Cost of Capital Observatory Launch Shows There Is Much Work To Do
Cost of Capital Survey Weighted Average Cost of Capital vs. Country Bond Yields
Sources: IEA/WEF, World Government Bonds
Key Points: Last week’s launch of IEA/WEF’s Cost of Capital Observatory starts to delineate investors’ views of the risks of energy investment in emerging economies. Initial results show underdeveloped risk assessment, which supports why investment is lacking. Also, a weak relationship between country bond yields and WACC suggest other drivers are also relevant.
Goal of the Cost of Capital Observatory (CoCO). The International Energy Agency (IEA), The World Economic Forum (WEF), ETH Zurich and Imperial College London have introduced the CoCO — an initiative to lower emerging markets’ cost of capital by bringing transparency to real and perceived risks of clean energy investing in specific countries. It is hoped that greater transparency, along with policy or mechanisms to address key risks, can lower investors’ return requirements and spur more investors to put money to work.
1,000 basis point spread in WACC illustrates how poorly risks are understood. The launch last week included publication of results from a survey conducted earlier this year. The survey solicited feedback from financial actors about the cost of capital and related inputs for two project types (one new solar facility and one natural gas facility) across five countries (Brazil, India, Indonesia, Mexico and South Africa). Illustrating the challenges of accessing funding currently, the surveys yielded Weighted Average Cost of Capital (WACC) spreads of as much as 1,000 basis points (i.e. 10%) for a given project in a given country.
Cost of capital 2-3x higher in emerging economies than “advanced” economies. The relative paucity of respondents and the aforementioned dispersion makes assessing results somewhat challenging, but median required WACCs in the survey responses for solar projects ranged from just under 10% (for India and Mexico) to 13% (for Brazil) (see Exhibit). This range suggests 2-3x more expensive financing than in the OECD. Further, the implication is that financing costs in these countries account for ~1/2 of total levelized costs of a solar PV plant vs. ~25-30% in the OECD and China.
Many of the perceived risks relate to the country, but go beyond country risk. The survey results include only contractually-supported revenue streams (like Power Purchase Agreements or PPAs), thus removing merchant risk from the evaluation. Further, the IEA indicates that respondents’ WACC for solar projects were equal or a bit below for natural gas. At the risk of over-reading relatively few results, we observe a only weak relationship with country bond yields; or to put it differently, survey respondents’ WACC requirements seem much less sensitive to bond yields for South Africa and Mexico and/or more sensitive for Brazil (see Exhibit). We imagine this weak relationship is due to the variety of risks including regulatory, political, off-taker (which is often a government-backed utility), currency and land acquisition (concerns about permitting and land rights).
Ideally, the CoC progresses with more granular perceptions of risk drivers. In its goal of transparency, the IEA et al is seeking more detailed insights into the impact of these various risks on WACC requirements. The effort may meet some resistance from the investment community, as some investors are likely to view their proprietary risk analysis to be a strategic advantage. Yet, it is hoped that the launch raises awareness of the initiative, which furthers efforts to get insights and responses.
9/28/2022