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July 3, 2023

Reforms needed to drive ESG investment in emerging markets, experts say

The Solar Photovoltaic Power Plant, some 45kms from Amritsar. Significant investment will be needed if emerging markets are to achieve climate goals. (Photo by NARINDER NANU / AFP) (Photo by NARINDER NANU/AFP via Getty Images)
The Solar Photovoltaic Power Plant, some 45kms from Amritsar. Significant investment will be needed if emerging markets are to achieve climate goals. (Photo by NARINDER NANU / AFP) (Photo by NARINDER NANU/AFP via Getty Images)

Solutions are slowly being discussed and implemented to drive capital into emerging markets and to reduce the cost of financing renewable energy projects in them, but finance experts insist much more needs to be done if they are to become net zero by 2050.

Emerging markets and developed economies made up over 95 per cent of the increase in global greenhouse gas emissions over the previous decade, said the World Economic Forum in 2022.

Private investors are, however, reluctant to support the climate transition in EMDE, leaving them reliant on public finance — public financing made up around half of EMDE clean energy spending in 2022, compared with less than a fifth in advanced economies, says the International Energy Agency.

The world must invest more than $4tn a year by 2030 to hit net zero by 2050, says the IEA. Of this figure, $1tn is required for emerging markets, meaning significant amounts of private finance will be needed, yet private sector spending on clean energy in EMDE has been flat since 2015.

“A lot of institutional investors want to deploy money [in emerging markets],” Matsi Modise, chairperson of South Africa’s Technology Innovation Agency, a public body, told Sustainable Views. “But they want policy certainty, which is still something that’s not there, especially in Africa.” Securing investment is also dogged by the lack of a functioning marketplace that matches money with climate technologies and infrastructure, she added.

Capital flows into emerging markets took a particular battering at the start of the coronavirus pandemic. In the third week of March 2020, EM portfolio capital inflows recorded a drop similar to that seen during the 2008 global financial crisis, says the Federal Reserve Bank of Dallas. Weekly portfolio outflows from EM funds sat at nearly 2 per cent of funds’ assets under management.

Outflows from EM bond funds were even faster over the same period, sitting at 4.5 per cent of EM bond funds’ assets in March 2020.

Since the pandemic, flows into emerging market ESG funds have remained weak, dropping to around $7bn last year from $25bn in 2021, says the International Finance Institute, not helped by an unforgiving economic backdrop. In March, ratings agency Fitch Ratings said the Federal Reserve’s tightening of monetary policy would put pressure on net capital flows to emerging markets this year, though predicted a recovery in 2024 owing to anticipated interest rate cuts and improved EM growth relative to that of advanced economies.

Technology transfer

The costs of deploying early-stage technologies, in particular in emerging markets, are high. In June, Pavina Adunratanasee, smart solutions manager for renewable energy provider Iberdrola Australia, told the World Climate Foundation’s Climate Investment Summit that a “really exponential learning rate” is taking place for solar, wind and lithium ion battery storage.

“The costs are exponentially coming down,” she said. “From the emerging markets perspective, however, cost of capital is obviously going to hamper the return on equity and debt on the project, and we’ve seen that the cost for developing utility-scale solar is three times as high in emerging markets versus developed markets.” 

Capital needs to be allocated to drive down these costs, she added, calling for “a global pact that’s focused on technology transfer along with financing”.

Increased risk levels are usually reflected in higher financing costs. Jenn-Hui Tan, global head of stewardship and sustainable investing for Fidelity International, told the Climate Investment Summit the cost of capital for debt and equity for infrastructure projects in these markets is “unacceptably high”.

Even establishing these costs can be difficult. Financial markets data used to price equity and debt is less well-developed in EMDEs than in advanced markets, the IEA said in a recent report, while information on default rates is also lacking.

“This is a major drawback for investors, as inadequate assumptions around the cost of capital can lead to the mispricing of risk and misallocation of capital to different markets and sectors,” the IEA said.

New financing mechanisms are needed

Initiatives are underway to unlock new ways to finance clean energy in EMDEs. 

Earlier in June, the World Bank launched its ‘Private Sector Investment Lab’ aimed at finding new ways to mobilise capital towards emerging markets, at improving financing structures and addressing the risks faced by investors.

“We need some new mechanisms from a financing perspective to be able to help promote and deploy clean tech at scale,” Iberdrola Australia’s Adunratanasee told the Climate Investment Summit.

Concessional finance, which offers more generous terms than conventional loans, like below-market interest rates, may pave the way for channelling more private capital into EMDE’s climate transition.

Alexandra Paltschik Rønneberg, corporate responsibility advisor for KLP, Norway’s largest pension company, highlighted the role of concessional finance at the summit.

She emphasised the importance of “finding flexible mechanisms that are tailored to the specific risks that [drive] up the cost of capital”, adding the need to do this “in a way where you don’t unleash projects that shouldn’t actually be undertaken”.

Blended finance is another way to lower risk linked to projects and encourage investment in emerging markets. Public-private partnerships can blend philanthropic capital with commercial investment that would not otherwise be attracted to a project.

“Blended finance structures have seen increased awareness and increased implementation, but so far not at the scale that’s needed,” Panagiota Balfousia, head of sustainable business strategy at asset manager Kieger, told Sustainable Views.

A service from the Financial Times