12

# **Box 6**

# **Investing to Bring Down Power Costs**

SWFs can use a variety of instruments to support domestic investment, including equity (ordinary or preference shares), debt (including subordinated or syndicated loans) and guarantees (commercial or political risk). Projects can also be implemented through Public-Private Partnerships (PPPs), contracts between public and private parties in which the latter provides a public service and assumes substantial financial, technical and operational risk. The SWF might co-invest on purely commercial terms, or it could modify the terms of its engagement to reflect clearly identified economic or social benefits. For example, the national market could be unable to support a market price for power that is high enough to justify the construction of a generation plant on commercial terms. A SWF could co-finance the project with a private company, accepting a positive but below-market return and a long investment horizon to enable an acceptable return for the private partner with lower power tariffs. A similar approach has been used in Mauritania, as well as other countries. PPPs can be attractive vehicles for SWFs that seek to promote developmental objectives while still generating reasonable financial returns. But experience shows that proposals need expert assessment to ensure that they will deliver their social and development objectives and that the balance between risk and profitability is not heavily tilted in favor of the private partners.

For investments which are not fully justified on commercial grounds, it is essential to have a clear and transparent process for benchmarking financial return and for trading off financial and non-financial goals.<sup>4</sup> The risk is that any such formulation may reduce public accountability because the measurement of economic benefits is more ambiguous than that of financial benefits. Identifying the size of the home bias is a challenging endeavor, owing to country specific and project specific considerations. An alternative approach could be for the government to set the overall target return on investment for the SWF’s portfolio, and the threshold minimum rate of return for all investments (for example, the government’s average long-term real borrowing rate on commercial loans). The SWF would then be free to decide the composition of its investment portfolio so as to maximize the overall rate of return, while guarding against investing in project with expected negative returns. For clear accountability, it is also important to separate out the below-market portion of the portfolio from the rest. Box 7 provides examples of capital objectives and methodology used by some institutional investors to assess investment projects.

# **Box 7**

# **Trading off Financial and Nonfinancial Investment Objectives**

SWFs that invest domestically need to formalize the trade-off between policy and financial objectives, since investing in domestic development to fulfill policy mandates can conflict with financial performance and jeopardize long-term financial sustainability (Scott, 2007). It is illustrative to look at the type of capital objectives used by development banks to ensure financial soundness of investments with a developmental purpose (Luna-Martinez and Vicente, 2012). These include (i) achieving a minimal return that exceeds inflation (Financiera Rural of Mexico and Credit Bank of Turkey), (ii) generating a rate of return that equals or exceeds the government’s long-term borrowing costs (Business Development Bank of Canada), and (iii) an explicit target return on capital, ranging from 7 to 11 percent annually (Development Bank of Samoa, EXIM Bank of India, Kommunalbanken of Norway).

The International Financial Corporation (IFC) uses the Development Outcome Tracking System (DOTS) to measure the development effectiveness of its investment services. At the outset of a project, standardized industry-specific indicators are adopted, with baselines and targets. The indicators facilitate the tracking of progress throughout project implementation, allowing for real-time feedback. Four performance categories are considered: financial performance, economic performance, environmental and social performance, and private sector development impact. These performance categories are in turn informed by industry-specific indicators.

> 4 Home bias can be defended on various grounds, including providing jobs for underemployed labor, pecuniary externalities and the expected contribution of investment to diversification and reduced exchange rate risk. However, this should not unduly dilute the financial motivation for SWF investments.

12