Decarbonisation and transitional risk: How will your investment decisions be impacted?

We have already seen the road to decarbonisation producing systemic shifts to the way that assets are viewed and the value attributed to them, whether we are talking about a storage project or period buildings with little to no energy efficiency measures in place. Transitional risks of changes in policy, changes in technology, changes in societal attitudes and even changes in the physical environment in which projects are built will continue to feature as increasing risks to the value of projects in a move to a decarbonised world: risks that investors will need to navigate. In some cases, the extent of the impact of these risks may lead to the economic return of projects no longer standing up to the expected returns - they will become a "stranded asset".  

Stranded assets are assets which, due to market changes, have suffered from a decrease in value and/or revenues, in a way that was not factored into any financial model or anticipated rate of return when investment into such asset was made. 

With energy projects operated and their returns modelled for such long periods of time, is there a way to future proof assets against significant loss in value due to market changes that are even at this date unforeseen? 

Policy changes

The Paris Agreement set in place a legally binding international treaty on climate change. Adopted by 196 parties, this agreement has been translated across the globe into various domestic political commitments, policy and regulatory changes, and concerted action to limit global warming to well below 2 degrees centigrade.  

In the UK, the government earlier this year imposed a new interim target to its net zero goal by 2050: it now also aims to reduce greenhouse gas emissions by 78% by 2035. This follows its Ten Point Plan released at the end of 2020, which set out an overview of how it intended to accelerate private investment into the technologies it sees as crucial to achieve net zero.

Earlier this year, the EU Commission released its "Fit for 55" package, comprising reforms to existing legislation to reduce emissions by 55% by 2030 and ensure that the EU is carbon neutral by 2050.

And coming out of COP26 we have seen new commitments to phase out coal and invest in new (including as yet unidentified) technologies to reach global decarbonisation targets.

Each announcement and initiative necessitates policy and regulatory changes. While to date these have been focussed on growth and investment in green technologies driving decarbonisation (so more carrot than stick), both an ever-approaching deadline and an increase in scrutiny of the actions being taken at every level to develop a more sustainable way of life are encouraging a huge significant rise in activity  to meet emissions targets. 

An example of such action in the UK is the prohibition on selling new petrol or diesel cars and vans from 2030. Bringing this deadline forward by ten years effectively accelerated the depreciation of value of assets involved in delivering fuel to vehicles and the infrastructure that sits behind that. It is not out of the question that the government could legislate to render carbon-intensive or fossil fuel-based technologies obsolete in order to achieve its targets.

Technology changes

As a number of the UK government's existing policies focus on growth and investment in green technologies to drive decarbonisation, continuous technological change will occur for the foreseeable future. Such technological change may result in assets becoming obsolete, becoming less relevant or being subject to increased competition for provision of the same services.

The increased focus on the growth of low carbon hydrogen and its use in energy capture and storage, together with continued development of battery technology in the provision of grid balancing services, may render the delivery of such services by non-green technology a thing of the past. Balancing plant such as gas peakers and diesel generators may cease to retain their place in the energy mix in the favour of more green technologies that do not rely on any level of carbon capture. Some commentators predict that by 2030 energy storage will outperform gas peakers and become the technology of choice across all markets.

That said, the impact is not solely faced by fossil fuel-based technologies. Progress in energy storage technology is making renewable energy-generating assets more efficient. In projects where co-location of energy storage is not achievable, the revenues capable of being generated may become increasingly affected by competition from energy sold from other projects, reducing the forecast revenues modelled at the outset of the project. In addition, battery storage technology is moving at such a pace that many batteries may become outdated as new storage technologies are developed.  

Societal attitude changes

Consumers are becoming ever more conscious of their impact on the environment and their potential to effect change through their choices. This shift is being further recognised by the companies that serve those consumers. Through actively making green choices, consumers may divert their spending from industries and technologies that are more carbon-intensive to those that are more climate change friendly. Diversion of such spending will in turn have a negative impact on the earnings capacity of such affected assets.

On the other side of the coin, investors are also becoming more cognisant of the environmental, social and governance (ESG) impacts of their investments and how they can deploy capital more positively. The availability of equity for carbon-intensive technology may become constrained as investors seek more environmentally positive investments to support their ESG credentials. This in turn reduces the efficacy and funds available to establish and run projects.

Physical environment changes

While policy, technology and societal attitudes may shift to bring about decarbonisation and may reduce emissions to meet the UK government's 2030 target, the assets themselves may become compromised by physical environmental changes in the meantime.

The extent of climate change on the Earth is already serving to increase risks of extreme weather events such as flooding, sea level rises, high winds, drought and abnormal temperatures. Each of these events may in their own right serve to damage assets (perhaps beyond repair). However, continued exposure to such events on a regular basis may serve to undermine the project or the economic potential of a project. For example, rising sea levels may cause projects or the land on which they are situated to becoming increasingly more affected by the tidal flows and raised average sea level, resulting in subsidence as the land becomes more waterlogged. A project that seemed viable in the physical environmental conditions in which it existed when established, may no longer be sustainable.

Beyond major weather events, more permanent climate change will reduce the effectiveness of renewable energy assets. For example, a sustained increase in temperature can reduce the efficiency of photo-voltaic modules, can reduce air density and therefore capable output of wind turbines, and can increase surface evaporation from water storage impacting on hydropower generation capacity. Long-term climate change models and their impact on technology efficiency will be important in determining any effects on investments.

The impact on financing and refinancing

The more affected a project may be by policy, technology, societal attitude and physical environmental changes, the more uncertain its financial outlook becomes. As with all projects, the risks are more heightened at the outset of a long-term project given the forecast remainder of its life. Usually, for those projects with a smaller number of years to run, the risks are more predictable or identifiable and quantifiable.

However, should the changes to policy and regulation continue to accelerate to ensure the economy becomes ever greener, and as carbon-intensive technologies become outdated and we close in on the 2030 and 2050 decarbonisation targets, then each of these risks will need to be evaluated for each investment on a regular basis to ensure that value is not reducing to an extent that would render the asset "stranded". This transitional risk may have an impact on or, in some cases, eradicate funder appetite to finance or refinance such projects.

In order to identify these risks, comprehensive due diligence should be carried out not just on the asset at hand but also on how the technologies employed, the environmental factors utilised and societal or policy requirements may interact with the project, not just now but also in the future. For example, what are the expected changes in the climate in the vicinity of the asset? How would this affect the asset's performance? Could the technologies employed become so outdated or so unfavourable to society or policy makers that they become redundant? 

Horizon scanning the future risks to projects will become crucial as we transition into a decarbonised world. As these considerations have not necessarily been part of the decision-making process for investors or funders until now, education of these groups is key. The Green Finance Education Charter has been formed to ensure tools for assessing climate change risks within the financial sector are implemented as quickly as possible, not least because of the imminent reporting requirements in respect of this. The International Sustainability Standards Board will hopefully ensure these are applied consistently. 

While transitional risks are not a new concept, they are becoming much more important as a consideration due to the pace of change of policy and legislation in the face of climate change. To deal with their prevalence, some firms are already reducing their investments into carbon-intensive technologies to manage these risks. A key part of any funder's decision to lend is the residual asset value available to it at any point in a project. These transitional risks are uncertain but could necessitate more conservative credit decisions, loan to long term value financial covenants being included in all loans and/or more requirements being imposed on borrower to actively mitigate the impact of such risks on its assets. Assets may become stranded irrespective of how well the assets are managed or how good, all things remaining the same, their return might look right now. A crystal ball would always be welcome, but maybe now so more than ever. 

Technology of the future

While existing technologies may be subject to the transitional risks discussed, the coming decarbonised world will be underpinned by a variety of new technologies. We know from the Glasgow Breakthroughs (global goals that aim to make clean technologies and sustainable solutions the most affordable, accessible and attractive option in each emitting sector before 2030) that the scale and pace of investment into such technologies is intended to (and needs to) be hugely increased. 

Investment in these new technologies may provide opportunities to partially de-risk positions held in technologies that become more risky over time. New and growing technologies such as battery storage, electric vehicle charging infrastructure and even hydrogen may not yet be on the books of many funders at this time but that will need to change. Working with clients, we have been exploring how funders can become more comfortable with these new technologies and potential structure – all of which will underpin the transition and may offer more stable returns compared to technologies affected by the transition. It is worth investigating these now to be ready to build a balanced portfolio as transitional risks begin to grow. These new technologies are the future for decarbonisation, as demonstrated in our recently published report with Economist Impact.

The transition is coming – how will your investment decisions be impacted?