At the 2023 UN Climate Change Conference, goals were set to transition away from fossil fuels, triple renewable capacity, and double energy efficiency improvements by 2030, requiring a substantial increase in clean energy investments among emerging market and developing economies. Against the backdrop of tight fiscal space and relatively high financing costs, foreign direct investment could play a pivotal role in helping these economies close their clean investment gap. Based on recent success cases, this column argues that climate policies are key to attracting much needed green investment, as are leveraging comparative advantage and linking into international initiatives.
Announcements of green foreign direct investment (FDI) projects in emerging market and developing economies (EMDEs) are on a notable rise, quintupling as a share of global GDP between 2014 and 2022. In dollar terms, they increased from close to $40 billion in 2014, to $80 billion in 2019, and surpassed $200 billion in 2022. A breakdown of FDI inflows related to low-carbon technologies (‘green FDI’) from the Financial Times fDi Markets database shows that three technology clusters account for the bulk of green FDI flows over the past 20 years (Figure 1). The first is renewable energy, which has played an important role for FDI since 2007. A second cluster entails FDI in activities related to the production of electric vehicles (EVs), which emerged in 2016. Finally, green hydrogen appeared as a major source of green FDI only in 2020 but became a very important technology by 2022. These three technologies cover most – though not all – FDI related to low-carbon technologies .
Green FDI is important for EMDEs because it has the potential to both reduce their emissions and boost economic development by allowing them to tap into the most efficient technologies. As low-carbon technologies become increasingly affordable, introducing climate policy becomes economically beneficial at a macroeconomic level (Bretschger 2024). Adopting low-carbon technologies capital also typically goes hand-in-hand with a productivity upgrade as the new equipment replaces older and less efficient machinery, especially in EMDEs where the capital stock is older and more polluting (Capelle et al. 2023). From a decarbonisation perspective, FDI is crucial to finance the green transition of EMDEs as they face limited fiscal space, high financing costs, and a lack of portfolio investment in green companies (de Crescenzio and Lepers 2023).
Figure 1 Green FDI inflows to EMDEs ($ billion)
Source: Financial Times fDi Markets database.
Note: The database records project announcements and deletes entries that did not materialise after some years, thus data for recent years might be overstated.
A key question for policymakers is how to entice foreign investors to invest in green technologies in their countries. Our recent research (Jaumotte et al. 2024) analyses what has underpinned the surge in observed green FDI flows to EMDEs drawing on econometric analysis and an examination of successful country cases and points to three factors. Implementing climate or green policies focused on the sectors of interest has been key to boost green FDI, especially for renewables. Beyond domestic policies, international initiatives creating global demand for low-carbon technologies and comparative advantage have also played an important role.
Climate policies are key to attracting green FDI, subsidies and pricing policies work best
Our analysis shows that climate policies increase the amount of green FDI that is announced for a country (Figure 2, panel a). 1 The effect is quantitatively important. Closing the climate policy gap between the average EMDE and the average advanced economy would triple the green FDI inflow-to-GDP ratio in the average EMDE. With that, between 30% and 50% of the private renewable investment gap in EMDEs (excluding China) could be closed.
Figure 2 Climate policies and green FDI
Sources: Financial Times fDi Markets, ESMAP (2020), Climate Policies Database, World Development Indicators, CEPII’s BACI database.
Note: Panel a quantifies the impact of a change in log climate policies on each green FDI subcategory. Panel b estimates a similar regression but distinguishing by type of climate policies. In both panels, coefficients are responses to a one-standard deviation change and error bands are 90% confidence intervals. Panel c gauges the impact of climate policies on solar and wind FDI, allowing the coefficient for policies to vary with a country’s solar energy potential. The grey portion of the line is not statistically significant at the 90% level. Panel d quantifies the impact of climate policies by G7 countries and China in the transport sector on EV FDI, allowing the coefficient for policies to vary with the country’s revealed comparative advantage in transport at the beginning of the analysis. In both panels, coefficients are changes to a 1% change in log climate policies. EV = electric vehicles; FDI = foreign direct investment; G7 = Group of Seven; PV = photovoltaic; RCA= revealed comparative advantage.
A more granular look by technology shows that the evidence is strongest for FDI into renewable energy, for which the longest observation period is available. Countries that introduce climate policies see a substantial increase in renewable energy FDI and this increase is larger, the higher the solar energy potential of the country (Figure 2, panel c). Many EMDEs are well-suited in this regard, especially countries close to the equator that have very abundant solar energy. Zooming into country cases, Chile, Mexico, Uruguay, and Vietnam are key examples of countries that have been successful at attracting substantial FDI into renewable energy. They have well-developed climate policy frameworks in the electricity sector, encompassing a large number of policies and covering all major policy areas (Figure 3, panel a). These frameworks are typically developed systematically and sequentially, from regulatory policies (such as declaring targets for renewables and removing obstacles to renewable energy use in the grid), to expenditure-generating policies (such as offering incentives or making complementary investments) to revenue-generating policies (such as emission trading schemes for fossil fuels in electricity generation) (Figure 3, panel b). A key common feature across these countries’ policy frameworks is that they ensured a stream of revenues to investors through power purchase agreements or feed-in tariffs, where the government commits to buy the electricity at a fixed rate for some time. These agreements typically came with a subsidy element that helped overcome any initial cost disadvantage. In Chile, connecting ideal locations for solar and wind energy with industrial centers and the capital was also key to ensure a market for renewables.
The econometric analysis confirms that expenditure-based policies, such as power-purchase agreements with an element of subsidy or feed-in tariffs, have the strongest effect on FDI announcements (Figure 1, panel b). Revenue-generating policies such as carbon pricing are also effective, but their quantitatively smaller effect might be due to the low price level observed so far.
Figure 3 Policy instrument types among renewable energy leaders
a. Number of policies by instrument type
b. Year of initial policy adoption
Sources: Climate Policy Database and IMF staff calculations.
Note: The classification into policy types follows the Climate Policy Database. The chart reflects all policies recorded in the Climate Policy Database.
Comparative advantage also matters
Turning to EVs, global climate policies in the car industry led to a significant increase in FDI related to EVs for EMDEs, highlighting the global nature of EV markets (Figure 2, panel c). A country’s prior car manufacturing experience was naturally an important determinant to attract these flows. While we cannot find econometric evidence that FDI related to EVs responded to domestic climate policies in the sector, this could reflect the recent emergence of these policies in EMDEs. The examples of Indonesia, Mexico, and Thailand – which have attracted substantial amounts of this type of FDI – suggest that the benefits of an existing comparative advantage have likely been enhanced by the recent adoption of national strategies. These strategies provided subsidies for investors and promoted the domestic market for electric vehicles, for example, through subsidies for EV purchases and tax breaks for charging stations. Hungary, another major recipient of FDI in EVs, did not pass any climate policies for vehicles itself but benefits from a range of policies at EU level and access to the EU market. Further, Hungary engaged in bilateral diplomacy with China, which is now their largest source of FDI for the technology.
In the case of green hydrogen, the countries best positioned to receive FDI are those that already have a high share of renewable energy. The reason is that hydrogen is considered ‘green’ only when it is produced with renewable energy. Investors in hydrogen production will want to make sure that the country has the complementary energy. Implementing a policy framework for renewable energy thus has the potential to bring a double reward. The EU Hydrogen Strategy which started in 2020 has facilitated green hydrogen FDI to EMDEs through strategic initiatives and engagement with potential recipient country governments. Chile, Egypt and Morocco, which were recipients of large green hydrogen FDI announcements, each passed some form of ‘national strategy’ for green hydrogen in 2020 or 2021, suggesting the key role of investing governments’ efforts in spurring the establishment of policy frameworks in recipient countries to align the interest of investing and receiving countries. These national strategies, which can be considered a form of industrial policy, included cost reductions along the supply chain, plans for regional industrial integration, the creation of industrial clusters, a national storage plan, reinforcing international coordination to ensure financing, the development of a national hydrogen market, the creation of national research and development capacity, and support for the export of hydrogen.
Structural policies can help raise green FDI levels
Last but not least, another important perceived obstacle to attracting financing in EMDEs is weaknesses in their structural policies, such as the quality of institutions and the availability of human capital. Indeed, we find that external sector openness (to trade and capital flows), rule of law, and the availability of human capital contribute to explain cross-country differences in green FDI levels. The latter complements the findings of Cai et al. (2024), who stress the role played by structural reforms targeting external sector openness and governance to attract official climate finance.
To conclude, to attract green FDI, governments need to implement climate policies in the sectors of interest, leveraging their comparative advantage and linking into international initiatives through strategic partnerships. Going forward, building strategic partnerships may become even more important in a context of geopolitical fragmentation, as our evidence shows that green FDI is less likely between politically distant countries. But implementing climate policies and improving the business environment are demonstrated strategies for countries to be attractive to foreign investors.
Source : VOXeu
