a transformation in the making
Regardless of where you stand on the “Trump–Thunberg scale” in terms of your attitude to the issue of climate change and the viability of a swift transition to a “zero-carbon” future, there can be no doubt that the power industry risk landscape is now on the cusp of a major transformation. That’s because there is a long running topic that has risen to strategic, board level importance and is now significantly affecting major business decisions across the globe – Environmental Social Governance (ESG)1.
In the past, business decisions taken by utility companies, their stakeholders and other corporates around the world used to be based purely on profit. Now in 2020, it is becoming increasingly apparent that, as well as profit, ESG ratings are also going to be an important driver for power industry stakeholders - lenders, insurers, shareholders, regulators – and even consumers. Indeed, it’s likely that the money will increasingly follow those power companies with the highest proven ESG credentials, because recognition of the systemic nature of ESG issues and a plan to manage them are likely to be key indicators of appropriate risk management. Much like the warning signs of the 2008 financial crisis, is it time to pay attention to the ripples before they turn into waves. Don’t forget that fundamentally sustainability is about efficiency – words any board will be happy to hear – and the transition to a low carbon economy is a financial opportunity to ensure your business is aligned with the new landscape. That means a fundamental re-appraisal of power company climate risk, to achieve (or maintain) an ESG rating that will enable them to attract and maintain the support of the stakeholders critical to their business. In short, today’s successful power businesses have to have a significant ESG footprint. The purpose of this article is to provide an overview of developments that will impact the power industry across the globe, with prudent risk management at the heart of managing this transition – both now and in the long-term future. It will discuss the gap between the science and policy response to climate change; it will examine the response of regulators, lenders and investors, along with some insights from a range of experts. Finally, it will provide a high-level summary of the consequences for the power sector as the world shoehorns ESG into strategy, business and investment decisions.
Set up in 1988, the Intergovernmental Panel on Climate Change is an intergovernmental body of the United Nations. They provide the world with objective, scientific information that is relevant to understand the risks of human induced climate change. They produce reports that cover the scientific, technical and socio-economic information of climate change, it’s potential impacts and options for adaptation and mitigation. The IPCC does not carry out original research, rather thousands of scientists and other experts across the globe contribute on a voluntary basis to writing and reviewing reports. These reports are then shared with governments, which includes a ‘Summary for Policymakers’, for them to use in their decision making. Their job is to put the facts on the table, and to use the analogy of the changes to the car industry since the move from horse and cart to the engine; it is then up to policy makers to decide if they want to put seatbelts and fire-retardant materials in and think about setting national limits to negate the speed.
In brief, the science is telling us that the earth is getting hotter. Figure 1 to the right shows that the trend of the global surface temperature of the earth; twenty of the warmest years on record were in the past 22 years. The grey line shows the rising concentration of CO2 levels. It seems that the scientific body of evidence from the Intergovernmental Panel on Climate Change (IPCC) is overwhelming. The IPCC interprets the science and summarises it to governments; it’s then up to governments what actions to take, based on the scientific data.
In 2018, the IPCC produced a special report on Global Warming of 1.5°C2. This set alarm bells ringing about the risks of climate change impacts, not only with policy makers but also with businesses and corporates, because it showed that the differences in outcomes between 1.5°C and 2°C are considerable. What’s terrifying is that, without changes, we are likely to blow through the carbon budget during the next decade and are likely to carry on warming beyond 2°C if significant action isn’t taken in transitioning to a zero-carbon economy.
Companies determine their risk appetite by analysing their exposure to a variety of segments, such as market movements, geopolitical events and changes in counter-party risk. There is now a sharper focus on environmental threats over the next ten years, and power sector industry leaders know it. For the first time in the history of the World Economic Forum’s Global Risk Report 2020, environmental threats dominate issues on senior leaders’ agendas, as evidenced by the position of the green diamonds in Figure 2 on the previous page – remember this is a survey asking them what issues are crossing their desks before the onset of the COVID-19 global pandemic. In summary: business and finance leaders know that the likelihood and impact of environmental threats to the power sector are high. The science is clear - high carbon intensive industries are particularly exposed to three primary risks: physical, transitional and liability, all of which have significant financial consequences for the power sector. Let’s discuss each in turn.
As many readers will already appreciate, climate change is not just about temperature rise - there may also be unpredictable changes to the weather. Chronic changes to temperature and sea level rise will accompany changes to acute extreme weather events such as tropical cyclones, wildfires or droughts. Indeed, climate change affects virtually every aspect of the energy system, with specific challenges varying by geography and intensity. A Florida electric company is worried about hurricanes; California utilities have to manage wildfires; droughts and flooding impact electricity demands across the globe and power plants’ ability to meet them. The concept of prudent expenditure is relevant to forecast normal operating conditions but it’s difficult to create an expenditure forecast assessment for extreme weather events if the past is no longer a reliable guide for the current of future climates; for example, Australia’s recent bushfires have been unprecedented in their frequency, severity and geographic spread. The region you’re in might not be impacted by water stress or flooding right now, but that could change and seasonal tolerances might be further stressed. This is where the use of those IPCC scenarios is incredibly useful because they give an evidence-based frame to consider possible futures for asset management and new capital expenditure. Business Interruption The power industry will also face an increasing number of Business Interruption (BI) scenarios according to the Allianz Risk Barometer 2019, and natural catastrophes were the third biggest fear of businesses, after BI and cyber incidents.3 What’s it going to cost? The potential costs of insuring assets against the impact of climate change is higher for the energy industry than any other line of business. According to an analysis from Schroders as part of a physical risk assessment for the oil & gas industry, it could equate to more than 3% of their market values, as outlined in Figure 3 right.4
Transition risks occur as societies move toward a zero-carbon economy. 49% of annual global GDP – more than $39 trillion – is now covered by regions of net zero targets, according to the latest analysis from the Energy and Climate Intelligence Unit (ECIU).5 Investors have a growing concern over the viability of high carbon business models in an increasingly carbon-constrained world. Creating an effective climate risk mitigation plan is proving difficult for the power industry, but it is not impossible. The transition away from coal generation is ongoing. Gas has been promoted as a “bridging” fuel in the transition to a zero-carbon economy; however, it is still a fossil fuel. And any advantage it might hold over more carbon intensive fuels such as coal or oil are lost with even small amounts of leakage of methane, which is a far more potent greenhouse gas than CO2.
Furthermore, it has been estimated that the implementation of a carbon tax, which is one of the most commonly cited potential policy responses, on the power generation and oil & gas industries with a tax level of about $50 /tCO2e could result in $50 billion to $300 billion in losses on outstanding debt across both sectors; the report extrapolated that as much as $1 trillion could be at risk in the broader economy7. “Transition risks are more advanced in the power sector as renewable energy has disrupted power more than any other sector,” says Mark Lewis, Head of Climate Change Investment Research at BNP Paribas Asset Management. While global electricity production has grown continuously since 1974, except for the blip in 2008-2009 due to the financial crisis, with non-OECD countries more than doubling the share they held in 1974,8 Mark Lewis points out that, “electrification is going to be one of the main drivers of the next three decades. Electricity is the fastest growing part of the energy sector, and renewable energy the fastest growing part of electricity demand.” Indeed, in Europe electricity produced with renewables have increased as much as 150% since 2000, whereas fossil electricity dropped by 17% according to Eurelectric, the federation for the European electricity industry.9
The 3 big Ds “The big three Ds to watch in the power sector are decarbonisation, digitalisation and decentralisation,” says Laurent Segalen, a clean energy banker, and co-host of the Redefining Energy podcast. Segalen has a point; the world is now committed to decarbonising the economy, digitalisation has increased efficiency and decentralised power is more in demand as it meets the needs of society better while technology, such as solar rooftops and batteries, has become much cheaper. Electricity customers across residential, commercial and industrial segments want cleaner energy sources, increased resilience and more control over their energy use.10 Many power companies are already exploring new business models. “Ten years ago, the power industry had fat margins, but now utilities operate on thin margins, they’ve had to adapt,” says Segalen, “and utility companies had technological choices to make regarding renewables - some of them took that route while others fought against it. At the end of the day, it was not a given to make the move to renewables, it was a choice.” The energy chain has been consolidating and new business models have appeared. Energy big-data created by smart metering, coupled with AI, is providing new insights into demand and customers preferences, allowing utilities to continuously improve the customer experience and manage the grid more effectively. However, digitalisation creates its own challenges for power companies; for example, with regards to managing growing cyber risk and the rise of new nimble actors such as aggregators, Virtual Power Plants (VPP) and traders. Nuclear power and Carbon Capture & Storage In my view, nuclear power is a bit like marmite: you either love it or hate it. For the benefit of non-UK readers, marmite is a sticky, dark brown spread that’s made from yeast extract, vegetable extract and spices that the Brits spread on toast for breakfast. Much debate goes on in the UK about which camp you are in11; a parallel universe seems to exist regarding opinions on nuclear power. Choosing where you stand is not so simple because on paper, it’s great. Many studies in top scientific journals find that nuclear power plants are one of the safest ways to make reliable energy; they provide a stable baseload, in contrast to renewables which are intermittent. Unfortunately, it is also one of the most expensive options to produce electricity and there is a significant construction time lag; it takes 5-17 years longer to build a new nuclear plant than a utility scale solar or onshore wind farm.12 Whatever camp you are in regarding your views on nuclear power, the fact of the matter is that we must abate carbon in the shortest amount of time and in the most cost-effective manner. Laurent Segalen makes three substantive points: “First of all, nuclear power is one of the most centralised ways to make electricity, which conflicts with the growing trend of decentralisation that seeks stable grid management and can still serve the last mile of customers. Secondly, it is also inflexible, so difficult to manage in grids integrating more and more renewables. And finally, nuclear is the most expensive form of energy, being the only source of power which costs have gone UP in the past 10 years by around 20% to 30%, when wind and solar were benefiting from costs reductions of between 50% and 80%. Without huge subsidies, nuclear is now uneconomic and has become a political rather than an economic choice.” Furthermore, Mark Lewis indicates that, “there will be further step changes in renewables efficiency and battery storage during the time it could take to build new expensive nuclear power plants.” Carbon capture and storage technology is not advancing quickly enough to curb emissions growth. There is no silver bullet to tackle decarbonisation; it is a complex and challenging task requiring all stakeholders, governments and society to come together to find solutions. And as shown below, the task is will only become more challenging as policy continues to tighten.
Business interruption Of course, business interruption risk is not just physical; it can impact a company’s reputation and has the potential for liability. As well as choosing not to insure high-carbon assets in some instances, insurers are also hedging against losses due to physical impacts by improving their risk analysis with advances in climate modelling. Premiums are being adjusted and industries with large environmental footprints are under increasing pressure to safeguard sensitive ecosystems, both on land and at sea.
Utility companies are already facing the physical and transitional risks of climate change and now they have to confront a third risk in the form of litigation liability. Some of the litigation claims seek to attribute Scope 3 emissions (third party emissions from the end use of products) to the power/energy producer or seller of those products. New litigation cases are using science to quantify and show the relationship between emissions to particular place-based companies and climate change related impacts, such as sea level rise.13
Pacific Gas & Electric: the first “climate change bankruptcy” PG&E has been heralded at the first ‘climate change bankruptcy’ when they filed for bankruptcy in the face of liabilities from wildfires of $30 billion or more that swept across their service areas in northern California. PG&E is a regulated utility that serves approximately 5.2 million households. It’s been over a year and PG&E is trying to restructure its debt to emerge from bankruptcy. During the past year PG&E announced a $13.5 billion settlement with a committee of law firms representing about 70% of people who suffered losses from fires in recent years and reached an $11 billion settlement with insurance companies on claims related to the recent wildfires. Regulators boosted a previously agreed $1.7 billion settlement announced in December 2019 to a record $2.1 billion penalty in February 2020. PG&E still face hurdles and California Governor Gavin Newsom set a deadline for a bankruptcy exit plan to be in
place by 30 June 2020, which would allow PG&E to access a new state “wildfire fund” to pay for damages. PG&E still needs state approval of the plan to qualify for the fund.
On March 16 2020 PG&E won court approval to raise $23 billion to help pay its bills over destructive California wildfires after Governor Gavin Newsom dropped his opposition to a financing package designed to help the nation’s largest utility get out of bankruptcy.
Sources: https://www.mercurynews.com/2020/01/23/confused-about-pges-bankruptcy-heres-what-you-need-to-know/ https://www.cnbc.com/2019/09/13/pge-reaches-11-billion-settlement-relating-to-wildfire-claims.htmlhttps://www.nbcbayarea.com/news/california/california-wildfires/regulators-boost-pges-wildfire-fine-to-2-1b/2243860/ https://www.marketwatch.com/story/pge-wins-court-approval-of-23-billion-bankruptcy-financing-package-2020-03-16
Global trends in climate change litigation According to a “Global Trends in Climate Change Litigation: 2019 Snapshot” policy publication at the Grantham Research Institute on Climate Change and the Environment housed at the London School of Economics, climate change litigation is expanding across jurisdictions as a mechanism to strengthen climate action14. There are over 1,800 climate laws and policies according to Climate Change Laws of the World, an open-access compilation of climate change litigation, which is increasingly viewed as a tool to influence policy outcomes and corporate behaviour15. Combine this with increasing climate-related disclosure reporting and one starts to question, and look into, who the shareholders are in the utility provider. “The investor in the power company could be caught by new climate mandatory reporting rules,” according to Wendy Miles, Partner at Debevoise & Plimpton, who deals with international dispute resolution, including climate change. Article 173-VI of France’s Law on Energy Transition for Green Growth (LTECV) has set a global precedent by requiring institutional investors to be transparent on the climate impacts of their investments. Much like obligatory financial reporting, investors have to “comply or explain”. Since 2016, when Article 173 was put into law, there are several French legal cases that have been brought forward. Claims have issues ranging from companies failing to adequately assess and report climate risks of their own activities to action taken against the French government’s failure to take further action to reduce greenhouse gas emissions, claiming that this violates a statutory duty to act under domestic and international law. Investors in France have a legal obligation to report and reduce the carbon footprint of their portfolios; by continuing to hold carbon intensive assets in them, they hold direct and indirect litigation risk. “Litigation risk for the investment target detracts from its investment appeal and the investor itself could face claims for director’s breach of fiduciary duties if it were to misreport the climate risk across its portfolio,” points out Wendy Miles.
The push for climate disclosure Michael Bloomberg tweeted in 2014: “if you can’t measure it, you can’t manage it.”16 The truth of the matter is that climate risk is hard to measure. Much of this is due to a lack of data - how do you take decisions when faced with the uncertainty of climate change, knowing that your data is incomplete? Work is being done across governments and industry that addresses those data gaps. For example, the EU taxonomy for sustainable activities released last year provides guidance to around 6,000 EU-listed companies, banks and insurance companies that have to disclose non-financial information under the Non-Financial Reporting Directive. However, more methods are required to asses climate risk. Researchers out of the University of Arizona specifically focused on literature about climate risk management in the case of the electric utility sector and learned that while the industry anticipates climate change extreme events, that there were no observably uniform methods for assessing risks.17 This is why new tools, such as Willis Towers Watson’s Climate QuantifiedTM, will be crucial to risk managers (see the next chapter of this Review). Increasing action by investors and the banking sector During 2016 to 2018 ESG investment grew 34%, representing $30.7 trillion in assets, according to the Global Sustainable Investment Alliance.18 The growth of sustainable and ethical investing continues to rise, with new funds being developed alongside ESG products and services. The overall rational for ESG, or sustainable investing, is that those companies who are managing their risk would, in theory, perform better in the transition to a low-carbon economy. Furthermore, some research shows that companies with higher risk of climate change have a higher cost of capital.19
Lenders are responding to calls for them to do more. The rise of green financial products continues, with banks creating new green instruments and implementing climate risk assessments or a 2°C scenario analysis. Alongside this there is thorough work being undertaken to consider what green is, so there will be no room to hide behind surface level efforts. The UNEP FI Principles of Responsible Banking is an example of one of the initiatives that is actively exploring this space.
In addition, the rise of green and sustainability linked loans signals the start of a fundamental shift in the broader economy. The key difference between a green loan and a sustainability linked loan is that use of proceeds in sustainability linked loans are not conditional for a particular green purpose. Rather, the sustainability linked loan incentivises the borrower to improve its performance against predetermined ESG criteria and KPIs. “Sustainability linked loans are one way for utilities to finance their transition and transition financing is going to take on more importance as we further advance to a low carbon economy,” says Graham Smith, Director, Sustainable Finance Unit at HSBC. Smith represents HSBC on the Loan Market Association’s (LMA) Green Finance committee. The LMA, in consultation with private sector financial institutions and law firms, have developed documentation to help standardise Green Loan and Sustainability Linked Loan Principles. Standardisation is one of the keys to improving market liquidity as it creates a pathway for other banks and investors to follow. It sets the “rules” of the game, so to speak, so that other actors, including utilities, can participate. “However, one must understand that there are global differences and you can’t apply just one standard globally. The IFC guidance is to use the best standard available in that country with the view to always looking for improvement,” said Graham Smith when questioned about how the EU Taxonomy will fit into the green and sustainability linked loan principles.
Central banks are taking action Climate-related risks pose complex challenges not just to private banks but also to central banks, regulators and supervisors. Contrary to the lack of significant global policy responses from governments, the rise of central banks examining climate risk shocks to financial stability has been swift. They are becoming organised via the Network for Greening the Financial System (NGFS) which was launched in December 2017 with eight central banks and has grown to 65 members and 12 observers across five continents20. The NGFS is a group of central banks and supervisors who are developing guidance around climate risk assessment and scenario analysis. This work will provide frameworks for other regulators who are also looking to evaluate climate risks – at the end of the day what they want to know is that companies understand their risks and are taking concrete action.21 The rise of climate stress testing Stress testing is conducted to focus on financial stability, to ensure that financial institutions are adequately capitalised for the next crisis. Regulators develop macroeconomic scenarios; firms evaluate their portfolio against these scenarios and create their own scenarios too. The Bank of England is looking to test the resilience of the current business models of the largest banks, insurers and the financial system to the physical and transition risks from climate change.”23 Central banks tend to adopt the best market practices of their peers; it would be a logical development for other central banks to follow suit with climate stress testing in their own countries. Efforts by the NGFS are gathering momentum and numbers to create a framework, and the development of more low carbon policies is just a short matter of time. These policies will increase the burden on risk managers.
Physical and transition risk The costs of physical impacts and business disruptions can be considerable for the power industry. Utilities still depend heavily on fossil fuels for power generation, yet many are locked into high emissions from long-lived fossil fuel power plants until 2050, so transitioning out of this will prove challenging.24 The global financial system and the power industry must make a faster shift towards the alignment of climate security and sustainable development. Liability risk Some commentators have shifted their focus to physical and transition risk, grouping litigation risk within the latter. This detracts from the significance and unique challenges of litigation risk, which encompasses risk arising out of new transition reporting regimes, but also myriad potential claims affecting all aspects of utility operations, from permitting to licensing to environmental protection and continuing efforts by NGOs and citizens to seek to attribute historic climate change to energy and power providers. As transition continues to change the regulatory framework, that litigation risk is likely to increase without careful and focused risk management by utility providers and their investors. The growing trend of litigation cases against energy companies has just got started and the financial and solvency, implications could be severe. The bankruptcy of PG&E has been recognised as the first major corporate casualty of climate risk, and few people expect it to be the last. Final thoughts: prudent risk management will be critical! Capital has to be reallocated to support the just transition to a zero-carbon economy. Such a just transition means balancing society and the economy, along with managing the transitional implications for potentially “stranded” assets, communities and workers. Transitioning to a zero-carbon economy for the power sector is extremely complex, with lots of moving parts. ESG actions, financial flows and alignment are not happening fast enough to deliver impact at scale. Fundamental systemic change is required on a global level - change is coming, whether we like it or not. It can be embraced or delayed – but not avoided, so starting now is key. The COVID-19 pandemic highlights the importance and value of collective action with coordinated support; long term strategies and sustainable investment approaches are required.
To conclude: as stated at the beginning of this article, prudent risk management is at the heart of this piece. For utility companies to remain a going concern in the future, action is required: be prepared, share information and work with other relevant stakeholders and governments to find solutions for the eventual transition to a zero-carbon economy. Only in this way will the industry respond effectively to the future transformation of the power market risk landscape.
Margaret-Ann Splawn is a climate policy, finance and investment consultant. She is a member of the Energy, Sustainability & Climate taskforce of the B20, the official G20 dialogue with business and Active Private Sector Observer for developed nations at the UN Green Climate Fund. margaret.splawn@cmia.net
1 ESG has been defined by the Financial Times as “a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies. ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability” - http://markets.ft.com 2 https://www.ipcc.ch/sr15/ 3 https://www.agcs.allianz.com/news-and-insights/expert-risk-articles/risk-barometer-2019-nat-cat.html 4 https://www.schroders.com/fr/insights/economics/how-will-physical-risks-of-climate-change-affect-companies/ 5 https://eciu.net/news-and-events/press-releases/2020/almost-half-of-global-gdp-under-actual-or-intended-net-zero-emissions-targets 6 https://webstore.iea.org/download/direct/2563?fileName=Electricity_Information_2019_Overview.pdf 7 https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2020/February/Climate-Change.pdf 8 https://www.iea.org/reports/electricity-information-2019 9 https://cdn.eurelectric.org/media/4005/power-barometer-final-lr-h-3A4C4DC9.pdf
10 https://www2.deloitte.com/content/dam/insights/us/articles/5065_Global-resources-study/DI_Global-resources-study.pdf 11 https://www.theguardian.com/lifeandstyle/2016/oct/13/what-is-marmite-british-food-spread-tesco 12 https://www.worldnuclearreport.org/IMG/pdf/wnisr2019-v2-hr.pdf pg 25 13 https://insideclimatenews.org/news/04042018/climate-change-fossil-fuel-company-lawsuits-timeline-exxon-children-california-cities-attorney-general 14 http://www.lse.ac.uk/GranthamInstitute/publication/global-trends-in-climate-change-litigation-2019-snapshot/ 15 https://climate-laws.org/ 16 https://twitter.com/mikebloomberg/status/425738442803511296?lang=en 17 https://reader.elsevier.com/reader/sd/pii/S2212096317301572?token=8D05ACC7D9A8C5678504212F21F8CDC8E47B155F50B292F16A6C41D8748E44 B7555C43297DBB78EA727DAC43C0F2A56F pg 16 18 http://www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf
19https://www.researchgate.net/publication/326350603_ Relationship_between_Climate_Change_Risk_and_Cost_of_Capital 20 https://www.ngfs.net/sites/default/files /medias/documents/ngfs-a-sustainable-and-responsible-investment-guide.pdf 21 https://www.ngfs.net/en/about-us/membership 22 https://www.bis.org/press/p200430.htm 23 https://www.bankofengland.co.uk/-/media/boe/ files/paper/2019/the-2021-biennial-exploratory-scenario-on-the-financial-risks-from-climate-change.pdf 24 https://www.cdp.net/en/articles/media/major-european-utilities-put-14-billion-of-earnings-at-risk-by-missing-climate-goals-new-report-finds
