Financing energy in developing countries without breaking the World Bank

Last month the World Bank and the International Monetary Fund had its spring meetings in Washington, where thousands of ministers, officials, private investors, NGOs and academics gathered to discuss economic development and poverty eradication. Through the hum of seminars, side meetings and coffee table chats, one question came up repeatedly: what is the best use of public funds from multilateral development banks and national governments?

The World Bank’s “cascade” approach

The president of the World Bank, Jim Yong Kim, outlined their “cascade” approach to deciding when and where to deploy public funds.

“We start by asking whether the private sector can finance a project. If the conditions aren’t right, we will work with our partners to de-risk that project”.

This starts with whether reforms to regulation or policy can get private investment flowing. Then if the project is still not privately financeable, the World Bank will look to deploy risk sharing tools, such as guarantees and insurance. Finally, if these measures are still insufficient to bring in private funding, direct public finance becomes the option of last resort.

A preference for private investment where possible is understandable given pressure on government budgets. In the power sector, the rapid expansion of investment required over the next two decades represents 7.0% of GDP a year in India and 6.8% in Africa. If governments financed all these investments it would put further pressure on their budgets and credit ratings, which are already typically near to or below investment grade.

Around half of existing power generation capacity remains state-owned. But despite this dominance, there is a growing drift towards private finance. This is particularly the case with renewables, which have been opened up to private finance through PPA auctions.

Private finance can cause problems downstream

However, private finance should not always be pursued as an end in itself. Some risks are still better managed by governments or development banks. For example, if we ask private investors to manage risks they are not well-placed to manage or understand, the investment may only be financeable with high risk premiums and at a high cost of capital. Ultimately, this increases customer bills and drags on public budgets. So private finance can be a false economy.

In addition, while many generation projects are notionally privately funded, in practice many risks are ultimately still borne by taxpayers or consumers. For example, where renewables investments are underpinned by PPAs with the state-owned utility, as is the case with Eskom in South Africa, price risks are effectively transferred to taxpayers and the contract implies large contingent liabilities for the national government.

So what is the right way to think about public versus private finance of energy?

One approach, which we are developing at CPI Energy Finance, is to consider the right allocation of each specific risk for a power generation project (eg, operational, construction, price). For each risk we need to determine whether it is best managed by private investors, public entities (and ultimately taxpayers) or flowed through to consumers via their bills. We can then think about the right blend of ownership models, finance instruments and policy to achieve the ideal allocation of all the risks (see diagram below).

Channelling risks to the right place

The ideal risk allocation will vary depending on the context. In most countries, private investors are typically better at managing construction and operational risks — not least because private shareholders exert strong pressure on management and competition tends to weed out private firms who are bad at managing costs. So generally private ownership and finance of generation is preferable during the construction or operational stage.

By contrast, policy risks are not well managed or understood by private investors. It is difficult for investors to judge the uncertainty around whether governments will retrospectively reduce subsidies or change rules around compensation of curtailment. Exposing them to these risks means they will price in high risk premia (more than 200–300 bps in some cases), particularly in developing countries where policy is more erratic.

Policy risk insurance from public multilateral institutions such as the World Bank’s Multilateral Investment Guarantee Agency is popular for power investments in developing countries. It can be effective where development banks can manage the risk by using their influence to pressure host governments not to renege on policies, and to secure compensation if they do. Development banks are better able to do this than individual private investors, not least because host governments want to ensure that the flows of development bank finance do not dry up in the future.

The ideal allocation of other risks, such as market price risk, can be less clear-cut and varies depending on technology. There is a strong case for private owners of flexible generation types (such as CCGTs) bearing price risk, as they are flexible and this encourages them to dispatch efficiently and flexibly to meet demand. But there is little to gain from exposing private onshore wind investors to price risk as they can only generate when the wind blows, so exposing them to price risk does little to promote efficient dispatch.

This is one of the reasons why fixed price Feed-in Tariffs and PPAs, which transfer price risks away from private investors to consumers or state-owned utilities, are popular around the world. They have been crucial to reducing the cost of capital of renewables investments, contributing to the record low auction prices we have seen over the last year.

Finally, the right allocation of some risks can vary depending on the country context. Development risk is a good example. In some countries, such as India, land acquisition can be difficult for private investors to manage due to bureaucratic and politicised planning rules while grid connection can be subject to unpredictable delays.

Public entities are better placed to navigate these issues, reducing delays, costs and risks. This is one of the reasons why state financed “solar parks”, such as those in Gujarat, are starting to sprout. Sites in these parks, with planning permission and grid connection already secured, are then sold to different private developers who do not need to bear the development risks. Similarly, the national Danish Energy Agency finances pre-development of offshore wind farms ahead of auctions.

Blending ownership models, finance and policy to get the right flow

All of this demonstrates that it is not simply a case of choosing public or private finance. Rather it is about ensuring different risks are allocated and shared according to who is best placed to manage, understand and bear them. This can be achieved through a blend of ownership models (public versus private), policy, regulation and specific finance instruments (see diagram above).

The World Bank’s “cascade” approach gets right to the heart of these issues. But it is important to recognise that for some risks public finance is the ideal least-cost solution, not just a last resort.

Will Steggals is a consultant at CPI Energy Finance in London.