All companies are exposed to climate risks, which broadly fall into the two categories of physical and energy transition risks. Both of these include elements of regulatory risks.
Climate change demands transformation for many aspects of a company’s business model. These range from the evolving demand for products to a potential increase in its operating costs, the need to invest in new technologies and to adapt to changing consumer behaviours.
These all have to conform to burgeoning public policy changes and regulations in a variety of jurisdictions, coupled with whatever recovery follows COVID-19, which may demand a faster transition.
Are energy companies measuring and adjusting to the impacts of climate change? Yes, broadly they are, but there are two elements missing. One is the impact of climate change on their cost of capital. The other is to ensure that energy investments become climate resilient.
Energy companies have traditionally allocated capital expenditures upfront and recouped their investments over the life of an asset. Investment decisions are made on the basis of expected returns by taking into account a variety of parameters over a certain timeframe and discounting future cashflows.
If the net present value is positive, the investment goes ahead. This is textbook finance theory.
Except that it is no longer enough.
Coming up short
The traditional investment appraisal framework has many shortcomings in the new climate conscious financial environment. It often excludes carbon emissions from the supply chain as they may not be priced by suppliers (so-called Scope 2 emissions) and from customers (Scope 3 emissions).
It can only make educated guesses about long-term product prices.
Downside risks, including physical climate risks, are analysed through sensitivities, with little ability to estimate the probabilities of worst-case scenarios.
In short, investment decisions in the energy sector have too often relied on an outdated framework that has in the past failed to capture relevant climate risks. This can be seen in the recent decisions from Repsol and BP to write down a significant portion of the value of their undeveloped upstream assets.
As a result, the business-as-usual investment appraisal and capital allocation are likely to lead to broad divestments of carbon intensive stocks by institutional investors and a lack of debt capital for new investments in the energy sector. This will damage the ability of the energy sector to implement its transition towards a low-carbon future.
The widely accepted recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) go a long way. They provide a coherent framework through which companies and their stakeholders can engage in a meaningful dialogue on the main climate risks faced by a company. This is a first step that should be complemented by a shift in the way decisions on energy investments are made.
What is needed is a new investment appraisal framework inclusive of climate risks. This would see a discounted cash flow model where capital and operating costs include the incremental climate resilience costs. Prices would reflect energy transition risks and, importantly, where the cost of capital is adjusted to account for a climate-adjusted “beta”.
Beta is a parameter widely used in financial theory to measure the volatility of returns of an investment relative to the market. The significant increase in ESG data will eventually allow analysts to identify correlations between ESG ratings and financial performances. This can then be used to quantify a set of climate betas.
Ultimately, climate resilient cashflows will be more predictable and therefore attract a lower cost of capital.
This new investment appraisal framework should be applied by corporations and the financial community to appraise real assets such as infrastructure and natural resources. The private sector-led Coalition for Climate Resilient Investment is tackling the issue of physical climate risks and will make its findings available in the coming months.
A true pricing of climate risks will then lead to a more adequate differentiation in the risk and return profiles of the different kinds of energy assets. Upstream assets are likely to see their risk-adjusted returns significantly reduced. This will ensure that capital is better allocated, with low carbon and climate resilient investments likely to offer more rewarding investment opportunities in the long run and thus attract more capital.
The new framework should make it easier to benchmark climate resilient investment opportunities. It could potentially lead to the creation of a new asset class of resilient investments.
An efficient climate pricing model will go a long way to directing capital to the investments that are most in line with the objectives of the Paris Agreement. At that point, finance will be able to say that it has truly played its part for the climate.