Arguably the biggest problem in attracting foreign capital to finance infrastructure and climate change mitigation projects in developing countries is the large macro (country) risk that translates into prohibitive capital costs. The interest rate premia is much higher than would be expected based on any theoretical model or assessment made on the basis of economic fundamentals.
Avinash Persaud demonstrates this problem in an excellent paper. This table captures the fundamental problem of high returns expectations of foreign investors.
Persaud points to the striking differences in returns expectations of foreign investors in developing and developed countries.
The average cost of capital of a utility-sized solar farm in our sample of industrialising emerging economies excluding China (Brazil, India, Indonesia, Mexico and South Africa) is 10.6%, compared to 4.0% in the EU (statistics from the IEA for 2021). This difference of 6.6% per year in the cost of capital matters critically because renewable energy projects are capital-intensive. Take solar; after a developer has paid for the land, panels, batteries, and erection and connection cost upfront, the operating costs of generating power are nearly zero. Given these different costs of capital, most of what is profitable in the EU and other G7 countries is not profitable in industrialising emerging economies. 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. We must lower the cost of capital.
He compiles data on macro (country) risks and micro (project) risks faced by solar power generation developers in developed and developing countries. He finds that the average difference in the cost of capital between developed and developing projects is 6.6%.
The difference in project risks is not adding to the higher cost of capital in industrialising emerging economies compared to developed ones – it is subtracting from it.
He points to policy risks even in developed countries and the market failure in discounting it even as it disproportionately penalises the same in developing countries.
Twenty-five-year power purchase agreements that span several elections will carry risks and uncertainties wherever they are. Germany and Spain, for instance, started off with feed-in tariffs for renewable projects but then changed tack and introduced auctions. Pipeline projects in the US have a long history of stop–go with commercial consequences for all energy projects. There is an evolving and sometimes bewildering set of community, national and EU-wide carbon credits, renewable subsidies, and tax regimes. Europe will introduce a new Carbon Border Adjustment Mechanism next year which I quite like but its effects and implementation are uncertain. And yes, even in the US and Europe, regulatory changes or the lack of changes are the result of local lobbying that may be prejudicial to foreign firms and investors...Across these tax and incentive changes, developed economies (correctly) hold tightly to their sovereign right to make changes without compensating anybody who loses directly or indirectly. But in developing countries, foreign investors threaten to walk if they are not given guaranteed fiscal privileges and immunities and agreements that subject developing countries for decades to come to international arbitration around compensation for policy changes.
He points to the need to mitigate the currency risk on investments that generate local currency revenues. This currency risk is a proxy for the macro risk. He highlights the scale of the risk-premia.
For example, in March 2016, the average spot rate for the Brazilian Real was 3.91 to the US dollar, and the fiveyear forward rate was 6.44, meaning that if you wanted to buy US dollars five years ahead and lock-in a rate, it would cost 71% more Real or 11.3% more per year. There are a few ways to look at that, but the bottom line is that the cost of guaranteeing yourself against the Real falling against the dollar (reducing the dollar value of your interest and dividends) was 11.3% per year. If a dollar-based investor invested in a Brazilian solar project that boasted a local currency rate of return of 15% per annum, after hedging out the currency risk, they would have been left with a US dollar return of just 3.7% per year (15% minus 11.3%). This would not be enough to get them out of bed in the morning – recall that the US S&P 500 equity index has a long-term return of 6.5% per annum plus inflation. 22 Across our sample group of major industrialising emerging markets, the costs of hedging currency risks averaged 5.7% per annum in 2021 and 2022. Like in the 2016 Brazilian example above, foreign currency hedged returns for long-term green projects which generate revenues from consumers in developing countries are too low to generate external investment demand across multiple currencies and decades.
He compares the FX futures cost with the actual FX deprecation and finds that the cost of FX hedging considerably overstates the actual risk.
We find a significant, +2.2% per annum, average ex post "overpayment" for FX risks, with an overpayment occurring in 62% out of 372 five-year hedges starting as early as 1999 and finishing in 2022. (The overpayment is the annualised percentage difference between today's spot exchange rate and the rate implied five years ago by the five-year forward market).
In our 2016 Brazilian example, between March 2016 and 2021, the Real depreciated against the dollar by 6.9% per annum, not the 11.3% discounted in the five-year forward market. In this case the overpayment for hedging turned out to be 4.3% per annum. To appreciate the significance of this overpayment, if an investor was charged what turned out to be the fair price for the hedge in March 2016, their expected dollar return would not have been a debilitating 3.7% per annum, but a compelling 8% plus diversification benefits. That is the prize. Is it achievable ex-ante or just observable ex-post?
In the absence or immaturity of forward foreign exchange markets to hedge for forex risks in any developing country, he proposes a partial FX Guarantee mechanism operated by an MDB
I propose a Partial FX Guarantee Mechanism limited to green transformation projects. Market failures and overpayments observed in the historic data offer a basis for intervening to reduce the overpayment when it is most extreme. The micro-economic arguments for the market failure described above, the distribution of the overpayments across time and the portfolio effects discussed earlier, guide us on how we could best operationalise such an FX guarantee. It is best implemented in a public-sector environment with a counter-cyclical and public-good mandate and where liquidity and capital can be employed in market stress. A conservative approach is also critical, as sticking to an objective of reducing the overpayment but not providing a subsidy will allow the mechanism to scale up safely enough to materially close the US$1 trillion per year gap on private finance. And spreading or pooling currency risks is also a valuable risk-reducer. Based on this, my proposal is for a joint agency of the Multilateral Development Banks and the IMF to offer a partial FX guarantee at specific times and to pool the risks. The MDBs would provide diversity and project expertise, and the IMF could provide liquidity and macro knowledge.
Some observations:
1. As I have blogged on several occasions, foreign capital faces the unavoidable problem of domestic currency revenues and foreign currency return requirements. This, coupled with the fact that infrastructure is at best a low and stable return asset class, means that foreign investments into infrastructure will always struggle to attract a significant volume of foreign investments.
2. The high return expectations on a low-return asset also mean that those projects being funded by foreign investors are also likely to be deeply risky. They would have to pay an exorbitantly high cost of capital, which in turn erodes the capital cushion available to the project to ride out shocks. Perversely, foreign capital into infrastructure and climate mitigation projects in developing countries could end up making the project riskier.
3. While Persaud's proposal appears sound in theory, operationalising it through the MDBs will be very hard. The markets will always be uncertain about such instruments and market participants will invariably hedge against the risks, thereby repricing the cost of capital upwards. This endeavour will be like the World Bank's Multilateral Investment Guarantee Agency (MIGA) which since its inception in 1988 has guaranteed just a few tens of billions.
4. While projects get de-risked, the returns expectations of foreign investors remain the same or only marginally lower. In these circumstances, de-risking with concessional finance becomes a convenient tool to boost private bottom-lines. When all's said and done, it's most likely that public subsidy ends up as private gains.
5. Given all the above, we need to see foreign commercial capital in climate mitigation and infrastructure in its true perspective. The prevailing financial market incentives make it almost impossible to attract foreign capital into infrastructure in all but negligible amounts. Wasting scarce effort and time on this endeavour is likely to be futile.
The balance sheet of long and arduous efforts to get foreign capital to invest in infrastructure in developing countries is deeply disappointing. Decades of efforts at derisking have failed badly. Far from being able to attract 10-20 times private capital for every dollar of public/MDB finance, they have struggled to leverage even a multiple of one. MIGA has struggled despite its best efforts to make any meaningful dent.
6. Instead of expending energies on complicated financial structures and market-making, a more prudent and meaningful approach would be to focus on lowering returns expectations. One way would be to get rating agencies to recalibrate their models to account for the distortions like what Persaud has shown. How do we discount the perception premium, over and above the fundamentals-based risk, in the models used by rating agencies?
Private institutional investors preaching ESG and sustainability goals should introspect about their returns expectations. At the risk of being branded hypocrites, they should be putting money where their mouth is.
7. Given all these, instead of chasing the impossible, it may be more sustainable and cost-effective for the IFC and World Bank to directly lend to developing countries to develop greenfield climate mitigation and infrastructure projects, and then have the revenue generating assets be monetised to repay the loans and use national budget finance to repay the loans made to non-revenue generating assets. This should be necessarily supplemented with efforts at project development and project management governance systems. These are all hard tasks, but they stand a greater chance of success than attracting foreign investors into climate mitigation infrastructure.
Further, instead of chasing only foreign investors, these efforts should prioritise unlocking domestic capital by de-risking them. This could involve working with local banks to de-risk projects and mobilising loan syndication consortiums. It could also lead to the general derisking of climate mitigation infrastructure investments in the financial system of those developing countries. At the least, derisking domestic capital is a less futile endeavour than derisking foreign capital.
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