Scaling Up Private Finance for Clean Energy in Emerging and Developing Economies

This intend to be a summary  post of the “Scaling up Private Finance for Clean Energy in  Emerging and Developing Economies” published by the IEA and IFC 

The Emerging Markets and Developing Economics (EMDEs) group contains the following territories: Africa, Developing Europe, Eurasia, Latin America, the Middle East and South and Southeast Asia.

In EMDEs there are 775 million people that lack access to electricity and 2.4B that lack access to clean cooking fuels. Clean technologies offer a compelling way forward and their use is growing, but, in most cases, energy demand is growing even faster.

At present, 770B USD invested each year in clean energy in EMDEs, but most of this is in a handful of large economies. China accounts for 2/3 of this total and together with India and Brazil accounts for more than ¾ of it. Growth in clean energy investment is a precondition not only for tackling climate change, but also to help reach a range of other sustainable development goals (SDGs), such as poverty reduction, health, and education.

To bring up the level of private investors and financing solutions providers, policy makers, governments and other stakeholders will need to deal with the following:

1. Create a healthy and balanced investments environment in terms of the right ratio for each type of investor.
2. Create clear environment of regulation and policy to reduce country and sector risks.
3. Support new financing instruments to provide confidence for investors.

Investors structure

To meet rising energy needs in ways that align with the Paris agreement, annual investments (public and private) will need to be more than triple, compared to today’s level, reaching 2.8 trillion USD per year by 2030. This surge in investment provides a powerful opportunity to underpin sustainable economic growth, create jobs and provide full energy access.

As can be seen in the chart below, just over 1/3 of total EMDE clean energy investment goes into low-emissions generation, mainly to renewables. Another 1/3 needed for improvements in efficiency and spending in end use sectors, under ¼ is needed for electricity grids and storage, around 8% goes to low-emission fuels, such as biofuels, low-emission hydrogen, and carbon capture, utilization, and storage. 

In 2022 finance by public entities accounted for about half of EMDE clean energy spending compared to less than 20% in advanced economies.  Bringing in private capital at the scale and pace needed will require developing a much larger flow of clean energy projects that match investors’ risk and return expectations. Now, the cost of capital for the same type of project can be two or three times higher compared to advanced economies, due to the inherent risks attached to these territories. Tackling those risks will be an essential part of bringing down the cost of capital for better cooperation between the private and the public sector.

The different potential sources include governments and development finance institutions (DFIs), including multilateral and national development banks; philanthropies; commercial banks; institutional investors such as pension funds, insurance companies and sovereign wealth funds; private equity funds; firms that reinvest their profits; and households and individuals.

The respective roles and responsibilities of the different public and private actors vary by country, but there are common themes. State Owned Enterprises (SOEs) tend to be major players for EMDE investment in electricity networks, and in nuclear and large hydropower projects. The direct role of governments as investors typically focuses on major infrastructure projects – sometimes in partnership with the private sector. Direct public support is also vital for the development of more nascent technologies, via funding for research and development and for first-of-a-kind projects. Public procurement policies offer an opportunity for governments to establish and grow markets for efficient and low-carbon equipment and materials. This can help drive down costs and provide consumer confidence in the adoption of such technologies.

In many EMDEs, regional governments and municipalities play important roles in electricity and energy provision as well as public transport. Building up clean energy infrastructure can be an important element of broader strategies to attract non-energy investment, especially as firms integrate sustainability criteria into investment decisions and look for locations with access to renewable and other low-carbon sources of electricity and fuels. This is a growing issue for many EMDE firms as they see on the horizon that access to certain major international markets may be shaped by their environmental performance, as with the Carbon Border Adjustment Mechanism in the European Union.

Type of Investors and return expectations.

Regulation and Policies

New policies in Europe, the United States and other advanced economies are attracting significant new investments in clean energy, spurring technology learning and innovation but making it more challenging for EMDEs to compete for private capital.

The pace of innovation in clean energy technologies is promising, with much of the sector seeing significant increases in capacity and declines in cost. However, much of this push has taken place in advanced economies and China, and more recently other large emerging economies. This leaves many other developing economies still struggling with accessibility and high costs of capital.

Addressing climate change requires broadly two types of actions: mitigation of GHG emissions; and adaptation to minimize damage resulting from climate change and extreme weather events. Every country needs to address both issues with priority action according to their circumstances. 

Public interventions are needed to create the incentives for additional private finance in EMDEs to differing degrees across all aspects of energy transitions. These aspects can be grouped into three: 

1. The supply side.
2. The power and fuels transitions - The power transition involves accelerating the ongoing shift to low-emission electricity produced by renewables and nuclear power. Specifically, renewables mean investment in solar PV, wind (onshore and offshore), hydro, geothermal, bioenergy and other renewable technologies. The power transition also includes investment in strengthening and restructuring the underlying electricity grid networks (transmission and distribution). Given the intermittency of some renewable sources such as solar and wind, investment in a range of sources of flexibility in power market operation is essential, including robust grids, dispatchable generation, storage (including batteries) and demand response. The fuels transition relates to the phasing down of fossil fuels, namely coal, oil, natural gas and their derivatives, and the scaling up of low-emission fuels, such as low-emission hydrogen (including hydrogen produced via electrolysis, using renewables), modern liquid and gaseous biofuels, and synthetic fuels. It also includes investment in carbon capture, utilization, and storage (CCUS)
3. The demand side, the end-use transition - The end-use transition includes shifts in the energy used by all enterprises and households, with a focus on decarbonization investments for three major end users of fuels: industrial production; transport; and buildings. It includes investments in energy efficiency and savings, with the introduction of economic incentives for a full circular economy that minimizes waste in energy and materials use. 

Demand for private finance in EMDEs is a derived demand. It is derived from the volume of projects that meet attractive risk-adjusted returns relative to other global bankable projects. Currently the main constraint to financing is not the supply of private finance, but the absence of projects at a scale that is necessary for the transitions to be realized. The main reason for the absence of enough projects, in turn, is the absence of a robust policy and regulatory framework, including the needed flow of concessional resources, to close the gap between private and social returns and thereby improve relative risk-adjusted returns.

An effective policy and regulatory framework is required to address those variations in country-specific costs and risks that are particularly acute in EMDEs. These are risks that raise the cost of capital in EMDEs relative to advanced countries (particularly relevant for high CAPEX/low-OPEX projects that characterize many renewable projects), a cost that cannot be compensated for by higher, though still uncertain returns, and cannot be controlled by the project investor, they include:

• Macroeconomic risks and political instability of the host country.
• Underdeveloped markets, such as financial markets, which reduce the ability to manage financial risks such as foreign exchange risk.
• Policy risk, regulatory shortfalls, and corruption, including renewable generation offtake risk.
• Higher costs of doing business due to poor infrastructure, reduced human capital, the overall business environment and investors’ lack of experience in many EMDE markets.

In addition to measures and mitigate country-sector-project specific risks and costs, additional regulations, and policies, including concessional resources, may in many instances be needed to enhance private returns on clean energy projects relative to fossil fuel production and use, and relative to clean energy projects in advanced countries. In choosing which projects to support, policy makers should use the social rate of return on investment as the appropriate benchmark. It accounts for externalities including all environmental and social co-benefits associated with the abatement of GHGs, other market failures, and other transaction costs that lead to divergences between private and social net benefits.

Policy measures taken by governments are a key determinant of how much capital is committed to the energy sector, and where and how it is invested. The energy crisis has prompted new initiatives aimed at advancing clean energy deployment and addressing existing and emerging energy security risks. Some of the most prominent have been in advanced economies, with the Inflation Reduction Act in the United States, the Fit for 55 package and the Green Industrial Plan in the European Union, and the GX Green Transformation program in Japan. China has also stepped-up policy support for a range of clean energy technologies and there are examples too in other EMDEs, including:

• India’s launch of a Green Energy Corridor program to evacuate power from renewable-rich states to India’s power demand centers. Phase II of the scheme, with a project cost of USD 1.5 billion, was initiated in January 2022. In January 2023 India also initiated the National Green Hydrogen Mission, with earmarked government funding of USD 2.4 billion and a target to mobilize almost USD 100 billion in investment to develop green hydrogen production capacity of 5 million tons per annum by 2030.
• The conclusion of Just Energy Transition Partnerships (JETPs) with Indonesia, South Africa, and Viet Nam, offering a new model for international support for national efforts to scale up renewables, reduce reliance on coal and other polluting fuels, and manage the social implications of change.
• A revamped procurement framework for renewable power in Cambodia, using competitive auctions and blended finance packages to boost market development, reduce revenue risks and lower financing costs. As part of the auction, the Cambodian single-buyer utility provides 20-year power purchase contracts, complemented by a loan from the Asian Development Bank (blended finance) to fund grid infrastructure.
• A tender program from Chile’s Economic Development Agency in 2021, worth up to USD 50 million, to develop green hydrogen projects that are to install 10 MW (or more) of capacity and commence commercial operation by the end of 2025.
• The United Arab Emirates becoming in 2021 the first of the major Gulf oil and gas producers to commit to net zero emissions by 2050, including a 30% share for renewables plus nuclear by 2030.
• Two new transmission auctions in Brazil that would amount to approximately USD 10 billion in new investment, a similar amount to that of the entire 2018-2022 period. The first transmission auction, announced in March 2023, was for the construction and maintenance of nearly 5 000 km of transmission lines to support further wind and solar deployment.
• Kenya introducing net metering regulations for distributed PV capacity, after passing enabling legislation in 2019. The regulations allow electricity consumers with on-site generation (no more than 1 MW) to sell excess power to the national grid.

Financing Instruments 

“Blended finance” is a combination of concessional funds from donors and commercial funds from private investors and development finance institutions. It is used to enable investment in projects that have high development impact but are not yet commercially viable, such as those with high upfront costs or involving adoption of new technologies that have not yet scaled up. Concessional funds are deployed to provide partial guarantees or subordinated debt or equity, cover some project development costs, or create performance-based incentives for project sponsors to meet targets.

The crowd-in effect of blended finance is best illustrated by its “leverage”, defined as the ratio of commercial financing (from DFIs, sponsors and private financiers) to the amount of concessional funds. Based on IFC’s experience, USD 1 of concessional donor funding has leveraged on average nearly USD 7 of additional finance, comprising USD 3-4 of IFC own funds and USD 3-4 of commercial third-party capital from private sponsors and investors.

For climate transactions, the ratio tends to be higher (USD 1 to USD 10), comprising USD 3 of IFC’s own funds and USD 7 of commercial third-party capital. This is due to relatively large project finance structures (using senior and mezzanine debt products) and significant deployment in middle-income countries that can crowd-in more commercial finance due to their generally lower country risk.

Blende finance instruments:

In addition to (or in combination with) blended finance, new financial instruments and platforms are needed to mobilize private capital at a scale. Green, social, sustainable and sustainability linked (GSSS) bonds have the potential to attract more private climate financing into EMDEs.

GSSS bonds and loans definition

Project aggregation platforms and securitization vehicles can overcome the asymmetry between the relatively small size of most energy transition projects in EMDEs and the relatively large minimum investment size that major institutional investors require. These platforms can pool large numbers of smaller projects and thereby create standardized investment-grade multi-asset portfolios, reducing transaction costs, diversifying risk, and attracting interest from institutional investors.

Voluntary carbon markets have the potential to channel more resources into clean energy investment in EMDEs but need strong oversight to grow from today’s low base. Carbon credits linked to real, verifiable emission reductions could be a valuable revenue stream for EMDEs, but there is still much work to be done on standards and monitoring, reporting, and verification processes.