Keeping their powder dry
Investors shy away from powering the emerging market energy transition
Where should investors direct their capital if they wish to make the biggest impact to cutting global carbon emissions?
It’s an important question for investors to understand if we are to avoid a climate-driven "Minsky Moment". This could occur if rapid climate change, coupled with a lack of action by politicians dealing with other pressing issues, means that governments are forced to “stamp on the brakes” and force carbon prices much higher (see A climate-driven "Minsky Moment": Revisiting the impact of a sudden repricing of carbon prices).
A starting point for investors is gauging just how much capital needs to be invested.
Forecasting the amount of capital investment required to hit net zero by 2050 is fraught with uncertainty. We can guess at the pace of technological innovation and the speed at which costs decline, but we cannot know for sure. Even the definition of what constitutes ‘green’ investment is subject to debate. Different assumptions and various definitions mean that estimates of the global capital investment required to hit net zero tend to be pretty wide.
A joint report from BNY Mellon (BNYM) and Fathom Consulting (FC) has entered that debate, estimating that $100 trillion will need to be invested to achieve net zero by 2050. They indicate that over 80% would need to be invested in replacing the ‘dirty’ capital stock with ‘green’ alternatives once it has naturally depreciated, while the remaining 20% will need to replace ‘dirty’ capital before the end of it’s usable life, effectively leaving what’s known as “stranded assets” (see Stranded asset, or last mover advantage?).
If it is half as big or twice a large, it is still a huge capital investment. Rather than focus on the whether the estimate is broadly correct, far better to consider the implications and challenges involved with raising and then directing those funds to achieve the best return (in terms of carbon emissions avoided) per dollar invested.
BNYM/FC estimate that more than half of the $100 trillion invested must take place in emerging markets (EMs) if the net zero target is to be met. First, EMs are likely to grow faster than developed economies over the next decade, and will need to grow their capital stock (including green capital) faster to support this growth. Second, EMs are typically lagging behind developed economies in the energy transition and so require more investment to green their existing capital stock.
The carbon reduction bang per buck argument in favour of funding EMs is strong. To see why consider the scatterplot below. It shows the share of current global carbon emissions and the share of the $100 trillion in global green investment needed by each of the 24 countries in the MSCI EM index.
Countries that sit on the 45-degree line have net zero investment needs roughly proportional to their current contribution to annual emissions. Countries above the 45-degree line currently emit a larger share of global carbon emissions than the share of green investment they need to make, and vice versa for those countries that sit below the 45-degree line. Investing in those above the line would potentially achieve more bang per buck in reducing emissions than in the countries below the line.
Remember that the scatter graph only shows current emissions, not expected future carbon emissions. For many EMs emissions are likely to continue to increase as the population grows and urbanisation and development accelerates. For example, energy related carbon emissions from Sub-Saharan Africa (that includes big emitters such as Nigeria and South Africa) are projected to rise by 61% by 2050, according to DNV. That’s a challenge but it also increases the opportunity from deploying energy transition technologies at speed in the right places (see Carbon risk dulls allure of gold miners).
Despite the potential carbon rewards from investing in emerging economies, the investment gap between developed and emerging economies has widened, according to analysis by BNEF. Global investment in low-carbon energy technologies hit a high of $785 billion in 2021, up 24% from the previous year as investment in developed economies surged.
In contrast, energy transition investment in emerging markets & developing economies (EM&DEs) was broadly unchanged in 2021 below $67 billion. All told, the share of global energy transition asset finance flowing into EM&DEs fell below 8% in 2021, its lowest level in 10 years, and far below the 20% peak reached in 2012.1
Even when finance is being directed towards EM&DEs, it is increasingly being directed at the largest economies. For example, the top 10 EM&DEs (such as India, Brazil and Vietnam) attracted $50.4 billion, or 76% of the EM&DE total.
Energy transition capital is not being allocated between countries according to decarbonisation needs. The top 20 EM&DEs together account for 29.5% of global energy sector emissions. During 2017-2021 they attracted just $28.8 million of energy transition investment for each Mt CO2e of energy emissions. Developed nations meanwhile attracted on average $121 million per Mt CO2e of energy emissions, more than four times higher.
One major obstacle to capital investment outside of developed economies is the cost and availability of finance. Energy transition investments in particular are typically very capital intensive, requiring significant sunk costs. This means that the absolute and relative cost of capital can make or break the commercial viability of a project. High interest rates could serve to delay the energy transition, especially for emerging markets and other less developed economies unable to borrow at competitive rates.
The problem of higher capital costs in EMs is very real. For example, in developed economies (non-EM&DEs in the chart), the benchmark weighted average cost of capital (WACC) for solar PV projects in 1H 2022 ranged from 1.7-5.8% according to BNEF. In EM&DEs, the benchmark ranged from 4.7-14.4%. The higher cost of capital can put emerging markets and developing economies at a significant disadvantage compared to developed economies.
The problem could get even more acute as central banks continue to normalise monetary policy and interest rates increase. The Bloomberg Global Emerging Markets Sovereign Index, which tracks the performance of major sovereign bonds in EM&DEs, has declined by 18.7% since 2019, pushing up the yield on government bonds. In turn this has increased the cost of funding all investments, not only those involved with the energy transition.
In a recent poll carried out by Reuters, 68 climate economists were asked what impact higher borrowing costs would have on the transition to net zero by 2050? Nearly 75% of them believed the impact would be mild or very mild. One-quarter said it would be severe, or very severe. Just one climate economist said that it would have no impact. Unfortunately, the questions posed did not distinguish between developed and emerging economies, otherwise the economists may have responded with a more nuanced answer.
There are other ways in which developed economies may inadvertently be making it more expensive for emerging and developing economies to decarbonise, increasing the incentive to continue to invest in fossil fuel generation. For example, America’s Inflation Reduction Act (IRA), signed into law in August commits more than $369bn of government support in the form of subsidies and tax credits. Ground breaking in many respects for the US, but it’s impact will reverberate down energy transition supply chains.
Subsidies may mean that suppliers of PV cells and wind turbines will be much more inclined to sell to buyers in the US, rather than Brazil, India or South Africa. Meanwhile, by encouraging the growth in domestic production in a bid to diversify the supply chain away from China it may also serve to undercut other producer countries such as Malaysia.
Emerging markets and other developing economies offer the best bet for investors looking to get the biggest cut in carbon emissions per dollar invested. Even more so since carbon emissions are expected to increase across many of these economies over the next decade as urbanisation accelerates.
However, the challenge is much greater for these countries. A combination of relatively high (and rising) interest rates, coupled with “crowding out” effects across the energy transition supply chain as developed economies increase demand for raw materials and manufacturing capacity.
In part II of this article I will look at the role that stable climate policy has on decarbonisation investment decisions, in particular the benefits that carbon pricing could have in reducing the cost of financing the energy transition for less developed economies.
BNEF define EM&DEs as non-OECD countries minus China but plus Mexico, Colombia, Chile and Costa Rica. This is consistent with the definition used by the IEA.