The Cost of Capital in Clean Energy Transitions

The cost of capital provides a critical benchmark to assess the risk and return preferences of investors and the pricing of money in the wider economy, and can act as a lever for financial flows to influence prices and choices in the real energy economy. But decision makers lack access to reliable financing metrics across sectors and geographies, especially in emerging and developing economies. Inadequate assumptions around the cost of capital can lead to the mispricing of risk, as well as the potential for under- or overinvestment in different markets and sectors, which has implications for the orderliness of energy transitions.

In this article, we seek to improve the understanding of the role of the cost of capital in energy transitions, its determinants and the ways to calculate it. The aim is to help governments better account for financing costs in policies, provide indicators that can support private investment decision making and lay the groundwork for improving future assessments.

The cost of capital expresses the expected financial return, or the minimum required rate, for investing in a company or a project. This expected return is closely linked with the degree of risk associated with a company or project cash flows. Another way of referring to the cost of capital is to talk about “financing costs” or the “discount rate”. “Hurdle rate” is also a commonly used term, though this refers to the minimum cost of funds, or internal rate of return (IRR), required to fund a particular investment, in contrast to the overall cost of funds for a firm.

At a fundamental level, the cost of capital is the sum of a base rate plus a premium. The base rate incorporates the return on an investment with low perceived default or reinvestment risk in a benchmark global economy such as the United States. The premium accounts for the risk perceptions associated with a specific investment and can be grouped in two categories: systematic and unsystematic risks. Systematic risks include those associated with the overall market (e.g. the chances of unexpected changes in the rule of law), while unsystematic are those associated with a specific sector or project (e.g. technology maturity). Systematic risks are difficult to avoid, while unsystematic risks can be managed through portfolio diversification.

The cost of capital also reflects the funding structure of a project or a company. It is calculated as the weighted average between the costs of debt and equity, where:

• Cost of debt is the interest rate (or yield) that the company, project or purchaser is able to secure from lenders (or bond subscribers).
• Cost of equity is the financial return expected by shareholders in exchange for providing capital; it is also referred to as the expected return on equity.

Unlike interest on debt, there is no commitment from a company or a project to repay equity to shareholders, who accept to take on higher risks in exchange for higher rewards in the form of dividends and capital appreciation. Debt providers have primary claim on assets in the case of solvency issues, while equity shareholders have a residual claim. There can also be considerable variation within each of these instruments. For example, lenders may provide convertible debt, which takes on characteristics of both debt and equity.

The calculation for the cost of capital for an investment is commonly expressed as the weighted average cost of capital (WACC), or

Estimating the cost of debt can be done by adding a base rate (e.g. benchmark lending rates of commercial banks) and a premium, which reflects the credit risk associated with the borrowing company or project cash flows. Another indicator can be derived for the cost of debt by dividing a company’s interest payments over total debt. Traditionally, the cost of debt (and cost of capital) is expressed on an after-tax basis as interest payments are tax deductible.

Estimating the cost of equity can be more challenging, given confidentiality around returns data as well as the large diversity of shareholders, with different expectations of returns on equity. The capital asset pricing model (CAPM) is a common assessment method, yet is prone to shortcomings around the availability and comparability of underlying data components. The CAPM is expressed as

While many of the building blocks to estimate the cost of capital are available through financial markets reporting (albeit often via subscription-based services), the coverage and comprehensiveness of metrics can vary widely, especially in emerging and developing countries where financial markets are less developed, as well as for project-level investments and consumer purchases.

Analysts often need to use a combination of methods to make estimates, including from financial and non‑financial sources. At the market level, this includes financial reporting (e.g. on equity performance, capital structure) from publicly listed companies. At the project level, this can include using the observed transaction prices of competitive procurement processes, such as auctions, to estimate the implicit cost of capital, as well as consultations with market experts.1

Macroeconomic data provide an indication of how the cost of capital has evolved over time. Benchmark government bond yields have fallen across many economies in recent years, on the back of more accommodative monetary policy, a trend which continued in the second half 2020 despite an uptick during the height of the Covid-19 crisis. As a result, economy-wide debt financing costs have broadly come down. Equity market risk premiums have also fallen in many countries. In 2021, market trends point to somewhat higher levels, however, as bond yields in global benchmark economies, such as the United States, have crept upwards in response to inflation pressures.

However, the economy-wide cost of capital remains quite different between groups of economies. When looking at the value of government base rates plus a broad market risk premium (to proxy corporate or project risk), nominal financing costs can be up to seven times higher in emerging and developing economies compared with the United States and Europe. Country-related risks and underdeveloped local financial systems account for much of this difference, which can be even greater in riskier markets and segments.

Different energy sectors will have different capital structures, making them more sensitive to variation in the cost of either debt or equity. Power investments typically rely on high levels of debt, which reflects the fixed element in cost and revenue structures, especially for renewables and grids. Some end-use sectors rely on debt financing, such as efficiency in commercial buildings, residences financed with green mortgages and electric vehicles purchased with car loans.

Still, equity tends to play a more dominant role in financing smaller transactions in cases where credit is constrained (e.g. consumers and small businesses) and for technologies with higher risks (e.g. low-emissions fuels). Investments in advanced economies typically have better access to debt. The share of debt to finance the investments in IEA climate-driven scenarios rises over time, but equity remains critical to kick-start investments in emerging or riskier segments.

Taking into account the indicators above, as well as additional assessments of risk premiums, the IEA World Energy Model incorporates differentiated cost of capital assumptions across regions and sectors. Inputs are expressed on a real, pre‑tax basis.

In power generation, the cost of capital for utility-scale solar PV and onshore wind range from 3-6%, depending on the region, while offshore wind is assessed at 4-7%. In end-use sectors, baseline cost of capital assumptions can be much higher and vary widely within buildings (5-25%), industry (4-15%) and transport (4-15%), reflecting the differentiated nature of investors and assets (from households to large corporations) across regions

To illustrate the importance of changes in the cost of capital, the IEA has examined solar PV projects in four leading markets (the People’s Republic of China [hereafter, “China”], Europe, India and the United States), using market- and project-level data from financial and non‑financial sources as described above. The analysis explored how the financing costs for utility-scale solar PV projects evolved over the last few years.

We found that a combination of strong policies, underpinned by revenue support mechanisms, and improved technology maturity helped reduce financing costs for solar PV projects by 15-30% between 2015 and 2019. The WACCs for new projects stood at 2.6-5.0% in Europe and the United States in 2019 (in nominal terms after tax), 4.4-5.4% in China, and 8.8-10.0% in India. As shown in the table below, lower WACCs were associated with projects in countries with lower systematic risk and more creditworthy off-takers.

The WACC can account for 20-50% of the levelised cost of electricity of utility-scale solar PV projects, so lower financing costs are critical for the affordability of energy transitions. Growing market experience and competition can continue to help drive down financing costs, as well as measures to manage project-specific risks. For example, better management of volume risk associated with curtailed solar PV output – as a result of operational and infrastructure improvements – also helped reduce WACCs in China. On the other hand, growing inflation could put upward pressure on WACCs if central banks increase long-term benchmark interest rates. For example, Brazil and the Russian Federation have increased interest rates various times in 2021.

Financing transitions in emissions-intensive industry will require investments in new technologies and attracting capital at scale in cement, chemicals and steel. Many of the industrial technologies needed to meet long‐term net zero emissions goals remain at early stages of market readiness, and transaction sizes tend to be small, making it challenging to attract project finance from banks. In IEA climate-driven scenarios, emissions reduction initiatives over the next decade focus on improving the efficiency of industrial equipment – as well as fuel switching, mainly to electricity and bioenergy but also to natural gas in areas where cleaner energy cannot yet be deployed on the scale needed. In parallel, transitions need to focus on laying the groundwork for a rapid scale-up of low-carbon liquids and gases, including hydrogen, as well as carbon capture.

While equipment providers and developers play an instrumental role, most investments depend on industrial company balance sheets, as investors or counterparties. The cost of capital for cement, chemicals and steel companies has broadly fallen in recent years, creating an opportunity to finance clean energy investments more affordably. Their ability to raise funds at relatively low cost suggests that participation of large industrial companies is likely to be crucial in anchoring early commercial‐scale projects incorporating new technologies, such as low-carbon hydrogen; carbon capture, utilisation and storage; and the development of shared infrastructure around industrial clusters.

However, important differences remain between regions, with emerging and developing economies (outside of China2) facing financing costs twice the level of advanced economies. Heavy industries are subject to cyclicality in profitability and exposure to wider credit markets, and the value proposition for investing in clean energy is not yet clear. The crucial uncertainty is the extent to which policy makers, consumers or investors assign value to cleaner production technologies, as well as the potential role of public finance (e.g. development banks) in helping to de‑risk new projects.

Addressing the risks and other factors that shape investment decisions is essential for financing clean energy transitions at scale. An appropriate assessment of the cost of capital has important implications for the type of public support required to achieve this, as well as impacts on social welfare.3

Governments will play an important role in ensuring effective risk management, whereby risks are allocated to the parties best equipped to manage them. Policy support in the form of revenue stability (e.g. via contracting mechanisms) or other guarantees is often instrumental to enhance clean energy project cash flows, reduce financing risks, and kick-start private investment in new markets and sectors.

Calibrating such efforts around a cost of capital measurement that accounts for evolving economic conditions and risk perceptions is critical to ensure that investors are compensated appropriately. Policy makers also need to take into account a range of financial performance metrics. Comparing cost of capital with profitability measures, such as return on invested capital, can provide a more complete view of an industry’s ability to create shareholder value, which is a driver for investment decisions.

There are particularly wide knowledge gaps in making such assessments in emerging and developing countries, as well as in newer technologies and sectors that lack a track record with financiers. The reasons include less developed financial markets, lower availability of historical data (e.g. in markets where there are relatively few publicly listed companies focused on clean energy), lack of transparency around sector and project-level risk premiums, and fewer existing projects.

Further efforts to improve the collection and assessment of data related to the cost of capital, as well as heightened awareness among policy makers, are critical to support better decision making. The IEA is working with partners – Imperial College Centre for Climate Finance and Investment, ETH Zurich and the World Economic Forum – on ways to enhance these efforts in emerging and developing economies, including through expert surveys and other analytical tools.