A Partial FX Guarantee Mechanism will reduce cost of capital for renewable energy projects in developing countries, says Avinash Persaud in his paper
Photo: iStock The Summit on New Global Financial Pact kicked off in Paris June 22, 2023, with participants discussing global financial system reforms that can catalyse the green transformation urgently needed in the Global South.
Close on the summit’s heels, a new and timely paper discusses the important issue of making green finance affordable to emerging economies.
In a new research paper, Avinash Persaud, climate finance envoy to Barbados Prime Minister Mia Mottley, titled Unblocking the green transformation in developing countries with a partial foreign exchange guarantee, discussesed how to make affordable finance available for renewable energy projects in emerging and developing economies.
Over the last 270 years, North America and Europe contributed to 70 per cent of the current carbon dioxide stock, however developing countries now account for 63 per cent of greenhouse gas emissions.
In order for the world to avoid crossing critical climate and planetary tipping points, green investments in emerging economies need to be ramped up. And fast.
According to the paper, developed countries have already used 86 per cent of the global carbon budget. Using more of this budget will mean that we will destabilise the planet’s physical, chemical and biological systems.
This means that as developing countries industrialise and develop, their development trajectories will have to be different from those that the developed world has used in the past — it will have to be one that involves a rapid green transformation.
The urgently needed green transition in developing countries is hindered due to a high cost of capital in these countries. The cost of capital, which broadly refers to the costs incurred for accessing funding for a new project or investment, is much higher in developing countries than in developed countries.
To achieve a green transformation of the scale that is needed in developing countries, investments need to reach $2.4 trillion per year by 2030 in emerging economies other than China. This figure is far above what governments can fund themselves, meaning that private capital must be introduced.
Currently, 81 per cent of green investments in developed countries are financed by the private sector. However, for developing countries this number is drastically lower at 14 per cent.
Investments in clean technology are highly sensitive to cost of capital, according to a new report by Delhi-based think tank Centre for Science and Environment. The report talks about urgent financial system reforms that are needed for the Global South to access climate finance and increase climate ambition.
Although costs of renewable energy have reduced over time, a high cost of capital continues to hinder investments in renewables and make it unaffordable in many developing countries.
According to Persaud’s paper, the cost of capital can be broken down into three components: A risk-free rate of return that investors need for their investments, and the macro- and micro-risk premia.
The macro-risk premium includes sovereign credit risk, political and currency risks. These risks are reflected in the high yields that developing country governments have to pay potential investors to buy their bonds. For instance, recently the South African government offered investors a return of 12 per cent when it borrowed money for a period of 10 years, whereas the German government paid investors 1 per cent.
According to the paper, micro-risk premia are either similar or smaller in industrialising emerging economies as compared to developed countries. This indicated that macro-risk premia are responsible for the higher cost of capital in emerging economies.
The study also indicated that macro-risks are over-estimated. Therefore, in order to reduce the cost of capital in emerging economies we must target macro-risks.
The paper analysed the over-estimation of macro-risks and foreign exchange risks by calculating the cost of hedging foreign currency risks (as foreign exchange markets provide a proxy for other macro-risks).
A forex (FX) hedge is the difference between the price at which a foreign currency can be bought with local currency in the future (forward rate) and the price at which it can be bought today (spot rate), which can be expressed as an annual percentage cost. The paper found that there has been an overpayment on FX hedges historically with an average of 2.2 per cent per annum, when the cost is below the three-year moving average.
The paper proposed a solution to this problem in the form of a ‘Partial FX Guarantee Mechanism’ through a joint agency of the Multilateral Development Banks and the International Monetary Fund, which can offer a partial FX guarantee at specific times and pool currency risks. Persaud suggested that in order to avoid losses, the agency could wait until hedging costs were above the three-year average.
A guarantee agency such as this one can provide investors with hedging at costs reduced by historic excess amounts, in addition to halving current market costs and providing protection for future foreign exchange risks. This can reduce the cost of capital for developing countries and provide enough currency-hedged returns to attract investors to emerging economy country markets, according to Persaud.
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