Here are 3 innovative ways to manage the challenge of financing the energy transition in developing economies

Clean energy investment in emerging economies is vital for our global decarbonization efforts. But the poorest countries in the world cannot fund their energy transitions without significant international investment.

Despite accounting for two-thirds of the global population, emerging and developing economies (EMDEs) hold just a tenth of the world’s financial wealth and have only made a fifth of the clean energy investment committed by developed countries.

Lack of funds already put EMDEs at a disadvantage compared with developed economies, while a range of fiscal, socioeconomic and climate risks make it harder to secure capital, significantly raising the cost of funding clean energy projects in developing countries.

Here we outline the key investment challenges facing emerging economies on the path to net zero, and some of the innovative financing strategies being developed around the world to facilitate a global clean energy transition.

The good news is that global investment in clean energy is rising, according to the International Energy Agency (IEA). The recovery from the pandemic coupled with responses to the energy crisis have caused global clean energy investment to rise faster than investment in fossil fuels.

But the growth in investment is uneven. Energy security shocks and ensuing price spikes in the wake of Russia’s invasion of Ukraine have drained developing economies of their financial resources. Therefore, without funding, EMDEs cannot pay for an energy transition, or the required network infrastructure.

The issue of risk as a barrier to cleaner energy in developing countries is explored in a report by finance, risk and crisis expert Avinash Persaud, which says a solar farm construction project in South Africa is no riskier than one in Germany, and yet the cost of capital for the project in South Africa is much higher, because exaggerated perceived macroeconomic risks increase risk premiums.

Renewable energy projects tend to be capital intensive too, so the cost of that capital is critical to the success or failure of a project.

“If two similar projects can earn a rate of return on capital employed of 10%, and the cost of capital is 4.0% in Germany and 10% in South Africa, it will happen in Germany but not South Africa. And it is unclear how the South African project could push up its local rate of return when it is essentially providing energy to poorer consumers than in Germany,” Persaud explains. The solution, he concludes, is to lower the cost of capital.

On top of a substantially higher cost of capital, investors also face a lack of transparency on the actual cost, making it harder for them to price risk and for policy makers to act. Initiatives such as the Cost of Capital Observatory, deployed by the International Energy Agency, the World Economic Forum, ETH Zürich and Imperial College London, help fill this gap.

Investments in emerging economies can also be hindered by currency exchange risk, which can drive up the cost of capital and hamper investment. While some options like currency hedging exist, more hedging services in EMDEs are required that cover the typically long contract periods that renewable energy projects require. Initiatives like The Currency Exchange Fund (otherwise known as TCX) are already seeking to address this.

Meanwhile, scholars from Columbia University, along with the World Economic Forum and the World Bank Climate Change Group have proposed a new exchange rate coverage facility that would provide currency exchange risk protection to international lenders.

Removing the risk premium creates a win-win situation; investors can make money, while making a positive impact on the global energy transition, the report says.

The next step is to build awareness that facilitating renewable energy projects in EMDEs is not only critical for our net-zero emissions targets, but could be profitable ventures too, if the right financial mechanisms are in place to support them.

The Forum’s programme Mobilizing Investment for Clean Energy in Emerging Economies (MICEE) aims to build awareness of the need to accelerate clean energy investment in EMDEs, propose effective solutions, and enable those solutions.

“Attracting much higher levels of financing for energy transition in the developing world hinges on addressing a few key factors that hinder investment such as the cost of capital, currency risks and political risks. Such risks – whether real or perceived – can deter investors from working with developing countries,” said Espen Mehlum, Head of Energy and Materials Programme at the World Economic Forum.

“To help solve those issues, we concentrate our work on identifying possible enhancements to policy frameworks as well as de-risking solutions that the private sector could pilot locally to overcome investment barriers,” he added.

In Africa, the Ghana Energy and Development Access Project (GEDAP) is another programme providing clean energy access via off-grid solar power. The mini-grids, made possible through subsidies and local bank financing, help isolated communities on islands to access clean power 24/7.

And, in India, Gujarat is leading the way with a rooftop solar programme – the state is home to nearly two-thirds of the nation’s residential rooftop solar power. To achieve this, local government ensured adequate numbers of solar vendors, then launched an information campaign to increase demand for solar. A digitized process made registration, subsidies and payments easy and traceable, and the subsidies were made on time.

The project’s subsidy system was the focus of a report from the Institute for Energy Economics and Financial Analysis and partner organization JMK Research. It recommends state governments make efforts to streamline subsidy-related procedures and emulate the Gujarat’s initiatives, which make it a shining example of how to roll out clean energy in a developing country.