- A joint report by the IEA and IFC highlights the importance of developing local capital markets for the clean energy transition in emerging economies.
- The report emphasizes the potential of scaling clean energy projects through domestic private investments and the growth of local capital markets.
- While foreign currency instruments have historically financed clean energy projects in emerging countries, middle and large-income countries have relied more on domestic private investment for the clean energy transition.
Developing local capital markets plays a crucial role in facilitating the clean energy transition in emerging economies, as stated in a joint report by the International Energy Agency (IEA) and the International Finance Corporation (IFC) in June 2023.
The report titled “Scaling up private finance for clean energy in emerging and developing economies” emphasizes the potential of leveraging domestic private investments and fostering local capital markets to finance clean energy projects.
According to the report, enhancing local capital markets and financial systems is essential for scaling domestic private investments in the clean energy transition. While foreign currency instruments have historically financed clean energy projects in emerging countries like Nigeria, middle and large-income countries have relied significantly on domestic private investment for clean energy investments.
Changing the narrative in emerging economies
According to the cited report from the IEA and IFC, local currency financing in emerging economies is often limited and comes with significant currency depreciation risks. These risks are especially prominent due to the long-term nature of energy sector project loans, typically lasting 15 to 20 years.
Consequently, interest rates tend to be higher for local currency loans compared to foreign currency loans. Additionally, local currency loans face greater refinancing risks due to the shorter tenors typically found in less developed local currency capital markets.
However, the development of domestic bond, equity, and derivatives markets, including currency swaps, can facilitate local funding for climate projects. This can involve utilizing domestic banks and capital markets, as well as employing currency swaps to convert larger foreign currency financing, offered by cross-border investors, into local currency with longer terms.
The report also suggests that domestic banks can play a crucial role in funding smaller climate-related initiatives, such as investments in electric vehicles and expanding electricity access through solar PV solutions in households and businesses. A part of the report stated:
- “Domestic banks can be a major source of financing. Domestic banks will be able to fund themselves where markets are sufficiently developed, adding long-term funding and loss-absorbing capital to backstop shorter-term deposit funding.
- “Larger projects, however, typically need to turn to capital markets, using instruments including bonds and securitization funded by mutual funds, pension funds, and insurance companies. Well-functioning capital markets can allocate resources more efficiently through better information and governance.
- “More resources can be mobilized for innovative projects, tapping investors with a higher risk appetite to fund riskier and more collateral-scarce activities than banks have traditionally served. Equity markets, moreover, have long been key to the financing of new businesses, particularly those relying on intangibles, R&D and human capital.”
What you should know
The IEA and IFC report emphasizes the importance of fostering local capital markets and enhancing the capacity of local investors to provide local currency for projects. According to the report, this approach offers a more scalable solution for climate finance.
It suggests that efforts to mobilize more local currency should build upon the achievements of development finance institutions (DFIs) in the past. To achieve this, the report proposes several strategies, including upskilling local lenders, expanding the pool of local savings for investment, designing well-structured climate projects, and creating incentives for funds to be directed towards projects that yield positive climate outcomes.
- These measures aim to facilitate greater access to local finance and support sustainable climate initiatives.
