World Development Report 2024: The Middle-Income Trap

To achieve the United Nations’ Sustainable Development Goals (SDGs) related to infrastructure and stay on track to limit climate change to 2 degrees Celsius, low- and middle-income countries will have to undertake investments of 4.5 percent of their gross domestic product (GDP) each year. Additional investments will be needed to provide safe water and sanitation, as well as reliable electricity and transport to meet the rising demand based on growing incomes.

Many of these investments can provide double dividends by enhancing living standards and mitigating greenhouse gas (GHG) emissions. For example, city developers that integrate land use and transport plans can enhance economic productivity while reducing GHG emissions. Designing buildings with emissions and energy savings in mind is likely to be more cost-efficient than retrofitting, the dominant practice in high-income countries. Similarly, scaling up investment in energy production and distribution, as well as transportation systems in low- and middle-income countries, can provide important benefits in structural transformation and economic productivity.

Considering the development and decarbonization potential of these investments, investment opportunities in middle-income countries appear to be untapped. By leveraging multilateral resources, private capital in high-income countries could alleviate the shortage of infrastructure in low- and middle-income countries, help achieve the SDGs, and contribute to economic growth, as suggested by the World Bank and International Monetary Fund, along with regional development banks.

Research conducted for this Report provides the first set of estimates on “investment potential” in renewable energy in middle-income countries by examining the expected rates of return and cost of capital. Capital costs constitute the largest part of life cycle costs in renewable energy projects. In middle-income countries such as Brazil and India, the cost of capital can even account for 50 percent of the levelized cost of energy for solar PV. For fossil fuel–based power generation, fuel costs and other operational costs make up the largest proportion of costs.

To assess whether investing in a renewable energy technology in a middle-income country would be an efficient use of domestic and foreign savings, this study compares a middle-income country’s social rate of return on infrastructure with its social rate of return on private capital and the social rate of return on foreign capital:

• If a middle-income country’s infrastructure is scarce, its social rate of return on infrastructure will exceed its social rate of return on private capital—that is, its ratio is greater than 1. The vertical axis in figure 9.6 clears such a domestic hurdle, so that to the right of the axis it is economically efficient to invest in low-carbon energy infrastructure.

• If a middle-income country’s infrastructure is scarce relative to that of a wealthier country, it becomes economically efficient for capital to move toward the middle-income country. Above the horizontal axis, the hurdle for foreign investment is cleared.

The unit cost of installing renewable energy and country-specific rates of return to capital are calculated using evidence from a new meta-analysis to derive the output elasticity of renewable energy together with data from the World Bank Private Participation in Infrastructure (PPI) database as well as country estimates from the International Energy Agency (IEA), the International Renewable Energy Agency (IRENA), the World Bank Electricity Planning Model (EPM), and renewable energy auctions. The following insights then emerge from the framework (figure 9.7):

• Quadrant I in figure 9.6 comprises countries in which the return on infrastructure clears both the domestic and foreign hurdles—that is, the minimum rate of return that an investor needs to proceed with a project. Five of 31 middle-income countries in the study pass both hurdles, including Ecuador, Jordan, and Malaysia.

• Quadrant II comprises countries in which the social rate of return on infrastructure clears the domestic hurdle but falls below the foreign hurdle. Although these countries would benefit from additional investment in renewable energy, it is not efficient for foreign savings to finance it. These countries can tap into domestic savings, and there may be a role for concessional foreign financing due to the global co-benefits in GHG reductions. This category includes 12 of 31 middle-income countries, including Brazil, Cambodia, China, Colombia, and India.

• Quadrant III comprises countries in which the social rate of return on renewable energy clears neither the domestic nor the foreign hurdle. Additional investigation is warranted for these countries. On the one hand, a country with a vibrant private investment climate (and therefore a high social rate of return on renewable energy) may be well endowed with capital in renewable energy. Thus the marginal benefit of installing another unit is not an efficient use of either local or foreign savings. On the other hand, a country may have a poor investment climate that leads to low social rates of return on private investment, even as it remains relatively undercapitalized in renewable energy.

Assess financial returns and cost of capital for renewable energy

For investments that add value in economic terms, investors—domestic or foreign—will want to know whether they can cover their cost of capital and secure sufficient revenue over an extended period to access finance on reasonable terms. Investors use the cost of capital to assess project risk. Costs vary among countries, with the spread often determining the competitiveness of renewable energy. Investment risk also varies according to type of renewable technology. Rotating equipment such as a wind turbine is prone to more wear and tear than a photoelectric system such as solar PV, thereby raising operating costs and increasing uncertainty about the costs of repairing the components of wind turbines. Country-specific and technology-specific investment risks can vary over time due to specific policy or cost changes in a technology or economywide variations in interest rates.

Before entering long-term commitments, investors consider the level of risk in a country, such as macroeconomic stability and political uncertainties. Where cash flow depends on payments from a state-owned enterprise, the credibility of the specific policy framework matters.

The cost of capital for low-carbon technologies affects the investment decisions of both financial institutions and private corporations. Data on the cost of capital in 45 countries using solar PV or wind technologies reveal that the cost of capital in middle-income countries is twice that in high-income countries, averaging 3.8 percent in high-income countries, but 7.2 percent in upper-middle-income countries and more than 8.5 percent in lower-middle-income countries (figure 9.8). The high cost of capital has material implications for affordable energy. For example, for a representative solar PV project or onshore wind project, the total cost of electricity increases by 80 percent if the cost of capital is 10 percent rather than 2 percent.

The high cost of capital in many low- and middle-income countries could increase the cost of renewables by 50 percent or more. The Energy Transition Risk and Cost of Capital Program of the Oxford Sustainable Finance Group tracks the cost of capital across equities, syndicated loans, corporate bonds, and accounting data, and it has revealed a significant variation in trends across regions. In European countries, the cost of capital for low-carbon electric utilities is significantly lower than the cost for high-carbon ones. In North America, the cost of debt and equity for low-carbon electric utilities is comparable to that for high-carbon ones. The trends in middle-income countries such as China are the opposite: low-carbon electric utilities have a higher cost of debt than high-carbon ones. In other emerging markets, such as Latin America and Asia, utilities focused on renewables are subject to a higher cost of capital. And there is a clear divide in the cost of capital between OECD and non-OECD countries, with average cost of debt in 2021 of 3.9 percent for OECD countries compared with 4.7 percent for non-OECD countries.

Accelerating reductions in carbon emissions will require reducing the cost of capital for low-carbon technologies. Addressing technology risk, development risk, and pricing risk can help incentivize investors—utilities, banks, or other institutions—to invest in renewable projects. Derisking requires a whole-of-economy approach. It depends on licensing, policy stability, and social acceptance, along with technical, market, and regulatory risks. Derisking not only makes renewable energy projects less expensive, but also reduces the amount of public finance needed to support these projects.