When Governments of Developing Economies Get an Equity Stake

Exhibit: RE and Fossil Fuel Projects, Average Spread in Debt Costs by Ownership, 2011-2022

Source: UNCTAD

Key Points: A 1,700-project review in UNCTAD’s latest World Investment Report quantifies the extra financing costs for LDCs’ projects; factors include lower credit ratings, lower leverage, and longer time to close. And a host government equity stake in Developing Economies has lowered financing by ~80 basis points relative to “only” policy or loan support.

UNCTAD’s annual World Investment Report. The United Nations Conference on Trade and Development (UNCTAD) published its annual World Investment Report (WIR) this week. The report is a compendium of trends and challenges in financing the investments required for countries to achieve their Sustainable Development Goals (SDGs) by 2030. It notes that developing countries need US$1.7 Trillion in annual investment in renewable energy (RE) but received $540 Billion in clean energy foreign direct investment in 2022.

The characteristics of more expensive financing in Least Developed Countries. As part of the report, WIR 2023 includes a review of ~1,700 project with yield type information financed from 2011 through 2022. The review characterizes some of the additional sources of financing cost for Least Developed Countries (LDCs) relative to Developed and Developing countries. To illustrate:

• The average interest rate spread (to a project base rate that can be considered a risk-free rate) is 283 basis points (bps, with 100 bps=1 percentage point) for Developed countries, 290 bps for Developing countries and 386 for LDCs.
• The proportion of a project financed by debt (vs. equity) is 75% on average for Developed countries, 71% for Developing and 67% for LDCs. (The higher the debt proportion of total financing, generally the less expensive the financing.)
• The proportion of projects bucketed as “highly leveraged” (classified as having a spread >400 bps over the base rate and akin to having a very weak credit rating) was 24% in Developed countries, 23% in Developing countries and 55% in LDCs.

In addition to that data on cost spreads, other observations in WIR23 point to higher costs in LDCs as well. The report notes, for example,

• sovereign credit ratings for the vast majority of LDCs are below investment grade. Most banks have internal or regulatory limits (e.g. Basel III) on how much they can lend (on a non-recourse basis) to non-investment grade countries.
• the average number of days to close (i.e. finalize) financing on energy sector projects was 156 for Developed countries, 282 for Developing countries and 524 for LDCs; this significant delay is itself a source of costs.

A government equity stake in the project has made a meaningful impact. The project review also found ~80 bps lower borrowing costs in Developing economies when the host government had an equity stake vis-à-vis when it (or Multilateral Development Banks) had provided other, non-equity forms of support such as subsidies, (concessional) loans or loan or price guarantees. Interestingly, there is relatively little benefit, in terms of lower financing cost, between projects with this non-equity government support and those that receive no government support at all. See Exhibit.

By way of explanation, the report suggests that non-equity government support can often be crucial to a project developer’s “go/no-go” decision, by improving risk-adjusted expected financial returns. Yet, such support is less effective in changing credit risk perception among lenders. Instead, a project’s actors — sponsors, equity investors, contractors, customers/power off-takers, and country administrators — as well as the size of the project (with larger projects being harder to reverse) are more responsible for lenders’ credit risk perceptions.

WIR23 notes, however, that a government equity stake can factor into the longer negotiating time for Developing countries and LDCs and, at too high a level, allow for concerns regarding project governance.

RE vs. Fossil. The project review finds significantly (150+ bps) higher borrowing costs for fossil fuel vis-à-vis RE projects, regardless of ownership profile. See Exhibit. The report suggests that regulatory and stranded asset risks may help account for some of this gap. Additional color on the projects might be helpful, but it seems plausible that market risk (less off-taker contracting) amidst volatile hydrocarbon pricing through the 2010s played a role in the higher costs as well.

July 6, 2023