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Can emerging market transitions survive Covid-19?

Credit rating downgrades are putting pressure on many developing economies, threatening the further progress of their energy transitions

Across the world, appeals are getting louder to ‘build back better’ and deploy once-in-a-generation stimulus packages to support sustainable development and cleaner energy value chains. But at the same time, policymakers in emerging markets (EMs) such as Turkey and India find themselves fiscally overstretched and having to assuage the concerns of creditors.

While a weakening dollar in recent months has allowed EM dollar debt spreads to recover, it is unclear if, in the wake of the pandemic, governments will rein in clean-energy subsidies to balance the books. And, in addition, whether lenders will price in greater risk against power projects dependent on government solvency.

Ratings agency Fitch Ratings revised its outlook for Turkey to negative on 21 August. The energy-hungry country with a population of 82mn is a renewable energy exemplar among its EM peers, with a liberalised electricity market generating 46pc from renewable resources in 2019, higher than the 17pc of the US and equal to Germany. 

46pc – Renewable power in Turkish energy mix

The downgrade was just the latest in a series of impairments to EM forecasts in the wake of the Covid-19 pandemic. In June, Fitch changed its outlook on India’s long-term foreign currency issuing from stable to negative. The world’s fifth-largest economy by nominal GDP is also one of the most ambitious EMs in terms of renewable energy capacity expansions and energy mix targets, and by all accounts has responded to the shattering impact of the pandemic with relative fiscal restraint.

Nevertheless, an “unprecedented crunch” in fiscal resources will weaken the government’s resolve to maintain previous levels of support for the renewable energy sector, according to a joint report by NGO International Institute for Sustainable Development and Delhi-based research institute CEEW. It is a concern that could realistically come to the fore in a number of EMs.

Credit risk

By the mid-point of the year, Fitch had downgraded 33 sovereign ratings—a record number—while also placing the credit ratings of a further 40 countries or sovereign entities on a negative outlook.

National responses to the pandemic are causing a deterioration in sovereign financial positions, according to Fitch’s global head of sovereign ratings James McCormack. Larger deficits, or at least smaller surpluses, in the government budgets—and therefore an increase in debt—are likely consequences over the short- to medium-term.

Those initial fears were also felt by holders of EM sovereign debt. In early April, EM credit spreads versus US Treasuries were at similar levels to those seen at the height of the global financial crisis.

Analysts feared that the textbook risks to EMs and frontier markets—of political instability, challenges in debt refinancing and currency depreciation against the dollar—would be exacerbated by lower economic activity, including falling rents from commodity exports, tourism income and remittance flows.

Most of these fundamentals are still in play. The IMF anticipates that EM economies will contract by 3.2pc this year, it writes in the June edition of its World Economic Outlook Update, the sharpest drop for this group on record. The outlook for oil-exporting EMs is bleak, with oil futures through to 2023 having been traded at 25pc lower than 2019 average prices (i.e. below $45/bl).

For now, however, market fears of EM sovereign (and corporate) default seem to have been allayed by a weakening dollar. The dollar Index dropped 4.1pc in July, the biggest fall in ten years, and EM dollar debt has been among the beneficiary asset classes.

Fiscal space

Short-term dollar trends aside, the long-term outlook is of greater importance for infrastructure investors. The IMF has sounded the alarm on what it calls “a worrisome lack of fiscal space”, having assessed that one-third of EM economies have limited or no room for discretionary fiscal policy in the event of a prolonged crisis. Debt sustainability is a major concern. The average gross debt-to-GDP ratio of EMs was 52.4pc at the end of 2019 and has undoubtedly deteriorated since, although this is by no means the worst ratio among country groupings (G20 gross debt-to-GDP was 90.4pc).

At the global level, the IEA recognises that government support will be critical to avoid a slowdown in renewable energy capacity expansion, impacting everything from rooftop solar PV installations for businesses and households to utility-scale assets.

Taking into account the negative impact of the Covid-19 crisis, the IEA’s updated forecast for renewable electricity capacity additions sees India and Brazil on course for slower capacity growth than 2019. In the case of Brazil, 8.3GW of new renewable energy capacity was added in 2019, and the IEA expects this to drop to 2.6GW this year, with a small rebound in 2021 (3.4 GW). Compared to Europe’s decline in capacity growth of 33pc, Brazil’s 75pc is stark and India’s subsidy trajectory has in fact been negative for the past three years.

The importance of subsidies to the continued commercial viability of renewable energy projects that do not have combined storage capacity—i.e. the vast majority—was illustrated by management consultants Oliver Wyman in a January report.

The global policymaking and financial order is united in the cause of climate action and the mandate to ‘build back better’

The intermittent nature of renewable power generation makes for unpredictable output, pricing and cashflows, which means these operations will typically receive a lower overall market price than the average generator. Volume-based subsidies have, up to now, dealt with the problem, ensuring that lenders can forecast cashflows against the feed-in tariff and are willing to deliver tenors to match the subsidy period.

The evidence is that, without subsidies, investment appetite falters. In China, for example, new solar installations in 2019 were down nearly 40pc on the previous year, as subsidies on centralised solar projects were eased.

Cautious transition

South Africa provides a cautionary tale for utility-scale asset operators. The country is one of only two EMs on the African continent, according to investment research firm MSCI’s 2020 classifications. In the short term, a decline in power consumption and the resulting spare capacity in the system have led state-owned utility Eskom to cease procurement of electricity from wind-based independent power producers (IPPs).

Over the longer-term, Fitch Solutions analysts warn that the utility's ability to fund new power projects, including the continuation of its Renewable Energy IPP Procurement Programme, could be severely impaired. Even before the virus hit, the government’s budget deficit was already on course to reach a three-decade high of nearly 7pc of GDP by 2021, indicating the fiscal squeeze ahead. Turkey, Chile and Brazil among other EMs face similar fiscal dynamics.

EMs will survive the buffeting of the current crisis one way or another, just as they did the global financial crisis. But, more than in 2009, the global policymaking and financial order is united in the cause of climate action and the mandate to ‘build back better’.

Although banks and funds will understandably consider the resilience of sovereign-backed power-purchase agreements from the vantage point of tighter fiscal conditions all round, hopefully the result will not be fewer renewables projects being financed. Greater focus on technology and execution efficiency is needed, as is another look at the indirect subsidies from which fossil-fuel-based power operators benefit.

 Joel Sam is a researcher and author on the topics of sustainable finance, African trade and the energy transition

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