Building large-scale renewable energy projects requires substantial capital. A loan is therefore often needed. While necessary, these loans add an additional cost to the capital. These added costs can have significant impact on projects like wind or solar parks, or grid expansions. Hence, the cost that is add on through loans impacts the cost of electricity. This effect is especially pronounced in developing countries. The higher cost in turn hinders both socio-economic advances in the global south and their green transition.
LCOE: The price of different energy sources
When renewable energy projects are considered, the most important factor to determine the projects’ economic feasibility is the same for every kind of energy product; how cheap can the electricity be produced. The LCOE or Levelized Cost of Electricity is a measure standard that provides insight into the cost for every MWh produced. Different forms of energy production can therefore be compared. In 2009, this meant that renewable solar electricity was expensive compared to traditional fossil fuels. Luckily, recent efforts in the green energy transition reduced the cost of renewable energy substantially compared to nonrenewable energy.
Comparison of LCOE (€/MWh) for different energy sources in 2009 compared to 2019 (figure: Econopolis Strategy, Source: Our World in Data)
If the LCOE for green energy is lower or equal to the LCOE for non-renewable energy, the choice to invest in renewables is sustainably as well as economically sound. However, problems arise when we look at the financing cost of renewable projects.
Cost of Capital
Placing a wind park in the middle of the North Sea is a substantial investment for a country to make. The capital needed for multibillion euro projects needs to be lend since it is nearly impossible to pay such high amounts up front. The old saying “lending money costs money” is applicable to these kinds of projects as well, with a much higher impact than one might expect. The WACC, or weighted average cost of capital, is a measure used by developers and investors to get insights into the cost of lending a certain amount for a project. This cost of lending is called the ‘cost of capital’ (CoC) and the WACC represents a percentage of the capital that is added as an additional cost every year until the project is fully paid off. The WACC varies from country to country based on interest rates, risk premiums, type of project etc. These variations can be a few percentage points and in turn cause fluctuations in the LCOE of a project.
To give more insight into the influence of the WACC on the eventual price of electricity, the team of Econopolis Strategy calculated the LCOE for the new 2.1 GW wind park in Belgium in the Princess Elisabeth Zone with varying WACC. For a WACC of 12%, almost half the cost of the project is due to lending the money, clearly highlighting the crucial importance of this factor.
In our calculations we used an optimistic timeframe for the debt to be paid off, which means the total amount of years that is used to lend is reduced to a minimum. As can be seen in the following graph, more borrowing years result in a higher CoC and LCOE.
Consequences of WACC on developing countries
In stable and developed countries, the WACC for renewable energy is fairly low, around 5% in 2021. This allows for production of cheap electricity in a rich country. For developing countries, this is the other way around. With GDP levels far lower, they are in need of cheap electricity. At the same time, the WACC in these countries skyrocket due to high investment risks, which makes for higher LCOE’s. This is one of the main bottlenecks for a green transition in a developing country. With a WACC of 7%, Belgium can build the wind park in the Princess Elisabeth Zone for a LCOE of 86.28 €/MWh. Building the same park in Africa with an increased WACC of 12%, increases the LCOE to 135.84 €/MWh, making the produced electricity 57% more expensive. The result is that even though renewable energy is cheaper, the cost of capital negates these benefits, forcing developing countries to cling to already established non-renewable energy sources.
WACC reduction options
A sure-fire way to reduce WACC is to remove uncertainty, which is basically risk an investor is taking, out of as much variables as possible. An example could be a government establishing green policies, so investors work towards a secured future. Furthermore, having more in-depth data available of established projects so future WACCs can be estimated correctly is important. This is also crucial for developed countries: Inaccurate WACC estimates can lead to uneducated investments and policies, which in turn increases the WACC for the following project. Since data of established projects is rare in developing countries, WACCs tend to stay high. But after initial investment and profitable outcomes, as seen in Morocco’s and South Africa’s solar investments, the WACC becomes more stable and opens the door for new investments. The importance of a ‘first renewable project’ can therefore not be underestimated. Development banks could play a huge role in supporting developing countries to kickstart their green transition and create a healthy business environment. Smaller projects could also provide a more profitable LCOE since the amount of years that is needed for debt pay off reduces. Having a plethora of small successful projects might be the best way for developing countries to capitalize on their huge renewable potential.
