Sustainability Financing In ASEAN — Sustainable Or Not?

Photo by Jason Blackeye on Unsplash

PART 1: JUST ANOTHER SUNNY DAY

Amidst the scorching heat of the sun in Ho Chi Minh City, Hung Pham is struggling with his long jeep that shuttles commuters around the biggest city in Vietnam. Having his vehicle broken in this weather is just a stroke of bad luck, but Hung moans over the rising price of diesel. Not being able to weather the astronomical housing costs in one of the most expensive cities of Vietnam, Hung resides on the outskirts in a small townhouse with his family of four. The close-knit bond his family has forged with their next-door neighbors is probably the one great thing about the outskirts, but not the frequent blackout that hinders their nightly activities: “The cuts occur at very unexpected and late notice”, he said. As inflation surges, causing energy and utility bills to skyrocket, Hung and other working-class members in underdeveloped neighborhoods of Southeast Asia have to reduce other expenditures pertaining to their basic needs such as clothes and food.

Hung and his family are just part of the 45 million ASEAN residents who remain without stable electricity for daily activities and clean cooking due to endangered energy security from reliance on traditional fossil fuels (Franco et al.). The emission from fossil fuels deployed in daily activities like transportation and cooking contributes to air pollution which causes 2.4 million annual premature deaths (Board). These numbers will accelerate in the next two decades should the transition into renewable energy fail to happen quickly enough to accommodate the surge in demand for electricity. Indeed, the region’s overall dependence on oil imports is forecasted to exceed 80% by 2040, up 15% from the 2019 level, should insufficient clean energy be generated from renewables plants to cater to this rising energy demand. (Lauwerys and Tung).

1. Funding Gap

One obstacle behind ASEAN’s slow transition from fossil fuels into renewables is the huge funding gap for renewables projects. The ASEAN Center for Energy forecasts that energy demand in the region will grow by two-third between 2017 and 2040 (Iea, Southeast Asia Energy Outlook 2017 — analysis). The collective goal of the region is to have 23% of this demand fulfilled by modern sustainable renewable sources by 2025 which requires an annual investment of about US$27 billion, up from US$6 billion a year between 2009 and 2016 (Lauwerys and Tung). While some ASEAN countries like Thailand, Malaysia, and Singapore have more mature markets with developed financing infrastructure for clean energy investment, others still struggle with higher cost of capital and undeveloped financial instruments for renewables projects.

These developing countries, then, became dependent on public financing — loans and grants from the governments, to fund renewables projects. Meanwhile, private investment only accounts for about 45% of the total investment volume (Susantono, 169). Instead of the government, a group of commercial banks and eligible financial institutions are the entities who syndicate private loans. Unfortunately, Asia’ syndicated loan market has been dominated by the People Republic of China, who originates 4.2% (Susantono, 60) of the total renewables loan volume across the whole region.

2. The role of China in ASEAN’s energy transition race

It is understandable why developing countries in Asia would depend on China to fund their transition into renewable energy. China had always been active in financing coal and oil projects in developing Southeast Asian countries before unfavorable regulations banning such carbon-rich resources rolled out. To make up for years of profiting from depleting developing countries’ resources while also hedging against the Russian-Ukraine war-induced energy shortage, China naturally jumped at investment opportunities in the renewables sectors among emerging markets. Diplomatically, China can also exhibit its goodwill in helping developing countries in their green energy transition.

After all, analysts from the Institute for Energy Economics and Financial Analysis claim that it is logical for China to be part of the solution to the deteriorated climate change after reaping huge gains from its 41% stake in the total investment of operating coal power plants in Indonesia, an ASEAN country that is ranked third worldwide as an oil and coal exporter (Ng). This approach should also be in China’s diplomatic interest to portray its commitment to the sustainable development goal by aiding less developed ASEAN countries in their renewables race. China would not want to be seen as the villain who only cares about coal-generated profits before leaving the developing population to suffer from the repercussions of depleting fossil fuels.

However, depending solely on China for financing is dangerous, given most Chinese banks and companies remain biased against renewables projects in developing countries due to weak grid infrastructure and costly electricity distribution to rural areas where residents live far away from each other. China’s active investment and partnership with government and enterprises in developing countries within Africa also teach meaningful lessons about how its banks perceive renewables projects from emerging markets. Indeed, the due diligence process for renewables projects in countries with underdeveloped infrastructure might take up to 2 years as seen from the case of China Policy Bank’s prolonged assessment period for Ethiopia’s Adama Wind Farm 1 (Kong and Gallagher, 6).

ASEAN can learn from this discourse between what lenders from developed markets like China want to invest in versus what requires actual allocation of capital among countries within the region. In fact, to more conservative lenders who have been used to the traditional oil and coal market structures, medium-to large-scale investments that involve conventional and mature technologies tend to be less risky, incur higher returns on investments, and command broader sources of financing. What many ASEAN countries need, however, is the distribution of power to remote rural areas, which requires novel, unproven and small-scale technologies and business models that are much riskier to these lenders’ appetite. Therefore, instead of relying on China for capital, financial institutions across Southeast Asia should integrate various fields of expertise for multi-sector solutions to maximize gains and reduce risks, ensuring the relevance and impact of clean energy financing.

3. The political barrier behind emerging markets’ funding gap

But the major obstacle to procuring private investment from sources other than China is as much of a political barrier as a financial one. Indeed, the SEA governments seem like risky and unpredictable partners to many investors. According to Trung Nam Group — one of the largest private builders and operators of renewables plants in Vietnam, foreign investors expect something these governments cannot provide: a clear, predictive policy framework for the renewables market to ensure lower risks and higher returns. Such uncertainty is reflected through the latest change in Vietnam’s new Public-Private Partnership (PPP) Law enforced on January 1, 2021 (Phuong Thu).

Back in 2020, renewables investors and developers in Vietnam are contractually guaranteed to have their entire projects’ yield purchased by Vietnam Electricity (EVN) — the state-owned power company. However, from the start of 2021 onward, the government no longer forces EVN to buy the tire yield of domestic renewables projects, leaving owners of projects that are already in operation at risk of not being able to pay off their loans using their sales proceeds (Phuong Thu). Policy changes like this increase the perceived risks of Vietnamese renewables projects to lenders and investors given the uncertainty of who the energy off takers are and at what price they would be bought for once the government refuses to buy.

Vietnam’s PPP is just one example of a law that creates risk for investors, who are by definition, interested in maximizing their yields. From an investor’s perspective, a renewable project’s yield is determined by two crucial factors: electricity price and capacity, both of which are usually set by a government entity, such as the Department of Renewable Energy within the Ministry of Trade. The price and capacity allowance of a project are usually contractually agreed upon in a Power Purchase Agreement, which is an arrangement between a third party developer who constructs, installs and operates the energy system and a customer, who can be the government, a state-owned or private enterprise. Vietnam’s Trung Nam group’s representative also pointed out that one critical weakness of a PPA is its inability to address a discouragingly common scenario in developing countries, whereby the power plant is unable to generate energy since the grid cannot support it (Phuong Thu). This happens when too many renewables projects are developed and operated, resulting in an overwhelming amount of electricity output. This might have been due to developers and investors being too excited over governments’ incentives, such as the widely adopted feed-in-tariff scheme, where governments provide a guaranteed, above-market price for renewables producers.

Meanwhile, developing nations’ grid infrastructure and electricity transmission lines do not have sufficient capacity to accommodate this sudden surge in electricity production. The Vietnamese government, having witnessed this situation arising from their use of feed-in-tariff in 2020, decided to limit electricity production to avoid overwhelming the grid (Saur News Bureau). However, another ironic scene emerges as a huge proportion of the population remains lacking access to secure electricity supply while the government imposes a lower cap on electricity output.

4. Why lenders are turning their backs against developing countries?

When sponsoring projects in developing countries, foreign lenders and investors also dread the foreign exchange risk when converting the revenue of renewables projects from a weaker currency. This causes projects whose revenues are denominated in such weaker currencies to face potential devaluations before being converted into the lenders’ native currencies. Meanwhile, domestic financial institutions in developing markets are also conservative in underwriting renewables projects due to a loose legal framework, unpredictable revenue stream from PPAs, and variation in energy buyer structure. Given the high transaction costs and human resources required in underwriting potential loans to renewable projects, domestic lenders might be hesitant toward the huge transmission and interconnection risks that impair the ultimate distribution of electricity, hence the cash flow of these projects.

Specifically, Vietnam’s current PPA requires the sellers, who are often the legal entities that install the renewables plants, to invest in, operate and maintain transmission facilities to connect the plant with the power distribution grid, besides bearing the metering system assembly cost at transformer stations (Freshfields Bruckhaus Deringer). The risk averse sentiment among these institutions is manifested in how only 1% of total green bonds in the region have been issued for clean energy compared to the global share of 4% (Lauwerys and Tung).

On a more optimistic note, this signifies the potential for growth in green bond issuance in the region, though it requires a concerted effort by governments across ASEAN countries for a collective framework to facilitate green bond programs. Instead of retreating domestically, markets such as Vietnam and Cambodia that remain immature in adopting new financing schemes need to cooperate with more consolidated ones like Singapore who is a clear emerging leader in the green finance space. Understanding how ESG-linked products are effectively issued at a lower cost and quantity of resources in more mature markets like Singapore will also allow domestic banks in emerging markets to profit from higher returns.

5. ASEAN, let’s talk collaboration!

Collaboration in terms of technology, infrastructure and financial expertise among ASEAN countries places the region in an attractive light to renewables investors both within and outside Asia. Within ASEAN, Indonesia, Malaysia and Thailand have become leading examples by issuing $43 billion in green bonds within the past five years. Their success stems from the ability to harness the know-how and funding from the local branch of the International Finance Corporation (IFC). For example, between 2017 and 2018, the Financial Services Authority of Indonesia established the regulatory foundations for green bonds issuance. IFC helped Bank OCBC NISP become the country’s first commercial bank to issue green bonds. OCBC, a top local bank in 2018, helped kick start the local market besides launching the Indonesia Sustainable Finance Initiative. Citibank, HSBC, Dubai Islamic Bank and Standard Chartered then issued green bonds by 2021. Vietnamese banks, meanwhile, remain lagging behind with only $216 million worth of green bonds issued. Thus, countries like Vietnam can learn from the success of Indonesia and Thailand whose financial and electricity market structures are pretty similar. Merger and acquisition (M&A) movements have also allowed renewables developers and manufacturers across ASEAN to enjoy cross-selling and distribution synergies, besides increasing their chances of securing capital from foreign investors at lower costs. This will also enhance ASEAN countries’ competitiveness in attracting investment from fund managers in Europe and North America compared to other subregions within Asia.

Notably, ASEAN countries can benefit from both each other’s economic power and natural resources as they cooperate, given the diversity in economic development and unequal distribution of natural resources within the region. While it would be in the interest for emerging renewables markets like Vietnam or Indonesia to seek for the expertise and technology sharing from a renewables market leader like Singapore, an incentive for Singapore to support the former is its natural resources limitation. Specifically, Singapore does not have enough land area for large solar installations, major rivers for hydro and huge breeze power to push a wind turbine. For Singapore’s Asian equivalent — Hong Kong, imports are the only viable way to bring in enough energy to generate 30% of its electricity from renewables by 2035(Koh).

Singapore’s strong and consistent demand for renewables imports provides another source of revenue guarantee for domestic renewables developers and electricity providers from emerging markets like Vietnam. This symbiotic relationship ultimately addresses the issue of energy security. For example, countries which have actively invested in and been part of M&A activities in Vietnam and Indonesia are Thailand and Singapore, whose estimated 95% of electricity is powered by natural gas (Koh). As commodities’ prices rise with gas being costly due to the Russian invasion of Ukraine, even these countries with developed renewables financing instruments and markets are ramping up their transition into renewable alternatives to ensure sufficient energy supply.

Outside ASEAN, ASIA-focused PE funds have been active in deploying dry powder — cash and low-risk, highly liquid securities — in ASEAN’s renewable energy projects. Globally, the number of Asia-focused infrastructure funds managed by firms with mission-driven equity focusing on environmental, social and governance (ESG) policies has increased from five in 2020 to eight by 2021 (Lee). For example, New York-based firm KKR launched the KKR Asia Pacific Infrastructure Investors SCSp to invest specifically in sectors like waste and renewables within Asia. This trend presents ASEAN with a golden opportunity to tap into an increasing investment appetite for their renewables production as a region.

Meanwhile, US and Europe’s private equity tycoons can generate huge returns from filling in the financing gaps for renewables projects in Southeast Asia. Not only can they capture the huge potential market of green bonds, US-based companies and funds who acquire stakes in ASEAN renewables will profit from the high fixed price of PPAs offered by the local governments to enhance their electricity capacity. Research also suggests green bonds slightly outperform their conventional peers (for both municipal and corporate bonds), despite the warnings that such outperformance by ESG-linked products might be dampened by the war in Ukraine (Delteil). Foreign firms who might be unfamiliar with local regulations and bidding procedures can partner with local developers who complete the approval process before selling off their projects. In this way, foreign firms and fund managers with strong credit ratings and development track records can take on approved projects to execute them until the electricity generation phase. This is a win-win situation for ASEAN governments who enjoy the acceleration of their renewable production while non-ASEAN investors gain higher profit from favorable PPA terms at lower financing and entitlement costs.

REVISIT THE BIG PICTURE

The overall picture of ASEAN renewables market shows many optimistic trends that the region should exploit to accomplish its sustainable development goal of having 23% of its energy demand fulfilled by renewables by 2030 (Lauwerys and Tung). While conflict remains between financiers’ appetite for risk and the pressing demand for renewables installation and distribution in developing countries’ rural areas, integration of multisector expertise into the loan evaluation process by financial institutions will enhance the chance of novel renewables technology and business models being financed. Having perspectives of fellow ASEAN countries is crucial, given the proximity in locations and climate situation that allows for mutual understanding on infrastructure development progress. Meanwhile, more developed players outside the region like China, Europe and the US might raise concerns about the bankability of renewables projects in ASEAN’s emerging markets as they might be unfamiliar with or biased against the locals’ evolving policy framework and grid infrastructure. Still, capital source diversification is just as imperative for ASEAN instead of relying on one single country for financing. That’s why an effective model of public & private partnership needs to be built with greater consistency across the region to position ASEAN in an attractive light for foreign investors.