Research

 

The Macro Picture: What Makes Power a Compelling Sector for Investment? 

The rise of emerging markets over the last two decades has had a transformative impact on the world economy. According to the International Monetary Fund, from 1995 to 2015, emerging markets’ aggregate GDP in purchasing power parity terms has increased from US$16 trillion to US$64 trillion, while their share of global economic output has risen from 41% to 57%.1 Sustained aggregate economic growth has brought hundreds of millions of people into the middle class and fueled increased demand for reliable and affordable electricity to produce basic consumer goods and industrial staples, as well as to light, heat and cool homes. Laird Reed, Senior Investment Manager at IFC Asset Management Company (AMC), illustrates the drivers behind the rise in power demand in emerging markets: “As countries grow from low-income to middle-income and the middle class starts growing, the very first thing people do is start buying appliances, televisions, more lights and bigger houses; these are all driven by power.” With the public utilities that dominate the sector in many emerging economies unable to keep pace with current electricity consumption patterns, let alone future demand, the need for increased private investment in the sector is clear.

Existing power infrastructure in emerging markets in many cases fails to meet the present and future needs of consumers and businesses. According to the International Energy Agency (IEA), as of 2012, 1.3 billion people in developing countries still lacked access to electricity, with most of this population concentrated in Africa and Developing Asia (see Exhibit 1).

Even where grid connections and generation assets do exist, substantial upgrades in capacity are needed to enable the new middle class to consume more energy-intensive goods and services. While total installed electricity generation capacity in emerging markets recently surpassed the total for developed markets, due in large part to the rapid build-out of power infrastructure in China over the last 15 years2, existing per capita consumption levels remain low across all major EM regions.

Looking forward, this problem will only grow in magnitude. According to the IEA, electricity demand in nonOECD markets is projected to grow three times as fast as in OECD markets through the year 2035. Annual projected demand growth in Asia, Africa and the Middle East exceeds 3% and ranges as high as 5%.

On top of capacity constraints, many countries are plagued by inefficient markets and obsolete or otherwise marginal power generation, transmission and distribution assets that incur substantial economic costs to residents and businesses. In Pakistan and Nigeria, for example, businesses lost 22% and 12%, respectively, of their aggregate revenues to power outages in 2012.

Existing government policies are likely partly to blame for these poor outcomes. Vertically-integrated, state-owned utilities dominate the power sector in a majority of emerging markets, and they are often legally obligated to offer subsidized electricity to businesses and residents, putting tremendous strain on state finances and discouraging investment in efficiency and new capacity by distorting the cost of power. Cyrille Arnould, head of the Global Energy Efficiency and Renewable Energy Fund (GEEREF) within the European Investment Bank (EIB), explains, “In poorly regulated or managed countries, power prices are kept artificially low, which starves investment. But in those countries, people generate their own power. You find this pattern from very poor households using kerosene lamps to companies keeping generation sets in the backyard, which cost them a fortune.” Leaving households and businesses in emerging markets to their own devices, however, is not a sustainable solution—economically or environmentally—particularly as demand for reliable power continues to grow. And even with subsidies, some individuals cannot afford electricity and can resort to outright theft, exerting further pressure on the system.

Investment in power infrastructure is the sine qua non as policymakers in emerging markets set their sights on attaining levels of economic and human development that match those on offer in the developed world. In this regard, Arnould of GEEREF notes, “I always like to quote Lenin. When asked ‘What is communism?’ Lenin replied ‘It’s the Soviets plus electricity.’ So you could ask ‘What is economic development?’ and I’d say it’s a lot of things plus electricity.” In tackling the challenge of electricity supply and demand, governments in emerging markets have begun to promulgate ambitious new investment goals to address existing power shortfalls and meet new mandates. Even with a call to action, however, the amount needed to catch up is beyond the public sector’s means, especially at a time when slowing EM economic growth and lower commodity prices have led to declining government revenues and increasing fiscal deficits.

Increasing generation capacity and connecting underserved populations to the grid, especially in rural areas, will take significant financial resources, as well as operational and technical expertise. IEA estimates—based on recently-adopted policies and commitments—suggest investment in electricity generation, transmission and distribution assets across non-OECD markets could total US$10.2 trillion through 2035. Private investment has the potential to help fill this financing gap and move emerging economies away from the state-run monopolies and subsidies that have discouraged innovation and investment in the past.

The confluence of increasing consumer and industrial demand with inefficient and insufficient existing infrastructure presents a commanding investment thesis for private investors in EM power, at least conceptually. Michael Harrington, Director in pan-EM investor Actis’s energy team, explains, “The supply and demand dynamic is very compelling. Power is a scarce commodity, and there is persistent and growing demand, and a supply that is perpetually trying to catch up.” Yet the opportunities available to private fund managers investing in power can vary widely from country to country and from one segment of the sector to another. The following section of this report examines the fundraising situation for GPs investing in the power sector and explores trends in private investment across different regions and industry verticals.

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