Rethinking the Role of Development Financing Institutions in Achieving Renewable Energy Transformation

By Jiajun Xu and Kevin P. Gallagher

According new research by the United Nations, swift and radical transformation towards renewable energy systems is needed to achieve the goal of the Paris Agreement on Climate Change, but there is a wide gap between need and delivery. In a new journal article published in Studies in Comparative International Development, we show how Development Financing Institutions (DFIs) can play a leading role in global renewable energy transformations.

DFIs are uniquely positioned to foster renewable energy transformation. DFIs are initiated and steered by governments to proactively achieve public policy objectives. According to the first global database on DFIs developed by the Institute of New Structural Economics at Peking University in collaboration with the French Development Agency, there are over 520 DFIs from about 154 countries with cumulative total assets of $23 trillion.

Currently, DFIs have focused on making individual renewable energy projects bankable to crowd-in private capital. Such a project-based approach is useful, but, alone, it is far from the scale needed to transform energy systems.

Drawing on insights from two successive focal group discussions, our study identifies four system-level constraints on renewable energy transformation and calls for a transformational approach that goes beyond the conventional project-level approach. The severity of these constraints may vary across different country income levels. The reason income levels matter is that there are substantial differences in factor endowment (i.e., labor, capital and land), energy intensity of industrial structures and production capacity of renewable energies across countries at different stages of development, which have implications for the key impediments to their renewable energy transformations.

Main findings

The first constraint is on the energy supply side: if fossil fuels predominate the existing energy mix, scaling up clean energies would encounter resistance from incumbent fossil fuel interests. Such resistance may be further be exacerbated by massive subsidies for fossil fuels. Moreover, the prices of incumbent fossil fuels are distorted downward, as countries fall short of absorbing the social and environmental costs of the production of fossil fuels. Subsidies and the lack of correction of externalities can give incumbent fossil fuel actors significant market power, which can allow the firms in these sectors to pose significant barriers to entry for clean energies.

Such incumbent entrenchment is likely to be more severe as countries move to the more advanced stages of development, as fossil fuels often play an increasingly significant role in the existing energy supply in more advanced countries.

Figure 1 and Figure 2 show that fossil fuel energy consumption as a percentage of total energy consumptions is as high as 80 to 90 percent in upper middle-income countries (UMICs) and high-income countries (HICs), whereas it is as low as 20 percent in low-income countries (LICs). By contrast, renewable energies account for the lion’s share – nearly 80 percent of total energy consumption – in LICs and 33 percent in lower-middle-income countries (LMICs) and about 10 percent in UMICs and HICs.

Figure 1: Fossil Fuel Energy Consumption (% of Total)

Fig. 2. Renewable Energy Consumption (% of Total Final Energy Consumption)

The second constraint is on the energy demand side: if energy demand is high, it would be more challenging for countries to transition towards renewable energy systems without undercutting the international competitiveness of their industries, because the price of clean energies tends to be higher, and their supply is variable. Even though recent years have witnessed rapid declines in solar energy prices and continuing reductions in the costs of wind energy, the variable energy supply may be difficult for some countries to manage owing to the lack of storage technology.

LICs and LMICs are often endowed with rich labor and poor capital and hence have comparative advantages in light manufacturing sectors. As they accumulate more capital, they are likely to move into more energy-intensive and capital-intensive industries in UMICs. As countries move to advanced stages of development, service sectors that are less energy intensive will account for a substantial share of their GDP. In other words, the energy demand may exhibit an inverted ‘U’ shape across different development stages.

Figure 3 shows that compared with HICs, energy use per $1,000 GDP is much higher in UMICs and LIMCs. If in the foreseeable future, clean energies are more expensive and variable than conventional fossil fuels, developing countries will face a significant challenge in transitioning to clean energy systems while enhancing the international competitiveness of their industries.

Figure 3: Energy Use (kg of Oil Equivalent) per $1,000 GDP (constant 2017 PPP)

The third constraint is that weak renewable energy manufacturing capacity would constrain their deployment and hinder renewable energy transformations. Given that renewable energies are relatively new, there is uncertainty about the creditworthiness of nascent renewable energy industries because they lack an established credit history. UMICs and HICs are often better positioned to make technology breakthroughs in renewable energies, as is evident in the recent innovations in solar power in Europe and the US. They must overcome uncertainties to incubate frontier renewable energy technologies. By contrast, LICs and LMICs are often price-takers because they must borrow to import renewable energies from abroad. There is evidence of a learning curve in terms of the necessary skills needed to build, operate and maintain renewable energy facilities, given that much of the technology is imported from abroad. Yet, foreign borrowing is often denominated in hard currency. As a result, some countries will suffer from foreign exchange risks and related balance of payments concerns if they try to build out their domestic renewable energy industry.

The final constraint is a lack of supporting infrastructure to make large-scale deployment of renewable energies unfeasible. Solar and wind technologies are smaller in scale versus the relatively larger fossil fuel-based technologies. Given that renewable energy is often distributed, countries may not have the supporting infrastructure for wind and solar, such as storage technology, transmission lines and integration into the larger electricity grid. This constraint is severe for both developed countries and developing countries. The nuanced difference is as follows: for developing countries, the challenge is to build new supporting infrastructure; for developed countries, the challenge is to replace old infrastructure with new.

Policy recommendations

Our study argues that DFIs can potentially address these constraints by setting a mission-driven vision, acting as honest brokers to overcome the incumbent entrenchment, scaling up renewable energy financing to make the cost of renewable energies more competitive, incubating renewable energy technologies, providing affordable long-time capital to purchase foreign renewable energy technologies and financing supporting infrastructure.

First, unlike profit-maximizing commercial banks, public policy-oriented DFIs can set a mission-driven vision for renewable energy transformations at the national or economy level. This may help to break the business-as-usual inertia to speed up the large-scale deployment of renewable energies.

Second, as honest brokers, DFIs can help to shape public policies to overcome the incumbent entrenchment challenge. As public financial institutions at the intersection of government agencies and financial institutions, DFIs can act as honest brokers to proactively shape public policies in favor of renewable energies. They can also lead by example by excluding fossil fuels from their portfolios and calculating the social costs of fossil fuels when considering projects through shadow pricing methods to induce other financial providers to follow suit.

Third, DFIs can scale up renewable energy investments to make the price of renewable energies more competitive to ensure that renewable energy transformations will not undercut the international competitiveness of energy-intensive industries in global markets. Overall investment size matters, as economies of scale can help make the price of renewable energies as cheap as—and even more competitive than—conventional fossil fuels.

Fourth, regarding the constraints on weak manufacturing capacity of renewable energies, DFIs can provide high-risk capital to help more advanced countries incubate frontier renewable energy industries. DFIs can also help provide low-cost and long-term capital denominated in local currency to help less developed countries import renewable energy technologies without undermining their balance-of-payment problems (if their domestic production capacity is weak).

Finally, DFIs can help make corresponding investments in energy transmission and distribution lines and other complementary infrastructure. DFIs can provide corresponding financing to develop transmission and distribution lines, construct industrial parks to produce renewable energies and support complementary technological innovation such as smart grids and energy storage that help facilitate the integration of renewable energies into the grid.

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Dr. Jiajun Xu is the Executive Deputy Dean of the Institute of New Structural Economics at Peking University. She is leading the first global database on development financing institutions worldwide and claiming the field of development finance by publishing articles in top finance journals. She is the initiator and co-coordinator of the International Research Initiative of DFI Working Groups and the member of the Executive Committee of the Finance in Common Summit.

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