Wake up and smell the coffee: why the rise of renewables poses its own risks and challenges
Wake up and smell the coffee: why the rise of renewables poses its own risks and challenges
Introduction: new developments, new challenges
At the same time, overall corporate knowledge and understanding of the economic and societal impacts of climate change has evolved far beyond the original “bubble world” of the sustainability department. The UN Conference of the Parties (COP)1 is now under the spotlight, with UK prime minister Boris Johnson stating that “the UK will lead by example” ahead of hosting next year’s COP26 summit in Glasgow.2 3 4
New developments 5 . Renewable generation capacity increased by 176 GW (+7.4%) in 20196 , while hydropower accounted for the largest share of the global total, with a capacity of 1,190 GW. Meanwhile, solar and wind energy continued to dominate renewable capacity expansion, jointly accounting for 90% of all net renewable additions in 2019.7 8 9 Figure 1 below shows the global weighted average levelized cost of electricity from utility-scale renewable power generation technologies between 2010-2019.
Furthermore, the projection is that renewable energy spending - for the first time in history - is now set to surpass upstream oil & gas in 2021, according to a research report by Goldman Sachs as shown in Figure 2 overleaf. According to their research, the clean energy sector is to reach $16 trillion by 2030 and the main driver is the diverging cost of capital.11
New challenge number one – overcoming barriers for scale While the solar and wind markets were largely kick-started by global subsidies or tax breaks depending on the region, it was the continuing advances in technology, decreasing prices and innovations in policy and financing that helped make renewables more attractive, affordable and bankable. Nonetheless, it’s been a bendy road and the industry is now met with various barriers for scale challenges, including high set up costs, intermittency issues, and storage limitations.
New challenge number two - regulatory scrutiny arising from climate change Declaring the climate emergency and setting net-zero targets was the easy part; designing low-carbon solutions that are widely available will be much more difficult and targets need to be underpinned by deliverable plans. This poses particular challenges for the renewable energy sector; while it may currently be the darling of the global energy market, renewable energy companies don’t hold a Monopoly-style ‘get out of jail free card’ for simply delivering low carbon energy. Instead they will be subject to increased scrutiny, as several of the materials used in renewable energy infrastructure carry a heavy carbon footprint and /or carry supply chain risks. Furthermore, many renewable energy companies operate under the umbrella of larger utilities or oil & gas majors; new, more stringent regulations are bound to be imposed on carbon intensive industries as government policy tightens across the globe to meet the objectives of the Paris Agreement.
And as most readers will be aware, there has been a constriction of insurance and access to capital for the coal industry, a trend which is now being directed increasingly to the oil and gas industry.
New challenge number three – Environmental, Social, and Governance Alongside designing, implementing and executing a low-carbon strategy, renewable energy companies also have to confront another issue growing in importance – Environmental, Social, and Governance (ESG)12 . ESG has proven to be a safe haven in the pandemic for investors, while ESG ratings are proving to be an important driver for renewable energy stakeholders, from lenders, insurers, shareholders, regulators and even consumers.
Part One – barriers to scale: flexibility, transmission and storage challenges
“The lower cost of capital and scaling of the renewable energy market will drive innovation further,” says Marina Valls, Chief Economist at Renewables UK, an industry association representing over 400 international member energy companies. I also questioned Valls as to how many of their members have net-zero targets and she replied: “most of our members have net-zero goals and this builds the business case for a network that allows flexibility to be valued.”
Flexibility - to fatten or flatten the “duck”? The grid therefore needs to be flexible and able to integrate renewables into the system. The fastest growing segment of new energy is solar, so let’s consider what this means to integrate it into the grid. In some regions solar can supply nearly all the electricity to customers for part of the day, which creates a mismatch between supply and demand. There is customer demand for electricity in the mornings and as the sun gets stronger, solar takes over. But just as soon as the sun goes down, utilities must ramp up their supply with conventional generation. Following this pattern, the utility supply curve can end up looking rather like a duck.
This demand curve situation was illustrated and created by California Independent System Operation (CAISO) in Figure 3 above.
The National Energy Renewable Lab (NREL) suggests two approaches to re-shape the curve: “fatten the duck” or “flatten the duck”.14 Fattening the duck consists of figuring out how to make it cheaper and easier to turn on and off large power plants that normally run all the time. Flattening the duck consists of energy efficiency gains, storage capacity, transmission ties and shifting demand response. More often than not, to flatten the duck requires a combination of some or all of these; hence the need to optimise the grid. This is where technology, artificial intelligence (AI), and innovation come into play.
Transmission – “push” or “pull”? Grid flexibility is challenging, as most grids were not built to accommodate intermittent renewables. Furthermore, for the most part transmission grids run inefficiently as they route power flows to the path of least resistance, which means that some transmission lines are overloaded while others are not utilised. Pushing or pulling power to transfer it in the most efficient way requires changes to the grid, which creates additional risk for utilities to manage. However, there are disrupters in the market coming up with innovative solutions for grid flexibility and transmission, such as Smart Wires based out of California.
Smart Wires is a small compact modular solution using semi-conductor technology that enables grid operators to put more intermittent renewables on to the system and get more transfer capacity. Their team of consultants works with grid operators and they use automated tools to identify where to put Smart Wires equipment based on the objectives and unique circumstances of the grid. They use silicon and software to produce the same device, thereby providing both high reliability and quality.
The UK’s National Grid Electricity Transmission awarded a five-year framework agreement to Smart Wires in November 2019 to help decarbonize the UK electricity grid by enabling greater volumes of renewable power to be efficiently transferred to customers.15 More utilities are looking for transmission solutions to accommodate renewables onto the grid and are turning to external providers for solutions.
Technology advances will allow power grids to become more intelligent and optimise transfer capacity. Furthermore, regulation can support and drive incentives such that the utility is incentivised to find the lowest cost and cleanest energy solution.
Storage – the struggle to be cost-effective If the need for flexibility in renewable energy can be graphically represented in the duck curve, then solving the storage problem - in a cost effective, scalable way - could be considered as the goose that lays the golden egg.
Alas, this continues to remain a bit of a fairy tale at this time, as battery storage alone struggles to be cost effective. New and emerging technologies are happening in the industry, much of it driven by battery development in the electric vehicle market, but the investment case just isn’t there yet as a cost effective, wide scale solution. The battery market remains fragmented and these assets are increasingly being put into hybrid configurations, primarily with solar power, to solve for resource adequacy. What’s encouraging is that storage is versatile; it’s capable of doing what it is configured to do and can derive efficiencies to ensure moving energy to when and where it is most valuable while maintaining grid quality and reliability along the way.
Part two - climate risks: physical, transition and liability
Physical risks: wildfires, floods, droughts and windstorms Climate science shows that as average temperatures rise, more extreme weather events such as wildfires, floods, droughts and windstorms grow in frequency and severity. Renewables infrastructure assets, such as wind turbines and solar farms, could be damaged by flooding, fires and other hazards. If these assets are damaged or disrupted, the services they provide could decline or stop all together – as evidenced in California recently, where there was no electricity for days due to wildfires.
This is where the use of the Intergovernmental Panel on Climate Change (IPCC)16 scenarios are very useful because they provide an evidence-based framework to consider possible futures for asset management and capital expenditure.
Transition risk: pressure to enhance climate ambition Transition risks occur as societies move toward a zero-carbon economy. In June 2020, the Energy and Climate Intelligence Unit (ECIU) shared an analysis that 53% of annual global GDP – more than $45.9 trillion – was covered by regions of net zero targets.17 These figures are already obsolete as since this data was released, China, Japan and South Korea have all pledged to achieve carbon neutrality in the future.18 These announcements put pressure on other major emitters to enhance their climate ambition.
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Investors across the globe have a growing concern over the viability of high carbon business models in an increasingly carbon constrained world. All industries will be subject to more scrutiny and renewable energy companies will need to create effective climate risk mitigation plans; this will also include examining their procurement supply chains for lower carbon solutions in materials and construction standards.
Using a risk-based approach here is key for the renewables industry to move forward and find solutions. We are now seeing a shift in procurement to examine the carbon content of materials; building the cheapest to deliver is no longer good enough and considerations for lowest carbon must now also be part of the project strategy. Some asset owners and project developers are working with their supply chains to understand what the possibilities and risks are for lower carbon materials such as cement, steel, and aluminium.
What’s interesting is that this is being done without explicit regulation; forward thinking companies are seeing what’s on the horizon and want to get ahead of policy changes. The European Union has a €1 trillion European Green Deal that aims to make the 27-nation bloc carbon neutral by 2050. To this end, the introduction of a WTO-compatible carbon border adjustment mechanism (CBAM) was announced for selected sectors to be introduced by 2021.20 The exact design of the CBAM is still being worked out, but basically it will be a levy of sorts on imported goods from countries with weaker climate policies. The CBAM would place a carbon price on imported goods from outside the EU that fail to meet certain environmental standards. As the EU continues its climate ambition, it wants other countries to play ball by upping their climate game and reducing their risk of carbon leakage. Aligning the CBAM with World Trade Organisation (WTO) rules will be complex and politically challenging but the direction of travel is clear.
Liability risk: deliverability a potential litigation issue Climate change litigation is expanding across multiple jurisdictions as a mechanism to strengthen climate action.21
From 2020 to 2025, the IEA estimates that the main driver of 9% of renewable capacity expansion is expected to be corporate Power Purchase Agreements (PPAs) and merchant plants.22 Three drivers of PPAs include the lack of or insufficient support schemes, existing operations that will lose or are in the process of losing their support schemes, and corporate buyers wanting to ensure that they are purchasing carbon neutral electricity.
“Dealing with market vagaries such as these creates uncertainty for participants, alongside an increase of potential litigation risk in the form of deliverability”, according to Andreas Gunst, partner at DLA Piper, who specialises in renewable energy certificates and corporate PPAs. Most corporate PPAs are entered into for corporate ESG and carbon neutrality accounting and, increasingly, to support claims that the production of goods or provisions of services are carbon neutral. However, comparatively little thought is spent on whether the specific model of PPA or the way environmental attributes are claimed or retired correctly represents the picture communicated to the customers on a company’s carbon neutral activities.
“National laws on misrepresentation or misleading advertising can have severe and far reaching implications. Even keeping to industry guidance may not appropriately shield from compensation claims or rights to reverse consumer contracts concluded on the basis of factually incorrect or misleading statements about use of renewable energy in production or service processes. This is a significant sleeping risk,” says Gunst when I interviewed him about the growth of the market and potential PPA risk. “After all, there is not a great difference between customers seeking to reverse their purchase of a car because of a ‘defeat’ software or because the claim that the production of the car was 100% carbon neutral turns out to be factually incorrect,” concluded Gunst.
Climate change litigation is expanding across multiple jurisdictions as a mechanism to strengthen climate action.”
Part Three – rising ESG investment: implications for the renewables industry
Dealing with “unknown unknowns” as ESG funds increase If there is one thing that the pandemic has taught us, it is how to deal with “unknown unknowns”. Some renewables companies are manging these better than others and the pandemic is revealing that the future materiality of a company is increasingly tied to its resilience.23 ESG funds have outperformed conventional funds in the US during the pandemic,24 while ESG is already prominent in Europe - in terms of the availability of ESG products, dedicated ESG labelled funds or funds focusing on sustainable investing available from the top 100 asset managers, the UK led the way at 80%, followed by 73% of European managers.25
Furthermore, ESG investing now accounts for one-third of total US assets under management, according to the US SIF 2020 Trends Report, which tracked data as of year-end 2019 and found that investors are considering ESG factors across $17 trillion of professionally managed assets, a 42% increase since 2018.26 This is a continuation of the significant growth in money managers and institutional investors that consider ESG factors to be able to identify well managed companies that will be sustainable and resilient over the long term. The recent change in the US administration is likely to increase ESG investing further.
Why ESG matters: the money will follow it! 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. There is research that demonstrates the positive relationship between high ESG performance and superior financial performance, and another study reported that companies with the highest ESG ratings out-performed lower rated firms by as much as 40%.27 In addition, other research shows that companies with a higher risk of climate change have a higher cost of capital.28
However, ESG criteria advances further and now demands that companies also deliver impact by seeking to do no harm, improving stakeholder wellbeing and benefits, and providing a societal and/or systemic solution. The shift to renewables is a systemic change solution to move towards a low carbon economy.
ESG reporting initiatives Meanwhile climate risk disclosure and reporting is on the rise and will be mandatory in Europe for financial market participants and companies by the end of 2021 under the new EU Taxonomy rules.29 This will create an additional administrative burden on renewable energy companies to comply with this new regulation.
ESG scores and ratings But even as investors are calling for better ESG data, information asymmetry persists. ESG scores and ratings vary between agencies and these can be difficult to compare. Some ESG ratings might focus more on social purpose, while others might put more weighting on environmental issues.30 Bloomberg has their own ESG data and scores so including third-party data from providers like MSCI signals a move to increase transparency in the market.
The role of the risk manager in ESG: navigating the changes Climate change is a material risk that exposes companies to both financial and societal impacts. Investors need visibility from company accounts and reporting as to its ESG efforts and there is a real risk of companies getting left behind if they are not demonstrating thorough actions and transparent reporting. However, reporting is still nascent; diverse developments in ESG ratings, scores, disclosure and standards are on-going, so figuring out which direction to navigate safely across this “Serengeti” landscape isn’t straightforward.
Conclusion: implications for the renewable energy industry
Final thoughts: prudent risk management will be critical! Renewable energy risk managers and business leaders will need to adapt to climate change and integrate it as a major consideration in decisions. Developing robust quantitative knowledge is complex and requires new metrics, new tools and new relationships alongside new technologies and approaches to manage climate risk.
Margaret-Ann Splawn is a climate policy finance and investment consultant and is a member of the Energy and Resource Efficiency taskforce of the B20. She is the Executive Director of the Climate Markets & Investment Association, Active Private Sector Observer at the UN Green Climate Fund, and a Fellow of the Royal Geographical Society. margaret.splawn@cmia.net
