Emerging Market Premium in WACC Calculation: Cost of Capital for Belt and Road Initiative Investments

The SFC’s December 2024 consultation paper on the regulation of sponsor due diligence for Belt and Road Initiative (BRI) infrastructure listings on HKEX (SFC, Consultation Paper on Proposed Amendments to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, December 2024) has forced a fundamental re-examination of the cost of capital assumptions underpinning these cross-border transactions. The paper explicitly requires sponsors to demonstrate that the discount rate used in a valuation or DCF model reflects “all material risks specific to the investee’s jurisdiction and project structure,” a standard that the current market practice of applying a single, generic “emerging market premium” (EMP) cannot satisfy. For a CFO or financial advisor evaluating a HKEX-listed entity with operations in Pakistan, Indonesia, or Kenya under the BRI framework, the question is no longer whether an EMP is needed, but how to decompose it into its constituent, verifiable components. The SFC’s focus on sponsor liability for valuation inputs, combined with the HKMA’s December 2023 circular on credit risk assessment for BRI-related lending (HKMA, Credit Risk Management for Belt and Road Initiative Projects, December 2023), creates a regulatory environment where a poorly specified WACC can expose both the listed issuer and its advisors to enforcement action. This article provides a framework for calculating a jurisdiction-specific, project-specific cost of capital for BRI investments, moving beyond a single point estimate to a range of inputs that can withstand regulatory scrutiny.

The Structural Failure of a Single Emerging Market Premium

The standard approach to calculating a WACC for a Hong Kong-listed company with BRI exposure is to take a base cost of equity from a developed market (typically the US or Hong Kong) and add a single EMP sourced from a database like Damodaran or a credit rating agency. This method is structurally flawed for three reasons that directly affect compliance with HKEX Listing Rules and SFC codes.

The Diversification Fallacy

The first flaw is that a single EMP assumes the BRI investment is the marginal, undiversifiable investment in a portfolio. For a company whose primary listing is on the Main Board of HKEX, but whose revenue is 70% from a single BRI country (e.g., a power plant in Pakistan), the relevant risk is not the average risk of all emerging markets, but the specific sovereign, currency, and political risk of that jurisdiction. The SFC’s December 2024 consultation paper makes this explicit: paragraph 3.17 of the proposed amendments states that a sponsor must “identify and assess the specific risks of the project’s host country, including but not limited to foreign exchange controls, expropriation risk, and the enforceability of contracts.” A generic EMP of, say, 3.5% for “Emerging Asia” (Damodaran, January 2025 estimate) fails this test because it averages the risks of China, India, and Vietnam with those of Pakistan, which has a sovereign credit rating of CCC+ (S&P, March 2025) versus India’s BBB-.

The Currency Mismatch Problem

The second structural flaw is the currency mismatch between the cash flows and the discount rate. Most BRI projects generate revenue in the local currency (e.g., Indonesian rupiah, Pakistani rupee) but have financing costs in USD or HKD. A WACC calculated in USD using a USD-based EMP, then applied to local-currency cash flows without a proper currency adjustment, systematically undervalues the cost of capital. The HKMA’s December 2023 circular on BRI credit risk (paragraph 4.2) specifically requires banks to “assess the net present value of a project’s cash flows in the currency of the loan, after applying a forward-looking foreign exchange risk premium.” This means the EMP must be decomposed into a currency component and a sovereign risk component, each estimated separately.

The Project Lifecycle Mismatch

BRI infrastructure projects have a lifecycle that does not fit the static, single-period CAPM framework. A 25-year power purchase agreement (PPA) in Bangladesh has a very different risk profile in year 1 (construction risk, regulatory approvals) than in year 15 (operational risk, tariff renegotiation). A single EMP applied to all years of a DCF model is a mathematical error. The SFC’s consultation paper (paragraph 4.05) notes that sponsors should “consider a time-varying discount rate where the risk profile of the project is expected to change materially over the forecast period.” This is a direct regulatory mandate to move beyond a static WACC.

A Three-Component Framework for the BRI Cost of Capital

To comply with the SFC’s enhanced due diligence requirements and the HKMA’s credit risk guidelines, a CFO or financial advisor should replace the single EMP with a three-component framework: the Sovereign Risk Premium (SRP), the Currency Risk Premium (CRP), and the Project-Specific Risk Premium (PSRP). Each component is estimated using observable market data and documented with clear assumptions.

Component 1: Sovereign Risk Premium (SRP)

The SRP captures the risk of default by the host government on its obligations, including the risk of expropriation, contract repudiation, or changes in law that affect the project’s cash flows. The standard method is to use the host country’s sovereign credit default swap (CDS) spread, but this is only available for a subset of BRI countries (e.g., Indonesia, Pakistan, Philippines). For countries without liquid CDS markets (e.g., Laos, Cambodia, Myanmar), the SRP must be estimated using the country’s sovereign bond yield spread over a risk-free rate (typically US Treasuries of matching duration).

For a 10-year project in Pakistan, the SRP as of March 2025 is calculated as follows: the yield on Pakistan’s USD-denominated 2035 bond is 14.2% (Bloomberg, March 2025), while the 10-year US Treasury yield is 4.3%. This gives a raw SRP of 990 bps. However, this raw spread includes a component for global risk aversion and liquidity, which must be stripped out. The standard adjustment is to multiply the raw spread by (1 - R²), where R² is the proportion of the spread explained by global factors. For Pakistan, using a 5-year rolling regression of the bond spread against the EMBIG spread (JP Morgan, 2020-2025), the R² is 0.65, meaning 65% of the spread is explained by global factors. The adjusted SRP is therefore 990 bps × (1 - 0.65) = 347 bps. This is the incremental cost of capital specifically attributable to Pakistan’s sovereign risk, not global market conditions.

Component 2: Currency Risk Premium (CRP)

The CRP captures the expected depreciation and volatility of the local currency against the reporting currency (USD or HKD). The SFC’s December 2024 consultation paper (paragraph 3.22) requires sponsors to “demonstrate that the discount rate incorporates a forward-looking assessment of currency risk, including the potential for capital controls or exchange rate peg adjustments.”

The CRP is estimated using the difference between the local currency risk-free rate and the USD risk-free rate, adjusted for the expected inflation differential. For an Indonesian rupiah-denominated project, the 10-year Indonesian government bond yield is 7.1% (Bloomberg, March 2025), while the 10-year US Treasury yield is 4.3%. The raw interest rate differential is 280 bps. However, this differential includes both expected depreciation and a risk premium for currency volatility. The expected depreciation can be estimated using the 5-year forward rate from the NDF market. As of March 2025, the 5-year USD/IDR NDF implies an annual depreciation of 3.2% (Bloomberg). The residual, 280 bps - 320 bps = -40 bps, suggests the raw differential is fully explained by expected depreciation, and the CRP is effectively zero. This is consistent with the rupiah being a freely floating currency with a deep NDF market.

For a Pakistani rupee-denominated project, the situation is different. The 10-year Pakistan government bond yield is 16.5% (Bloomberg, March 2025), but the rupee has been subject to periodic devaluations and capital controls. The 5-year USD/PKR NDF implies an annual depreciation of 8.5% (Bloomberg). The raw differential is 16.5% - 4.3% = 1,220 bps. The residual after subtracting expected depreciation is 1,220 bps - 850 bps = 370 bps. This 370 bps is the CRP, representing the risk that the actual depreciation exceeds the forward-implied rate, or that capital controls prevent the repatriation of profits at the expected exchange rate. The HKMA’s December 2023 circular (paragraph 5.1) specifically flags this risk for countries with “managed exchange rate regimes or a history of capital controls.”

Component 3: Project-Specific Risk Premium (PSRP)

The PSRP captures risks that are unique to the project structure, including the enforceability of the PPA, the creditworthiness of the offtaker (often a state-owned enterprise), and the legal framework for dispute resolution. This component is the most subjective and requires the most documentation. The SFC’s consultation paper (paragraph 4.12) states that sponsors must “identify and quantify the specific contractual and legal risks of the project, including the jurisdiction for arbitration and the enforceability of awards.”

The PSRP is estimated using a scenario analysis. For a 300 MW coal-fired power plant in Bangladesh with a 25-year PPA with the Bangladesh Power Development Board (BPDB), the base case assumes the PPA is honored. The downside case assumes a 20% tariff reduction in year 10 (consistent with recent renegotiations for IPPs in Bangladesh, per the World Bank’s Bangladesh Infrastructure Diagnostic, 2024). The probability of the downside case is estimated at 30%, based on the track record of tariff renegotiations in the country (5 out of 15 IPPs have faced renegotiation since 2018, per the Bangladesh Energy Regulatory Commission, 2024). The PSRP is the difference between the weighted average cost of equity under the two scenarios.

Using a CAPM with a base equity beta of 1.2 (utility sector, MSCI Emerging Markets), a risk-free rate of 4.3% (US 10-year), and an equity risk premium of 5.5% (Damodaran, January 2025), the base case cost of equity is 4.3% + 1.2 × 5.5% = 10.9%. Under the downside scenario, the equity beta is increased to 1.5 (reflecting higher earnings volatility), giving a cost of equity of 4.3% + 1.5 × 5.5% = 12.6%. The weighted average cost of equity is 70% × 10.9% + 30% × 12.6% = 11.4%. The PSRP is therefore 11.4% - 10.9% = 50 bps. This 50 bps is the incremental cost of capital specifically attributable to the project’s renegotiation risk.

Integrating the Components into a WACC

The final WACC for the BRI investment is calculated as follows:

WACC = (E/V) × (Rf + β × ERP + SRP + CRP + PSRP) + (D/V) × (Rd × (1 - Tc))

Where:

• E/V = equity weight in the capital structure (typically 30-40% for project finance)
• Rf = risk-free rate (US 10-year Treasury = 4.3%)
• β = levered equity beta (1.2 for a utility)
• ERP = equity risk premium (5.5%)
• SRP = sovereign risk premium (347 bps for Pakistan)
• CRP = currency risk premium (370 bps for Pakistan)
• PSRP = project-specific risk premium (50 bps for the Bangladesh example)
• D/V = debt weight (60-70%)
• Rd = cost of debt (typically LIBOR + country spread + project spread)
• Tc = corporate tax rate (16.5% for Hong Kong, or the host country rate)

For a Pakistan-based power project with 35% equity, 65% debt, a cost of debt of 14.2% (Pakistan sovereign bond yield), and a Hong Kong tax rate of 16.5%, the WACC is:

Cost of equity = 4.3% + (1.2 × 5.5%) + 3.47% + 3.70% + 0.50% = 18.57% Cost of debt (after-tax) = 14.2% × (1 - 0.165) = 11.86% WACC = (0.35 × 18.57%) + (0.65 × 11.86%) = 6.50% + 7.71% = 14.21%

This 14.21% is significantly higher than the 10-12% WACC that would result from using a generic EMP of 3.5% for “Emerging Asia.” The difference is material: for a 25-year project with USD 1 billion in capital expenditure, a 200 bps increase in the discount rate reduces the NPV by approximately USD 150 million (using a standard annuity formula). This is the magnitude of error that the SFC’s enhanced due diligence is designed to catch.

Practical Considerations for HKEX-Listed Issuers

Documentation and Sensitivity Analysis

The SFC’s December 2024 consultation paper (paragraph 5.03) requires sponsors to “include a sensitivity analysis showing the impact of changes in key assumptions on the valuation, including the discount rate.” For a CFO presenting a valuation to the board or to investors, the WACC should be presented as a range, not a point estimate. For the Pakistan example above, the range would be:

• Base case: 14.21%
• Bull case (no sovereign default, stable currency): 11.50% (SRP reduced to 100 bps, CRP reduced to 100 bps)
• Bear case (sovereign default, 30% currency devaluation): 18.00% (SRP increased to 600 bps, CRP increased to 600 bps)

Each scenario must be documented with references to the source data (e.g., CDS spreads, NDF rates, World Bank reports). The board paper should state explicitly that the discount rate “incorporates a sovereign risk premium of 347 bps derived from Pakistan’s CDS spread, a currency risk premium of 370 bps derived from the USD/PKR NDF market, and a project-specific risk premium of 50 bps derived from a scenario analysis of PPA renegotiation risk.”

The Role of the Sponsor

Under the SFC’s proposed amendments, the sponsor is directly liable for the reasonableness of the valuation inputs. This means the sponsor must independently verify the data used to calculate the SRP, CRP, and PSRP. For example, the sponsor cannot simply accept the issuer’s assumption that the CRP is zero because the project has a “take-or-pay” contract denominated in USD. The sponsor must assess whether the contract is legally enforceable in the host country and whether the offtaker (typically a state-owned enterprise) has the creditworthiness to honor it. The HKMA’s December 2023 circular (paragraph 6.1) provides guidance on this point, stating that “the credit risk of the offtaker should be assessed on a standalone basis, without reliance on implicit government guarantees.”

The Impact on Deal Structuring

A properly calculated WACC has direct implications for deal structuring. If the WACC for a Pakistan-based project is 14.21%, the project’s internal rate of return (IRR) must exceed this to be value-accretive for shareholders. If the project’s expected IRR is only 12%, the issuer must either:

1. Renegotiate the PPA tariff to increase cash flows.
2. Obtain a sovereign guarantee from the host government to reduce the SRP.
3. Use a project finance structure with higher leverage (e.g., 80% debt) to lower the WACC (since debt is cheaper than equity).
4. Obtain political risk insurance from a multilateral agency (e.g., MIGA) to reduce the SRP and CRP.

Each of these options has its own regulatory implications under HKEX Listing Rules. For example, a sovereign guarantee from the Government of Pakistan would need to be disclosed in the prospectus under HKEX Listing Rule 11.07 (material contracts), and the sponsor would need to assess the enforceability of the guarantee under Pakistani law.

Actionable Takeaways

1. Replace any single “emerging market premium” in your WACC model with a three-component framework (Sovereign Risk Premium, Currency Risk Premium, and Project-Specific Risk Premium) to comply with the SFC’s December 2024 enhanced due diligence requirements for sponsor valuations.
2. Estimate the Sovereign Risk Premium using the host country’s CDS spread or sovereign bond yield, adjusted for the proportion of the spread explained by global factors (using a 5-year rolling regression against the EMBIG index).
3. Estimate the Currency Risk Premium using the difference between the local currency risk-free rate and the USD risk-free rate, minus the forward-implied depreciation from the NDF market; where NDF markets are illiquid, use the central bank’s inflation target and the purchasing power parity framework.
4. Document the Project-Specific Risk Premium with a formal scenario analysis that assigns probabilities to tariff renegotiation, expropriation, or contract repudiation, citing the track record of similar projects in the host country from sources such as the World Bank or the host country’s energy regulatory commission.
5. Present the WACC as a range (bull, base, bear) in all board papers and prospectus disclosures, with each scenario explicitly cross-referenced to the source data and the assumptions used to derive the three risk premiums.