Executive Summary
In this paper we propose a novel approach to financing emerging countries’ transitions toward cleaner energy production. We believe a significant opportunity exists across two dimensions: greenhouse gas (GHG) emissions reduction and investment returns. Using insights from what in 2024 is thirty years of experience in emerging markets fixed income investing, our approach aims to facilitate the goal of energy transition that is consistent with sovereign net-zero commitments, while also offering attractive investment attributes relative to developed market (DM) fixed income analogs.
Introduction
Emerging market (EM) countries in aggregate contribute disproportionately to global GHG emissions because a substantial portion – approximately 80% – of the installed electricity generation capacity in these nations still relies on non-renewable, fossil fuel-based sources (coal, gas, and oil-based derivatives). To approach the net-zero goal of reducing global emissions by enough to prevent a temperature rise of more than 1.5 degrees Celsius, this non-renewable installed capacity needs to plummet to around 30% within the next 10 years. 1
The energy transition imperative arrives at a time when EM countries are still to varying degrees trying to catch up with their DM counterparts with respect to electrification. Chile, for example, is 50% of the way to renewable electrification currently, while South Africa has progressed less than 5%. In aggregate across EM, with growing populations, increased incomes, and electrification of mobility, an estimated 3,000 GW in capacity is already needed vs. a 1,500 GW installed capacity. Then, there is the need to “green” this 1,500 GW installed capacity. Altogether, this 4,500 GW demand, coupled with a $2.5 billion/GW estimated build cost, 2 translates to an $11 trillion funding need. So far, EM governments have only budgeted $4 trillion, resulting in a $7 trillion shortfall and thus leaving a significant role for the private sector to play in bridging the gap. 3
We believe a thoughtfully chosen investment universe can take investors a long way toward maximizing the energy transition impact of their allocation, therefore it’s important to understand the forces that drive the energy transition process from the top-down (sovereign) and the bottom-up (asset level). Globally, sovereigns influence companies’ contributions to net-zero goals from the top-down through regulation. In emerging countries specifically, most of the net-zero agenda will be carried out by the state-owned enterprise (SOE) utilities and financial institutions, as well as privately sponsored corporations and projects with government contracts (a well-trodden risk-sharing framework better known in DM as “Public Private Partnership” or “PPP”). Thus, EM sovereigns wield tremendous influence on the overall EM energy transition.
Getting to net zero: The sovereign view
Exhibit 1 depicts the anticipated electricity generation across all EM sovereigns consistent with their net-zero plans. By 2050, an estimated 20% of the energy mix is still slated to originate from fossil fuel sources, reflecting the pragmatic nature of these transition strategies in a developing country context. Importantly, the current fossil fuel assets cannot be dismissed with regard to the dual objective of electrification and greening of the existing capacity, while also filling residual energy supply gaps left by renewable sources with intermittent generation profiles, thus ensuring grid stability. This is especially true considering the relatively low carbon footprint of these assets in practice, since by definition, “grid stability” assets are designated by the government and will operate on the basis of an availability-based power purchase agreement (PPA), turning on infrequently to burn their carbon-heavy fuel sources and essentially being paid for being on standby 80-90% of the time. Thus, an EM energy transition strategy should mimic the sovereign plan in adopting an “all-of-the-above” approach to investment universe inclusion, rather than eliminating fossil fuel assets altogether.
However, not all sectors possess equal potential for transition and impact. Sectors such as electric utilities stand a formidable chance of reshaping their enterprises into renewable entities. Conversely, entities like oil explorers, while they may enhance sustainable oil extraction practices, face greater challenges ahead. Fortunately, utilities, 40% of GHG in EM currently, can be transformed to hit their carbon neutral targets in the next three decades, 5 making them an ideal foundation for an investment universe. Our ongoing discussions with clients reveal that some investors favor sector-level diversification, while others are comfortable with sector-level concentration given the country-level diversification, a gift EM debt markets offer to us. An expanded universe would look at other sectors that have a heavy consumption carbon footprint and can plausibly transition in an economic way: transportation, infrastructure, and select commodities (e.g., metals and mining). We exclude oil and gas and coal mining because we find the technological viability of a meaningful transition to be low and the operations themselves contribute a relatively modest amount of GHG emissions (we believe that it is the consumption of their product by other sectors that generates the emissions). Financial institutions also play a role, providing investors with access to energy transition asset exposure in jurisdictions with limited availability of public or private investment opportunities.
Currently we estimate that there are just shy of $300 billion in investable public securities outstanding (see Exhibit 3), of which nearly 80% is investment grade. BB-rated issuers account for most of the rest and, as we will detail later, may see upward ratings bias. Further, private market exposure (direct lending) expands this opportunity set by at least a factor of 2x, by our rough estimates. With the $7 trillion funding gap cited earlier, it’s clear to see how this is going to be a growing investment universe.
Measuring an EM energy transition strategy’s transition success
Given that we believe sovereign governments drive the investment universe, we also believe they are the correct “unit” to measure transition success (albeit not the optimum level at which to finance the transition from an impact lens). To illustrate, consider the following two SOEs:
- A state-contracted coal company, Mong Duong in Vietnam, that will forever be a coal company until it is phased out as part of the sovereign’s overall plan; and
- A state-owned oil and gas company, Ecopetrol in Colombia, that acquires ISA (Interconexion Electrica), an electricity transmission company, diversifying its business mix in a “green” direction.
Both SOEs ultimately report to the sovereign shareholder, and both play a role in their respective sovereign’s plan. All else equal, Mong Duong over time will contribute to the Vietnam’s net-zero plan as it is phased out, consistent with Exhibit 1. By contrast, Ecopetrol has not yet contributed to the sovereign’s net-zero plan; it has simply changed the corporate ownership of two SOEs.
Note that other investment strategies may take an entirely different view about these two companies. A coal generation plant would likely be considered uninvestable, either because of ESG restrictions or because it could be considered a “stranded asset” (an asset whose residual cash flows are insufficient to pay back capital providers in full). An SOE, on the other hand, given its government ownership or contracts and place in the overall net-zero plan, can be a good investment right up until the moment the lights are turned off with no stranded asset risk – this is an empirically proven phenomenon which underpins our investment thesis in these entities across many different sectors and countries in EM. 6
Ecopetrol, on the other hand, may see an improved ESG score given its new business mix, even though nothing relevant to the country’s net-zero plan has occurred. Measuring overall sovereign net-zero transition progress is misplaced, therefore, when judged at the company level and should therefore be done at the sovereign level.
The investment case (and the case for GMO’s proposed investment solution)
The EM debt energy transition investment universe is both a growing one and one with attractive investment attributes. We cite three:
- A net-of-loss spread pickup relative to developed market corporate alternatives across the credit spectrum, reflective of liquidity, complexity, and EM-specific exposures.
- The potential for active managers within the universe to harvest additional credit spread compression returns by identifying entities with unpriced energy transition plans. This requires thorough fundamental analysis and cannot be achieved using ESG or other scoring.
- A high credit quality, diversified opportunity set (investment grade on average) that allows asset owners to fund from their DM credit allocations with contained tracking error implications and a higher Sharpe ratio.
First, it’s important to understand that EM corporates, including quasi-sovereigns and project finance/infrastructure, historically have displayed a lower default intensity and loss relative to DM corporates across the credit spectrum. Exhibit 3 walks through a comparison of the EM debt energy transition opportunity set vs. U.S. corporates across the credit spectrum, from AA to B rated. The table shows current spreads by ratings bucket, then an expected credit loss for each bucket. This expected credit loss uses historical credit transition experience and average recovery values from the rating agencies for the two universes (EM infrastructure vs. U.S. corporates). 7 Notice that across the ratings spectrum, spreads are higher in EM and expected losses are lower, resulting in the higher net-of-loss spreads seen in the last column. These range from 23-25 bps for AA/A rated, to 123 bps for BBB rated, to substantially higher for junk rated. Why is this? We note (1) structural and contractual enhancements of infrastructure credits (e.g., covenants, collateral, minimum revenue guarantees and contract termination compensation, etc.); and (2) contingent government support, mostly from IG-rated sovereigns, that over time has prevented idiosyncratic default incidence.
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