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26 September, 2022updated 27 Sep 2022 10:22

How do rising energy prices impact FDI and site selection?

While rising energy prices have a small impact on FDI flows on their own, they are affecting companies' expansion plans.

By Viola Caon

Rising energy prices have been a concern on a global level for more than a year now, for both businesses and end consumers. Initial pressures on consumer price indices started in mid-2021, but a more severe impact on the energy sector was brought about by Russia’s invasion of Ukraine.

The conflict caused a particularly severe energy crisis in the European gas sector, 40% of which is sourced from Russia. Following the invasion of Ukraine, it quickly became evident that the continent’s energy supply could no longer so heavily depend on an unreliable and risky provider such as Russia.

In the UK, the rise of energy prices – in connection with a more widespread cost of living crisis – is so concerning that the newly elected Prime Minister Liz Truss announced an energy price cap of £2,500 a year for the average household.

At the time of writing, the government’s Department for Business, Energy & Industrial Strategy had announced that the price of electricity will be capped at £211 per megawatt-hour (MWh) and that of gas at £75/MWh for businesses until the end of March 2023.

While this rise in prices is particularly worrying for consumers, the increasing cost of energy is also a concern for multinational companies (MNCs) that are looking for new foreign direct investment (FDI) destinations, especially in energy-consuming industries.

But to what extent are MNCs’ expansion plans being impacted by the rise of energy prices, and what is the correlation between that and FDI flows?

Rising energy prices and FDI

Studies have observed a correlation between the rise of domestic energy prices and the choice of a location where energy prices are lower in comparison. However, while an impact on FDI flows is identified, it is not one of great magnitude as many drivers tend to contribute to MNCs’ site-selection processes.

The relationship between rising energy prices and FDI activity tends to be greater in industrial and high energy-consuming sectors such as manufacturing, automotives and data centres. The introduction of more stringent energy regulations, like that of a carbon tax, for instance, tend to compound the impact on FDI flows.

An OECD study has investigated the relation between industrial energy prices and FDI flows in a cross-country setting. The underlying dataset is a panel from 1995 to 2008 covering 3,364 companies operating in 24 OECD countries across nine manufacturing sectors.

The results show that relative energy prices – the difference between domestic energy prices and foreign energy prices – matter as a driver of FDI, but the magnitude of the effect is small.

“The effect is only found for firms facing an energy price increase at home, while a reduction in domestic energy prices is not correlated with a lower amount of international assets,” the report stated. “For those firms that did see energy prices rise in their home country, a 1% increase in relative energy prices was associated with an increase of 0.71% in the firms’ international assets.”

Investment Monitor’s data team has analysed a select set of countries’ energy-trade balance and weighted it against each country’s domestic energy consumption to identify the countries that are more vulnerable to rising energy prices globally.

The starting point is that if a country imports more energy than it exports, then it is more exposed to rising energy prices internationally.

However, those numbers need to be put into context by weighing the energy trade balance – the difference between energy imports and energy exports – against domestic production. A high level of domestic energy production counters the vulnerability that comes from high levels of energy imports.

The chart above shows China, which emerged on top as net importer in the previous chart, as the second to last country by import reliance due to its high levels of domestic production.

Unsuprisingly, Germany – whose 40% of gas imports only come from Russia – emerged as the most import-reliant country for energy, and hence the most vulnerable of the selected group to rising energy prices.

Overall, rising energy prices have a relatively small impact on FDI levels on their own. It is at site selection level that the pressure is felt more.

The site-selection impact of higher energy prices

While not panicked by the rise of energy prices, site-selection professionals agree that some projects have suffered from a downward pressure because of it and some MNCs are pausing expansion plans as a result.

Energy-intensive industries such as manufacturing, automotives and data centres are the ones to have come under pressure as a result of rising costs.

Elias van Herwaarden, head of location strategy for Europe, the Middle East and Africa at professional services company Colliers, believes that the construction market has been particularly affected. “There is certainly a downward pressure on the construction market as a result of the rise in energy and raw materials prices," he says. "Here in Belgium, many suppliers of construction materials have decided to wind down operations as they need to relocate.”

While this represents a red flag for investors in the sector, van Herwaarden does not think it will turn into a massive wave of business relocations. “Energy-intensive businesses are also capital intensive and as such it is not straightforward to move them," he adds. "Another element that is essential to site selection and investment location decision-making is talent, which counters the effect of rising energy prices as those sectors require specific labour skills.”

The rise of energy prices above that of labour is causing a change in trends across Europe, which means many companies are a taking a fresh look at other destinations, according to van Herwaarden.

“Morocco is one of the beneficiaries of this new dynamic," he says. "It is a good proximity to Europe, offers a fairly high educated labour force and offers good investment in both renewables and semiconductors, two areas that Europe is looking at for energy diversification. In addition to that, it offers competitive prices compared with the central and eastern European countries, which used to be suppliers until now.”

As energy security rises to the top of governments’ agendas, less Russia-dependent countries are going to benefit, van Herwaarden adds.

Seth Martindale, senior managing director, Americas consulting, location incentives, at real estate company CBRE, argues that the US has been less affected by the rise in energy prices compared with Europe, especially because of its smaller dependency on Russian fossil fuels.

“Energy prices have not influenced US FDI activity as they have in Europe," he says. "Our clients are certainly taking this trend much more into consideration than they did until last year, but the US is more insulated as less of its energy production comes from Russia.”

How will price rises affect the energy transition?

The general rise of energy prices across the board is nonetheless posing challenges for many US companies that, for instance, are very focused on making their portfolio greener.

“Energy transition comes at a cost and companies typically decide whether to go ahead or not with a project on the basis of cost,” says Martindale.

“We are seeing companies considering more carefully whether to go ahead or not with certain projects because of rising costs, but so far it has not resulted in projects being cancelled altogether, and I do not expect that to be the case any time soon.”

Tom Stringer, managing director and site selection and incentive practice leader at BDO, agrees that a slowdown in MNCs’ decision-making processes has occurred because of rising energy prices. “We have definitely witnessed a slowdown after seeing the busiest point after the Covid-19 pandemic," he says. "The rising cost of raw materials, for instance, has caused a few processes to be put momentarily on ice.”

While the US is less dependent than Europe on Russian fossil fuels, and is therefore less impacted by the ongoing conflict in Ukraine, it does have a few hurdles of its own on the horizon.

Looking ahead to the future in an environment of rising inflation, Stringer concludes: “Business historically craves stability and certainty. In the US, we have few milestones to get through this year: mid-term elections, the Federal Reserve’s decisions on rising interest rates, the roll-out of the government infrastructure bill, and lastly the effect on FDI of the Chips Act. Businesses certainly have a lot to unwrap.”

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