Climate Risk Reality: A Wake-Up Call for Risk Managers
The shift to a low-carbon economy has been set in motion, and banks are now facing clear physical and transition risks. What do these risks entail, and where do climate-change-driven technology projects fit into the big picture?
Friday, November 1, 2019
By David Kelly
Contrary to the current contemporary narrative around climate change, from a risk manager's perspective, the scientific and political argument around climate change is now over. Governments and regulators, led by the UK, have set a strong policy for transitioning to a net-zero carbon economy. Indeed, it provides everything a risk manager desires: a metric, a target and a time frame.
Risk managers can now focus on enhancing their risk practices to identify and measure the risks associated with the implementation of this policy and the expected increases in realized risk from a changing climate.
The IPCC has presented a global budget of cumulative CO2 emissions to stay within an expected temperature increase of two degrees from pre-industrial times. Asset owners have started to use this metric to disclose how much of this CO2 emission budget applies to their investments, and are also reviewing the carbon intensity of their corporate investments.
An excellent place to start this journey is to measure risk factors associated with lending to new technology projects, such as offshore wind farms. Offshore wind farms are in the news, as the UK Government recently sold licenses for the deployment of turbines in the North Sea. The strike price set was £40/MWh for delivery in 2023/24.
The most critical risk factor is the wholesale price of electricity, which has significant intra-day variance, exasperated by renewables. Unlike fossil fuels, the marginal cost of renewable energy is zero, leading to over-supply during the day and under-supply in the evenings. Storage on a network scale is still a riddle that needs to be solved.
The project teams in the offshore wind farms market have entered a contract-for-differences (CfD), where a branch of the UK Government pays the farms the strike price of £40 for each MWh they produce, usually for 15 to 20 years. Without CfDs in place, no project would get funding. The farms' revenues are now known and have the same credit as the UK Treasury.
The £40 strike price is 30% below the previous auction held in 2017 - a reduction that recognizes the substantial technology-efficiency strides made in recent years and portends the continuation of this trend for a further four years. It is difficult, however, for a credit officer to buy into to these predictions - other than to point out that if these efficient gains fail to materialize, the project could start its operational life financially underwater.
The productive life of wind farms extends for a further 10 to15 years after the CfD expires. At this stage, the project teams are likely to enter arrangements with corporates keen to purchase renewable energy. These power purchase agreements (PPAs) are currently bi-lateral and carry counterparty credit risk.
It's also possible that the wind farms market can evolve into a central clearing paradigm - but the jury is still out on this.
Transition and Physical Risks
For banks that lend to utility companies that fund a portfolio of climate-driven tech projects, the risk manager can identify a new risk factor: transition risk. In this lending scenario, transition risk measures the expected impact on the balance sheet of retiring revenue-generating fossil fuel plants, together with the cost of investing in renewable assets.
Debt covenants restrict the utility companies' ability to borrow money. If the transition speed is too low, they are at risk of punitive carbon-related taxes, sanctions or customer strikes.
Utilities are also at risk to physical risk that covers the damage to power plants from the increased frequency and severity of weather events, which can leave them either permanently stranded or uninsurable. Banks that provide mortgages to utilities are focused on properties located in flood-risk zones and other potentially uninsurable areas.
Industries such as transport, where the customer burns fossil fuels, have similar risk factors to utility companies in that they need to transition their product mix away from internal combustion engines and gas burners to embrace clean energy consumption.
Transition and physical risks will lead to higher costs to consumers, higher tax or borrowing from governments and lower investment returns that are currently not disclosed. The political and public conversation on how society will bear these costs has not started.
Risk management, though, has a clear opportunity to step up - to measure the impact of transition and physical risk accurately and to support decision-makers in making strategic allocations. Moreover, it can contribute to a narrative around how well a country is doing in meeting the targets set out by its governmental policy.
If risk managers can keep a cool head and deliver on thoughtful climate-change disclosures, then the narrative around meeting climate policies can be more pragmatic and less emotive.
David Kelly is the managing director and co-founder of Quant Foundry, a leader in climate-related corporate credit modeling. He has held a number of senior leadership and technical SME roles in Tier 1 banks, including front office, market risk, model validation and counterparty risk positions. He has also been instrumental in the application of risk architecture designs for advanced modeling solutions for compliance under several regulatory directives, including Basel 2.5, CVA, stress testing, IFRS9 and FRTB.