Transition risk - element of climate risk

Climate risk impacts the power sector, especially the transition to a climate neutral economy, which influences negatively the value of power companies’ assets, and radical weather phenomena. Climate risk influences the economic conditions of power companies also through green finance – for example, insurance and re-insurance of companies, banks, pension funds. The severity of extreme conditions, resulting from advancing climate change, has a specific financial dimension for the power sector. In order to limit climate change, OECD countries should eliminate GHG emissions by 2035, and the rest of the world by 2040. The analysis of current RES growth rates also indicates that fossil fuels should be squeezed out of the power system by 2030. Hence, power companies face the challenge of adjusting their core activities to new market conditions that reduce the profitability of the traditional power sector. The maturation of RES technologies, and the related reduction of investment costs, affects the situation on the power market, changing the competitiveness of particular production technologies. Existing patterns of executing the operational activities of power companies become useless. For example, a wind farm, when investment costs are reduced, becomes more competitive than traditional fossil fuels-based power production, and can also obtain additional “green” support. The market price of electricity is the same, and the variable cost of production in a wind farm is assumed to be zero[1]. That is why climate change creates strategic risk for power companies, which must define the future structure of their production assets, and allocate funds for investments in generation assets as well as the power grid. In this way, the climate risk issue finds a new perspective reflected in the decisions of power companies concerning the shape of their core activities. They must consider the profitability of various options for RESs’ development, and low-emission power generation, in a constantly changing environment (the so-called 3P approach - Planet, Profit, People) and the impact it has on the efficiency of the operations of power companies. Therefore, the issue arises of determining the optimal model of the core activities of power companies by 2050. Such time perspective creates the risk of faulty investment decisions. Assets in the power sector are characterized by a very long period of operation (up to 30 years) while changes in available technologies are already under way and the maturity of RES, facilitated by investments in RES, has contributed to the reduction of their costs. This creates a need to design an effective strategy ensuring the maintenance of the profitability of operational activities of power companies in the new conditions of the power sector.

The power sector is notably exposed to the impact of climate change policies that affects the long-term operational activity of power companies, identifying the high risk of stranded assets in their balance sheets. The term “stranded assets” describes assets that face a high risk of having to be discarded earlier than planned. Stranded assets can lead to a reduction of the overall value of power companies, as a result of having to write off the value of assets related to the use of fossil fuels. Another result of such a situation may be identified as a sudden deterioration of financial ratings and an increased cost of debt. Therefore, it can be argued that there is currently a major risk to the business scenarios facing the power sector. It can already be stated that the current trends are not adequate for the period covered by this risk. This means a fundamental change must take place in the conditions for the functioning of power companies that must determine the path to achieve climate neutrality. Each of their investment decisions covers a period of at least a dozen (to several dozen) years of capital involvement. This makes them exposed to high strategic risk, which results from climate risk and revolutionary technological changes, increasing the importance for the power market of RES and power storage. As a result, finance institutions take a negative outlook on funding fossil-based investments and operations. Delaying the adaptation process to the new operating conditions of the power industry generates additional costs, and will be accelerated by technological innovations, reducing the costs of implementing zero-emission technologies.

Climate risk influences also customer expectations towards power companies with respect to: de-carbonization of the economy, reduced usage of products with high carbon footprints, electrification of transportation, and electrification of heating. The power sector must thus have the potential to use renewable energy to power transport, industry and heating, as well as hydrogen production. This means defining new ways of meeting customer needs as a response to climate risk. It increases strategic risk, the manifestation of which is particularly severe for power companies. The changes affecting their operating activities arise outside the power sector and destroy the previous status quo. Younger managers, computer scientists and entrepreneurs strive to transition the power industry into climate-friendly power supplies. Rigid and immobile, old-fashioned, concern-based power companies should shift towards a start-up culture. This approach becomes standard for all power market participants. Market dynamics shall be identified as an opportunity for profitability increases, and reflected in the change of the core activities of power companies. Ignoring climate risk can lead to losses resulting from incorrect long-term business planning. While green transition accelerates, responding and adjusting to fundamental changes in the business environment becomes increasingly important. The exit of companies from coal-based power production makes them more resistant to transition risk. Power companies must consider the development of smart solutions, as an instrument of reacting to such risk, which also support better customer connectivity. The long-term changes of core activities of power companies shall cover: initiatives developing prosumers, green electric mobility, using electricity to meet energy demands, green heating using RES, and an electrification of industrial processes. The next important area is the development of products of demand-side management and demand flexibility, offered to households as well as industry. These developments are the basis for new directions of capital investments. Climate risk management, and the use of new opportunities, becomes an instrument protecting the future success of existing power companies. This situation has direct impact on their strategic decisions concerning asset development (making assets greener), and reflected in their operations. Power companies responded to this challenge, deciding to cut GHG emissions or even to develop carbon-neutral production, supported by investments in power storage, pumped-storage plants, new types of nuclear power plants, and green hydrogen. Some power companies decided even to turn carbon-neutral already by 2025, requiring the same from their suppliers, demanding a carbon footprint minimalization schedule.

[1] The largest greenhouse gas emitters in Europe are the following power companies: RWE, EPH, Uniper, Steag, CEZ, Bulgarian Energy Holding, Endesa, ZE PAK, PGE, Enea.