As the dust settles on COP29 in Dubai, a list of new commitments unveils themselves. Among these commitments are tripling renewable energy (RE) capacities in developing nations by 2030 and upended financial assistance for them to accelerate clean energy transition. Far away from Dubai, a critical decision is taken inadvertently that can upset these ambitions.
Central Banks on both sides of the Atlantic have adopted a proactive stance to control inflation by increasing interest rates. This has resulted in skyrocketing capital costs that inadvertently disrupt the progress of the transition, especially in developing nations, where the cost of capital is ~2-3x of advanced economies and/or China. The clean energy transition is heavily dependent on the installation of new infrastructure and, therefore, highly susceptible to interest rates, affecting not just RE but also other critical sectors like electric vehicles (EVs), green hydrogen (GH2), and allied industries. All these technologies heavily rely on low-cost capital to compete with fossil-fuel-intensive energy systems and make them affordable to scale up their adoption.
A significant challenge arising from escalating interest rates is the disproportionate impact on the cost of RE projects compared to traditional fossil-fuel power plants. Since these projects are heavy on Capital Expenditure, rising interest rates significantly increase their costs, especially the cost of debt capital for both greenfield initiatives and refinancing of existing ones.
For instance, rising interest rates increase the cost of borrowing for entities that rely on foreign capital, compelling them to absorb this increase in capital costs or halt investments in green assets until interest rates show a meaningful decline. Given the shorter tenure of debt financing in RE compared to similar industries, business entities in developing nations find themselves in a position where they have to refinance projects at higher rates—a scenario that’s undesirable yet inevitable. Besides, on the macroeconomic level, capital outflows from developing to developed countries to take advantage of higher interest rates in the latter countries also increase developing countries’ sovereign risk by burdening them further on their debt servicing ability.
The International Energy Agency (IEA) has acknowledged the adverse impact of high-interest rates, expecting a pause in RE projects addition in 2024. Similarly, Bloomberg New Energy Finance (BNEF) predicts a decrease in RE investments in 2024, marking the first decline in five years. The repercussions, however, extend beyond RE to encompass electric vehicles and allied sectors like charging infrastructure. Higher borrowing costs dissuade households and businesses from purchasing capital-heavy electric vehicles. Furthermore, ancillary green technologies such as green hydrogen (GH2), transmission and distribution lines, and charging stations, need low-cost debt capital for deployment. In addition, small and medium-sized companies could postpone their plans to invest in low-carbon technologies that include rooftop solar, off-grid solar infrastructure, and energy-efficient technologies. Corporations may also postpone their plans to raise new debt capital or scale down their capital expenditure in clean technologies, further delaying the progress of the energy transition.Another key channel of disruption is the movement of foreign investors to developed countries due to attractive, low-risk treasury returns. Such movements divert capital away from developing countries and limit capital for green projects. It also exerts pressure on local currencies, making domestic borrowing expensive and unaffordable. Besides, the lower availability of capital also leads to further increases in the cost of domestic capital, reducing both the bankability and profitability of projects like RE. Moreover, it increases the credit default risk on existing renewable energy projects. An increase in the risk of default may lead to a lower rating of these projects, which signals domestic banks, investors, and FIs to be cautious of such projects, cutting off access to both the banking system and capital markets.
Finally, rising interest rates also cast a shadow on equity investment returns in existing renewable energy projects, diminishing investors’ appetite for new projects. The rising cost of debt drives up the cost of equity investment as well, potentially rendering several projects unviable, at least in the short term, reducing the attractiveness of critical sectors. The increase in both equity and debt costs increases the cost of service delivery/operation, e.g., the levelized cost of electricity (LCOE) for RE, and triggers the risk of uptake/offtake/adoption.
In sum, the combination of rising interest rates and access to affordable financing poses significant disruption to the clean energy transition in developing countries through three major channels. First, it delays the progress of the transition by obstructing the deployment of critical technologies. Second, it deters both consumers and businesses from adopting such technologies who see them as significantly expensive, at least in the short term. And finally, it diverts critical capital away from such technologies, both from domestic and foreign sources.
Overcoming these obstacles will require innovative financial solutions, international cooperation, and a renewed commitment to sustainability through meaningful public intervention. Innovative financial solutions that can mitigate the risk of high interest rates could be interest rate swap options. However, these could be expensive for borrowers in developing countries. Here, international cooperation is required to subsidize interest rate swap options to make them affordable. In the short term, till interest declines substantially, international institutions must expand their financial support to developing nations as quickly as possible to keep the energy transition on track.
