Relevance of physical risk for long-term changes of operational activities of power companies

Power companies unable to flexibly adjust their operational activities will not survive. In order to survive in the volatile environment of climate risk, it is crucial to be able to adapt to the radically changing business environment and market conditions. This is, however, always connected to the spending of funds. Power companies should ensure constant inflow of funds exceeding the costs of the manifestation of climate risk, and divest current strategic resources that don’t guarantee future profitability. They must also adapt to the new needs of customers following green transition developments, and increase their business complexity in order to secure future profitability. Management facing climate risk should be future-oriented, focusing the attention of top level managers on the main areas and main factors relevant to profit generation, and on the criteria for the assessment of their company's success. Climate risk changes the conditions for success of power companies making it risky to continue to pursue pre-existing business models. Hence, climate risk arising in the globalized green business environment cannot be ignored during the development of strategic changes of core activities of power companies, which have to be aligned to long-term trends of the world economy developing towards climate neutrality. Global climate risk disrupts many current strategies. A correct climate risk analysis becomes crucial for the success of business strategies, because it is the basis for creating variants of the decision to change operational activities to secure the highest possible rate of return on investments in the context of specific risk. It requires a radical change of the operational activities of power companies, in order to implement effective tools facilitating future goals, in a business environment characterized by the randomness and discontinuity of market trends. Climate risk becomes a systematic risk for the global economy, because climate change increases macro-economic and investment risks. Climate risk management becomes therefore an important success factor in the power sector. The severity of climate risk increases due to the growing frequency of extreme temperatures, fires, storms or floods[1]. Researches indicate that more than 65% of extreme weather events since 2011 were the result of human activity. Although one can observe a fundamental increase in severe, although not catastrophic, weather events, which are becoming the norm – the sum of small weather events creates high costs of the manifestation of risk. The most important physical risk factors for power companies are wind, fire and water. Physical risk, as the effect of extreme weather dynamics, may also lead to a reduction of the overall value of power companies, following the destruction of technical infrastructure and damage to real estate in exposed areas. Heatwaves increase the demand for electricity in the summer and, at the same time, they reduce the cooling capacity of power plants and water supplies in hydropower plants. There is also the danger of a reduction of the efficiency of solar power plants, which influences the power market because of changes in the demand-supply balance. Heatwaves can also be the cause of low water levels in rivers used to fuel transportation while higher temperatures reduce the efficiency of power production, due to lower availability of water.

The available production capacity of power plants is reduced and power grids are overloaded, which in turn leads to breakdowns, fires and interruptions in electricity supplies, which additionally leads to losses in the rest of the economy. Fires have not only reduced bio-diversity in many areas, but also bankrupted power companies that had to settle claims following fires related to their operations, which burdened public finances with the costs of extinguishing them. Wind is another physical risk factor. Hurricanes can significantly reduce the production in traditional- as well as wind-power plants. Extreme storms can reduce the supplies and quality of fuel, or damage power infrastructure (power plants, power grid). Floods can damage the transmission and distribution networks as well as power plants. Hence, power companies started to reinforce their infrastructure, treating this type of investment as one of the instruments of climate risk management, constituting the process of selecting and applying methods of mitigating the level of their risk exposure. The instruments of climate risk management should ensure continuity and flexibility of the power companies’ operations in the event of unexpected market events and extreme weather phenomena. Power companies should analyze the costs and impact of different measures on climate risk, and choose the most effective investments based on the relation between investment costs and the reduction of risk specific to existing characteristics of their assets. 

Examples of measures aimed to reduce physical risk include: reinforcement of overhead transmission and distribution lines; installation of flood-proof equipment in power plants and transformer stations; using temperature forecasting systems in rivers; creating cooling systems ensuring the continuity of production in power plants; re-designing wind turbines to handle higher wind speeds and passive airflow beneath mounting structures to reduce solar power temperatures; as well as a generally more robust design of power systems. There can be a necessity to consider a relocation of assets if net climate risk exposure (after risk reaction) is unacceptable. The costs of such activities can range from USD 100 million (strengthening overhead transmission lines) to even USD 1 billion (protecting power plants against flooding). The necessity to finance the investment activities of the power sector means that the risk affecting the functioning of individual power companies becomes also an element of risk of investments and credit portfolios of financial institutions.

[1] The Florida governor announced in 2019 that the state would have to spend $ 2.5 billion over a 4-year period to be protected from climate risk, including rising water levels.