The Azerbaijani capital of Baku is an attractive city but is struggling to diversity its economy away from oil. (Photo by Jamie Squire/Getty Images for Begoc)

Baku, Azerbaijan’s eye-catching capital, has a problem. Beyond its oil industry and annual Formula One event, it is not really on the map for international consumers and corporations. As the economic powerhouse of the country, this city issue is tied to a national one. 

Like many of its neighbours in eastern Europe and the South Caucasus region, Azerbaijan has grown rapidly in the decades since it moved from a centrally planned economy to a free market model. However, in 2014, something changed. The country’s GDP growth dropped markedly; then, from 2016, foreign direct investment (FDI) fell significantly too. 

The key problem is Azerbaijan’s over-reliance on the oil sector, which accounts for 80–90% of the country’s exports each year (more or less), and up to half of its GDP. Naturally, this has left the country significantly exposed to external shocks, such as the 2014 global crash in oil prices and Covid-19 (which drastically hit demand for oil in 2020). 

Little wonder, therefore, that the pandemic reduced Azerbaijan’s GDP growth to -4.29% last year, while FDI to the country hit lows not seen since after the global financial crisis of 2008, according to figures from the UN Conference on Trade and Development (UNCTAD). 

On top of this, the country’s tourism industry, which was beginning to blossom after 2019’s record highs, has been devastated (see below chart), while the country’s armed conflict with Armenia in 2020 over the Nagorno-Karabakh enclave has only exacerbated the overall economic impact of the pandemic. 

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The country’s economic recovery from Covid is, of course, dependent on its vaccine roll-out (combined with the hold the virus has on a global level). Over the past year-and-a-half, there have been about 330,000 registered cases of Covid-19 and 4,980 deaths in Azerbaijan, while as of early July 2021, the country has given 35% of its population a first dose of the vaccine (a good performance by regional standards). Azerbaijan's long-term recovery, however, rests not on vaccines but on economic diversification. 

How foreign investment reflects Azerbaijan’s problem

The main reason foreign investors go to Azerbaijan, and Baku for that matter, is for its oil and by far. No wonder, therefore, that the EU rushed to build the Southern Gas Corridor several years ago, which now transports Azerbaijani gas through Georgia, Turkey and the European mainland. 

Since 2015, FDI to the country has averaged about $2bn annually, according to figures from UNCTAD. The vast majority of this capital has gone towards hydrocarbons. 

Reflecting this is the fact that Russia remains the country’s main source of FDI, while its customs union with Kazakhstan, Armenia, Belarus and Russia is another key source of investment and trade – and one that deals almost exclusively within the realm of oil/gas pipelines and their related services. 

That said, the past decade has seen the Azerbaijani government make diversification one of its top priorities, at least on paper, with an emphasis on attracting more foreign investment to transportation, tourism, ICT and agriculture (to build on its sizeable fruit and vegetable exports).

The first major goal outlined in the government’s Strategic Roadmap of the National Economy Prospects is for non-oil FDI to represent 4% of the country's GDP in 2025 (compared with 2.6% in 2015). However, some observers have argued that this target is too modest. 

On the flip side, 2021 has seen some very encouraging moves, with the announcement of Azerbaijan's first foreign investments in utility-scale solar and wind projects. 

Excellent news for Baku’s green energy

Azerbaijan’s domestic energy sector is dominated by oil and gas. As things stand, the country has just 1.3GW of installed renewables capacity, although it does have the potential to generate more than 180GW in solar and wind power, according to the World Bank. Baku is nicknamed ‘the city of wind’ for good reason. 

The new projects, therefore, are estimated to quadruple the country’s wind capacity and raise its solar capacity sevenfold, thereby pushing Azerbaijan one step closer to its official goal of increasing renewables’ share of the electricity mix to 30% by 2030. 

The country’s inaugural facility is being built by Saudi Arabia’s ACWA, which will develop a 240MW wind project just north of Baku powering 300,000 homes. The other project is being constructed by Abu Dhabi’s Masdar, in this case for a 230MW photovoltaic project valued at $200m. Like most major foreign investments to Azerbaijan, both will be structured as public–private partnerships.

Welcoming the likes of ACWA and Masdar, world-class players in renewable energy investment, is a huge boost of confidence for Azerbaijan, thereby opening the gates for much more investment of this kind. 

When it comes to offshore wind projects, Azerbaijan has the advantage of already having a very well-established oil and gas industry with highly trained specialists in offshore oil activity, skills that are most certainly transferable to renewables. 

For several years now, the Azerbaijani government has been working on a comprehensive regulatory framework for renewable energy projects, including a range of incentives. It is expected to be approved in 2022. 

Although corruption remains a major issue in Azerbaijan, the government has stressed the importance of improving its business climate as a whole, which is why the country now ranks 34th out of 190 countries in the World Bank's 2020 Doing Business rankings.

Baku and the need for homegrown innovation

Innovation led by research and development (R&D) will be at the forefront of Azerbaijan's economic diversification programme something made abundantly clear in a recent report from the UN Economic Commission for Europe (UNECE). 

“[Azerbaijan] shows strong political commitment and investment into innovation infrastructure, such as high-technology parks," the report said. "For example, [it] has recently launched high-level events, such as the annual InnoWeek, to foster synergies in innovation policy and unite stakeholders from the government, the business sector, academia and international organisations.”

It also stresses the need for Azerbaijan to better use its well-endowed sovereign wealth fund: reinvesting its oil revenue into R&D across a broad range of potentially successful economic activities in the non-oil sector. Indeed, one only needs to look to the United Arab Emirates or Saudi Arabia for a blueprint. 

The Azerbaijani government has recognised the aforementioned needs. For one, it has displayed a high level of commitment to innovation by preparing the national innovation strategy and establishing government bodies in charge of innovation policy, such as the Innovation Agency. The country’s leading research institutions, such as the Azerbaijan National Academy of Sciences, have also been improving public-private partnerships to meet current market needs. 

However, despite the construction of high-tech parks and free zones (such as Alyat seaport south of Baku), commercialisation efforts at higher education institutions remain ineffective, impeding productivity in the labour market, according to the UNECE report. “To fully exploit its innovation potential, Azerbaijan needs to diversify its economy by increasing support for small and medium-sized enterprises [SMEs] in the non-oil sector and foster innovative activities by supporting investment in R&D activities in the private sector and by improving SMEs' access to finance,” it says.

Foreign investment will follow if Baku manages to build up its innovation ecosystem, thereby tapping its well-educated workforce. Add to this Azerbaijan’s competitive production and labour costs, as well as its infrastructure connecting China and Europe, and the city does indeed have the makings of a regional innovation hub for industry, manufacturing and tech. 

This is the first in Investment Monitor's 'Future of Eurasian Cities' series. In the coming weeks we will cover Tbilisi, Nur-Sultan, Almaty, Tashkent and Yerevan.