annual investments need to increase from USD 1.7 trillion in 2023 to USD 4.5 trillion in 2030. Over the coming years, most of the investment in clean energy is expected to be made by private developers, consumers and investors.
Low willingness to invest in emerging countries
This investment objective can only be achieved if access to low-cost financing is improved, especially in emerging markets. Although two thirds of the world's population live there, capital investments in clean energy in emerging and developing countries (excluding China) account for less than a fifth of the total investment. This lack of investment is concerning. If there is no viable path to low-emission growth for these economies, this is likely to be either CO2-intensive or limited by energy shortages. Both scenarios are risky and undesirable.
Costs of capital act like a brake shoe
The biggest barrier to investment in clean energy in emerging and developing countries is currently the high costs of capital. These express the expected financial return or the required minimum interest rate for an investment in a company or project. The expected return is closely related to the level of risk associated with the cash flows of a company or project.
High costs of capital diminish the prospects for returns, especially for capital-intensive investments – including renewable energies – which require high up-front capital costs but have very low operating expenses.
The IEA has analysed the costs of capital for various solar projects in different regions and countries (Europe, USA, China and India) for 2021. The chart below shows that in 2021, the costs of capital in emerging and developing countries (excluding China) were 3.5 to 11 percentage points higher compared to industrial countries.
Costs of capital (2021) for solar projects in industrialised vs. emerging and developing countries (ex China)
This also has implications for the levelised costs of energy. The rule of thumb is that the levelised cost of energy increases by 50 percent if the cost of capital increases by 5 percentage points.
Costs of capital eliminate natural advantage
The impact of the capital cost level is clearly evident when comparing between Zurich and Namibia's capital city Windhoek. Namibia is one of the sunniest countries in the world. Compared to Zurich, 65 percent more electricity can be generated there per solar module. While the energy yield per year in Zurich is 1,184 kilowatt hours (kWh) per kilowatt peak (kWp) according to the Global Solar Atlas, it is 1,982 kWh per kWp in Windhoek.
However, Namibia's natural advantage as a location for solar production over countries such as Switzerland diminishes significantly if the cost of capital in Namibia is 6 to 7 percentage points higher than in the Swiss Confederation. In this case, Namibia's levelised cost of energy would be comparable to that in Switzerland. In other words, solar-rich countries only have a cost advantage or a competitive edge in terms of the levelised cost of solar energy if the cost of capital is at a comparable level. This is not the case in many places.
Reasons for the higher costs of capital and possible reduction options
In many emerging markets, investors fear that electricity buyers – which are often electricity companies – may not pay their electricity bills regularly, if at all. They are often over-indebted and it is not clear whether they are viable in the long term.
A possible reduction option could be for governments of emerging and developing countries, international organisations or governments of developed countries to guarantee that the electricity produced will also be purchased and paid for in the event of payment defaults. They would then act as insurers and encourage potential investors to invest in renewable energy projects.
As mentioned earlier, lower costs of capital would reduce the levelised cost of energy and electricity could be offered cheaper. This would give broader sections of the population access to affordable electricity. This would be particularly helpful in the sub-Saharan region, where 600 million people or around 40% of the African population do not have an electricity connection.
Case study of a local investor
The number of companies that invest in renewable sources of energy in emerging and developing countries (excluding China) is rather small. One company we are looking at is Scatec, from Norway.
The company operates solar, wind and hydropower plants on four continents and is building a very large solar power plant including storage solutions in South Africa. The company tries to minimise risks through long-term contracts with reliable customers, which has a positive effect on the cost of capital. Scatec can therefore make a contribution to reducing the CO2 intensity of growth in emerging countries.
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