Evaluating the Weighted Average Cost of Capital (WACC) in the Power Sector for African Countries

Executive Summary

Energy access is essential for economic development.^1,2,3,4 Over several centuries, civilizations have relied on energy to drive productivity and meet critical needs. The United Nations (UN) Sustainable Development Goals (SDGs) recognize access to “affordable, reliable, sustainable and modern energy for all” as a global imperative. However, Africa is nowhere close to achieving this objective. Of the 2.3 billion people globally without access to clean cooking, over 900 million are in Africa. Over 600 million people in Africa (43% of the total population) do not have access to electricity. The continent accounts for less than 6% of total global energy use despite having more than 18% of the world’s population, and less than 45% of people surveyed say they have access to reliable electricity. Recognizing how critical well-functioning energy systems are to building robust economies, African governments and other actors are pursuing diverse strategies to improve energy access. 

The cost of closing the energy access gap is staggering. According to the International Energy Agency (IEA), African countries need USD 4 billion per year to provide clean cooking access to 1.2 billion between 2020 and 2030. Without this investment, the continent is projected to have the same number of people without access to clean cooking in 2050 as it does today. Additionally, the IEA estimates that to reach universal electricity access by 2030, African countries would need to invest an average of USD 30 billion annually. 

Nevertheless, cash-strapped and heavily indebted African governments are grappling with a scarcity of available funds to finance new energy projects. According to the International Monetary Fund (IMF), the median public debt as a percentage of GDP for sub-Saharan African countries increased from 29% in 2012 to over 59.1% in 2022. In addition, the UN Conference on Trade and Development estimated that 20 countries allocated more than 10% of their total revenues to debt servicing, worsened by currency depreciation from contracts often signed in USD, which diverted crucial resources from developing local infrastructure. As a result, many electricity projects will have to be financed by private capital. This aligns with the IEA projections that more than 70% of global clean energy investments will have to come from the private sector. 

An important factor in financing new energy projects is the cost of capital, which is the rate of return investors require to finance a new project. A number of factors, including prevailing interest rates, project risks, offtaker risks, and more, influence the cost of capital. However, many studies and reports use generalized cost of capital as country specific data is hard to come by for African countries. Reviews of several studies show the extensive use of uniform values from the Clean Development Mechanism’s Executive Board methodology. Applying uniform values for African countries risks underestimating bias in electricity project costs, which has the potential to misguide policy planning. For example, while energy transition planning studies and subsequent policy planning often use uniform values, they tend to prioritize capital-intensive projects, mostly renewable energy, like wind and solar, while downplaying less capital-intensive options like natural gas. To address this gap, this study presents a comprehensive methodology and generates cost of capital estimates for all African countries, intended to serve as discount rates for calculating country-specific electricity technology costs. 

Methodology and factors influencing Weighted Average Cost of Capital for African nations 

To address these shortcomings, we calculated the Weighted Average Cost of Capital (WACC)—a composite of the cost of equity and cost of debt, and a widely utilized measure to determine the cost of financing projects—for 48 African countries and five sub-regional groupings from 2023 to 2070. This approach captures country-specific costs that can be applied to electricity technology investments. We rely on available data at the national level given that more granular data at the project level is not available for African countries. We calculate the cost of equity over time using equity risk premiums, sovereign default spread rates (as a proxy for the risk-free rate)⁵, GDP, and population growth projections (from the Shared Socioeconomic Pathways). The risk-free rate (RFR) is the rate of return from an investment with zero risk such as the U.S. Treasury Notes. The equity risk premium (ERP) is the additional compensation expected by an investor from an equity investment relative to a risk-free investment. Our cross-sectional regression correlating each country’s GDP per capita with the annual risk-free rate and equity risk premium based on the most recent available data (year 2022) yields regression coefficients of -0.0003 and -0.0004, meaning that for every dollar increase in GDP per capita, the risk-free rate and equity risk premium reduce by 0.03% and 0.04%, respectively. We then compute the cost of debt using the commercial lending rates and corporate tax rates, sourced from the IMF’s International Financial Statistics and the Tax Foundation databases.⁶  

Where: D = Debt, V = Total value of investments, E = Equity, t = Corporate tax rate, Cd = Cost of debt, and Ce = Cost of equity. For the baseline computation, we use a ratio of 30% debt and 70% equity.    

We define the cost of equity Ce as: 

Where: r_f = The risk-free rate, β = The sensitivity of the assets to the market, measuring market  exposure or risk, and ERP = The equity risk premium. 

Our findings 

1. While we projected that the continental WACC value will drop from 18% to 13% during the study period, the average rate of 15.6% for African countries remains significantly higher than the 10% rate often used in uniform assumptions (See Figure 1). Our calculated rate is also much higher than the WACC values for other countries and regions such as 2.4% in Japan, 4.2% in Western Europe, 5.1% in the USA, and 6.6% in China.  

Figure 1: Projections of WACC for Africa and across sub-regions

2. Significant variations exist among the five sub-regions on the continent. Northern Africa exhibits the lowest WACC throughout the evaluation period, ranging between 8.6% and 15.88%. Following, in order, are Central Africa, Southern Africa, and Western Africa, with Eastern Africa having the highest WACC levels (See Figure 1). The high cost of capital comes from a combination of factors, including low economic development, under-development of the financial market, high instability leading to high-risk premiums, etc. Even though the capital cost for electricity technologies is decreasing over time, for the same electricity technology, the investment cost will be much higher in Eastern and Western Africa than in Northern Africa. Substantial variations exist even among countries within the same region. In Western Africa, for instance, Ghana records the highest WACC values ranging from 20.47% to 22.87%, while Côte d’Ivoire shows considerably lower rates ranging from 5.99% to 17.26%. The elevated WACC values signify the increased financial costs linked to electricity project development in the evaluated countries. Increased costs could potentially hinder the essential investments needed to build modern electricity systems in African nations and facilitate their transition towards a low-carbon future. 

3. We assessed the shares of debt and equity in the WACC value by dividing the cost of equity by the cost of debt. We find that on average, equity is twice as expensive as the cost of debt; however, this rate is not uniform across the continent as some sub-regions (such as Central Africa) show a higher cost of debt than equity (See Figure 2). The cost of equity and cost of debt have different implications for the differences observed in risk premiums associated with investments in electricity technologies and as reflected in the costs of financing those investments (i.e., WACC). For the same investment, the former translates the perception of risk by equity investors (via higher return expectations), while the latter reflects how lenders perceive the default risk (via higher interest rates). Hence, within the African electricity sector, equity investors, on average, perceive a greater level of risk compared to the default risk perceived by lenders. This discrepancy suggests that funding electricity investments through equity will be more costly than using debt, especially when funding investments reliant on capital-intensive clean electricity technologies like geothermal, solar, and wind. 

Figure 2: Projections of Cost of Equity/Cost of Debt ratio for Africa and across sub-regions

4. The risk-free rate and equity risk premium are usually lower in developed countries compared to emerging economies because investing in emerging countries requires compensating for higher risks and for other macroeconomic factors such as economic volatility. We projected that the majority of countries in Africa, which are currently developing, will see increases in their GDP between 2023 and 2070. Because of the inverse relationship between GDP and the risk-free rate and equity risk premium values, our projections show that both risk-free rate and equity risk premium will decrease over time as the countries’ economies grow. However, they will still be higher than developed countries and only become lower than Central and South America in 2070, while Africa is among the regions with the lowest debt default rate (i.e., 5.3% for all project finance, and 1.9% for infrastructure loans). 

5. We also examined the variations in the total cost of capital concerning the ratio of debt to equity employed. In our primary analysis, we utilize a 30/70 split between debt and equity unlike in Annex 1 countries including OECD countries, with split of 70-30. Additionally, we conducted analyses using 20/80, 50/50, and 70/30 distributions of debt and equity. Our findings indicate that scenarios with a higher proportion of equity exhibit a greater cost of capital (See Figure 3). Consequently, the order of cost of capital is as follows: the 80Equity20Debt scenario has the highest, followed sequentially by the 70Equity30Debt, 50Equity50Debt, and 30Equity70Debt scenarios. Over time, we observe a reduction in risk differentials between equity and debt as economies grow and countries become wealthier, diminishing the significance of weight distribution between these two factors in the total cost of capital.  

Figure 3: Projected WACC for Africa region over years for different scenarios of equity and debt allocation

Recommendations for addressing capital dynamics and encouraging investment in the African electricity sector 

First, we call for all stakeholders to depart from employing a uniform cost of capital for African nations. Our research underscores substantial disparities among countries, including those within the same region and subregions. While accessing data for certain countries might pose challenges, acquiring localized data is preferable to relying on uniform capital costs, which may inadequately capture the specific capital dynamics of individual countries.  Hence, not accounting for WACC properly will result in inaccurate modeling results for technology and costs, and misguide policymakers about pathways for energy growth and decarbonization. 

Second, acknowledging the inhibiting effect of heightened WACC values on investment levels in the capital-intensive electricity sector, there needs to be enhanced collaboration among African governments, the financial sector, multilateral institutions, and other stakeholders. The goal is to mitigate investment risks on the continent and enhance the attractiveness of African countries for financial investments. Potential instruments for encouraging investment include government debt guarantees, currency swap agreements, mandatory off-take arrangements (e.g., take-or-pay contracts), tax breaks aimed at attracting equity investments. Considering the budgetary constraints many African governments face and the resulting pressure to minimize guarantees offered due to long-term implications, we acknowledge the need for a balanced approach between the risks borne by private and public sectors. Some instruments, such as currency swaps, are not long-term solutions and can be complemented by current initiatives like the Pan-African Payment and Settlement System (PAPSS), and the Currency Exchange Fund (TCX).   

Overall, governments should pursue policies that: (i) sustain consistent economic growth together with capital market development strategies to reduce capital costs, (ii) support the development of regional power industry champions which will expand the equity available for power projects and project understanding, and reduce the risk of projects failing, (iii) address fundamental social, political, and governance issues that increase both real and perceived risks of investing in the respective countries, and (iv) ultimately encourage private investments in the electricity sector on the continent using financial instruments like political risk insurance and public equity co-investments or direct financial incentives such as tax breaks and subsidies. Otherwise, they will bear the cost of political inaction. 

Considerations for future research and refinement 

Our analysis relied on GDP projections and other assumptions. We recognize that these assumptions might not fully reflect the subjective nuances involved in the determination of the costs of projects in the real world. Our projections do not account for unanticipated macroeconomic variables (such as conflicts, epidemics, natural disasters, etc.) that might influence the conditions in a country. Thus, our work should be considered as an illumination of how capital costs will evolve in the future based on current assumptions rather than being an exact prediction of the trends of the costs.