Hydropower and the Cost of Capital – why does it matter?

A recent report by the International Energy Agency, ‘Reducing the Cost of Capital: Strategies to unlock clean energy investment in emerging and developing economies,’ shines a light on the role of the cost of capital and sets out the importance of making the energy transition affordable for most of the world’s population.

For hydropower, a mature technology with much of its greenfield potential in the developing world, this is a crucial area for minimising the cost of deployment. As a highly capital-intense technology, hydropower is particularly sensitive to the cost of capital. IEA analysis shows that an increase in the weighted average cost of capital (WACC) of one percent can result in a seven to 14 percent higher generation costs. If investor perception of risk in Emerging and Developing Economies (EMDEs), pushes up the cost of capital then these countries will be at a major competitive disadvantage in the energy transition, when their resource potential should make them green energy powerhouses.

Why is the cost of capital important? It comes down to the economic structure of renewables, including hydropower, compared with technologies that burn fossil fuels. For renewable generators, the costs are predominantly upfront: you are setting up equipment to harvest a flow of energy in the environment which comes to you for free. A gas generation plant, on the other hand, is relatively cheap to build, but you must buy the fuel on an ongoing basis as you need it – so the share of the capital repayments is a much smaller part of the cost of the electricity it generates.

Renewable developers are dependent on securing much larger amounts of capital in the form of loans or equity, and therefore the cost of doing so is a much larger factor in the cost of their electricity. Renewables’ “fuel” being free also makes them price-takers, overall, they can’t choose when to generate, while fuelled generators can set the price at which they choose to switch on, dictating the price for the market.

This report has specific recommendations for hydropower. There has been a steady increase in investment here across EMDEs, from $20bn in 2018 to $25bn in 2022, but this figure needs to quadruple to achieve the net zero trajectory. This is especially true for hydro which already provides the most power in 28 EMDEs and there is significant potential for more. The fact that it can provide flexibility and storage with low emissions is highlighted, but also that projects may not be adequately remunerated for these services. Currently the non-power benefits of hydropower, like flood management or irrigation, are not paid for, so projects do not secure revenue that reflects the services they provide.

The highly capital-intensive nature of hydro and its long lifetime therefore makes its harder to attract private capital to build it. Of all the hydropower installed globally between 2000 and 2020, 70% was publicly owned and operated. Projects in EMDE are often funded by large loans from multilateral development banks, secured against sovereign balance sheets, or financed by Chinese bodies, often tied to the use of Chinese state-owned contractors. The IEA estimates that over half of all new hydropower projects in sub-Saharan Africa, Southeast Asia and Latin America are set to be either built, financed, partially financed, or owned by Chinese firms, benefiting from the advances the Chinese have been making in the hydro sector since the development of the Three Gorges Dam. However, if there is to be the surge in hydropower development that we need, barriers to private finance more broadly will need to be reduced to access the quantity of money required.

To do this, key risks need to be tackled:

• Risks around permitting, which need to be reduced so that investor concern that delays and costs will unexpectedly arise can be allayed.

• Revenue risk, as related to increased variability in water resource due to climate change and the failure to monetise all the benefits hydro brings both within and outside the power industry.

• Offtake risk, as set out above, which has a key impact on ability to raise debt.

Fewer than 30 countries currently have policies directly targeting hydropower. IHA is working to persuade governments that it is in their citizens’ interests to have such policies, and thus to reduce the barriers to investment in this key technology.  Read the full report here.

Story by Gordon Edge, IHA Head of Policy.

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