Potential of Lower Costs of Capital for Faster Decarbonisation in Developing Regions

Executive Summary

While some clean energy solutions like solar photovoltaics are already cost-effective, many others represent a premium to fossil-fuel alternatives. The spread in prices can be bridged via carbon pricing or bypassed via other instruments such as renewable mandates.

In the cases where there is no explicit carbon price (either a carbon tax or market price determined through an emissions trading scheme), a growing number of entities use internal carbon prices (also colloquially called shadow carbon prices, though the technical meaning of a shadow price differs) to guide investments and decision-making. These are self-chosen and non-transacted (purely internal) carbon prices that are deployed either for societal benefit or, more traditionally in corporate settings, in anticipation of future high(er) carbon prices. These ostensibly prevent future stranded assets.

Similar to widely used internal carbon prices, this paper proposes the formal use of an analogous internal (and in this case lower) finance rate for choosing clean energy and low carbon infrastructure projects. While lower financing rates (cheap capital) are important for all infrastructure, traditional planning misses the dynamic nature of costs of capital (finance rates). Not only have these rates fallen over time, sector-specific rates will further drop as the sector matures. Planners may also not anticipate global finance that can step in post-facto (after the investment is made) and fill the gap between an internal finance rate and the initial project finance (market or equilibrium) rate.

Using the example of choosing to build a conventional coal power plant versus deploying solar power with a battery, we compare both instruments—internal carbon pricing and internal finance rates—to show that while both can be used to create a cross-over from conventional to cleaner energy, internal finance rates have several advantages.

Fundamentally, internal finance rates lower the project cost instead of raising the price like a carbon
tax would. Secondly, these can rely on markets and the private sector and not just the government.
Lastly, these would apply to the entire project capital costs (which are the bulk of costs for clean energy solutions) and not just fuel costs for fossil projects under a carbon tax.

This framework also aligns with global finance which is focused on emissions mitigation disproportionally through deployment of clean energy solutions. The spread in finance costs between domestic rates in developing countries and lower ones required to make clean solutions competitive can translate to global aid, other funding, or secondary risk-reduction instruments such as insurance, counter-guarantees, discounted foreign exchange hedges, etc.

Could global support pay the equivalent of a carbon tax? This appears unlikely for multiple reasons.
Could global aid directly subsidise clean energy projects? The track record hasn’t been encouraging.
This framework is a special form of support that lends itself to lowering costs in the long-term because the finance rate spread (and, thus, support required) will decrease as projects and the industry mature, independent of learning curve and technology improvements over time. The first part of this framework is the use of internal finance cost pricing for decision-making. The second part is conversion of the internal finance rates to actual finance rates, which can benefit from global support. Even the exercise of estimating the finance rate reductions required for over the crossover to clean solutions and the commensurate scale of funding is itself a useful exercise.

Given the capital-intensive nature of clean-energy solutions and the high rates of interest prevalent
in developing countries, such an instrument could help avoid substantial future emissions.