Capital Allocation Shift In 2023: Global Financial Changes Impacting World Energy Investment

Meeting the targets for sustainable development, climate, and energy security will require a substantial increase in capital investment in energy. As these investments scale up globally, understanding the trends affecting capital allocation decisions across various finance providers becomes crucial. The World Energy Investment report provides an overview of current financing trends and distinguishes between investment – capital expenditure used to build or acquire an asset – and finance, which includes the origin of the funds supporting an investment, its form, and its providers.

Within the energy finance ecosystem, capital providers such as governments, households, and the private sector (sources of investment) are distinguished from finance providers, including development finance institutions and other public and private capital sources (sources of finance). The report explores emerging themes like transition finance and how transition plans by financial institutions and corporations can support capital access for hard-to-abate sectors. The roles of carbon markets and carbon pricing are also discussed.

The year 2023 saw a spike in interest rates across many countries, reversing the trend of low inflation and low interest rates that followed the 2008 financial crisis. While the pandemic initially drove interest rates lower, inflation pressures in 2022 changed this trajectory. Geopolitical conflicts, such as Russia’s invasion of Ukraine, increased political risks and drove up the cost of capital. Interest rates on long-term government bonds rose in many countries, except China, which maintained low rates due to low economic growth and property sector weaknesses.

Sharp increases in US interest rates significantly impacted global capital investments, especially in emerging markets and developing economies (EMDE). These economies face higher capital costs due to perceived investment risks. Higher interest rates increase borrowing and equity costs, making it difficult to generate attractive risk-adjusted returns for capital-intensive clean energy technologies.

Despite policies, technological advancements, and declining costs offsetting some capital cost increases, high interest rates and a stronger USD are unfavorable for investments. In China, low inflation pressures have allowed for low benchmark lending rates. However, elsewhere, signs indicate that high interest rates may not persist, with the US Federal Reserve planning rate cuts in 2024.

Since 2016, clean energy’s share of total energy investment has increased, with private finance sources comprising the bulk of spending. Public financing plays a larger role in EMDE, but mobilizing private finance in these markets is essential due to high debt-to-GDP ratios. Government investment in global energy assets has remained stable, with significant involvement in fossil fuel asset ownership.

Household investments have increased, driven by rooftop solar, energy efficiency, and electric vehicles. However, affordability and cost-of-living concerns may hinder future investments. Capital structure stability is crucial for the energy transition, with debt playing a significant role, particularly in clean power projects. Reducing debt financing uncertainty is vital, especially in EMDE where equity supply limitations hinder bankable project development.

Sustainable funds rebounded in early 2024, but 2023 saw challenges for sustainable investment practices, including net outflows and growing concerns over fund classifications. Despite these challenges, sustainable funds increased in value, driven by a rally in growth stocks. The pushback against ESG in the US impacted sustainable funds, with some asset managers withdrawing from Climate Action 100+.

The banking sector is navigating tighter climate disclosure regulations while ensuring economic growth isn’t hindered by restricted sector financing. Banks play a crucial role in energy financing through debt financing and sustainable loan products. Domestic financial institutions in emerging market and developing economies (EMDE), lending in local currency, are vital due to currency risk concerns. New mechanisms are emerging to tap domestic capital sources, such as Nigeria’s InfraCredit mobilizing pension fund investments.

Development finance institutions (DFIs) are critical in catalyzing investment flows towards sustainable energy infrastructure in EMDE. DFIs provide policy support, capacity building, and concessional capital to de-risk projects and mobilize private capital. While China’s DFI financing has decreased, other DFIs have remained constant. Increased DFI participation is seen, with new pledges and financing mechanisms emerging to support green investments.

The report highlights the need for DFIs to mobilize private sector investments, particularly in lower-income countries, to meet investment goals under the Net Zero Emissions (NZE) Scenario. Effective utilization of DFI capital to de-risk private investments is essential for sustainable development and energy transition.

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