Electric Utility Risk Management in the Face of Climate Risk

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Electric utilities are a key contributor to greenhouse gas emissions, and have been thinking about climate change and climate policy longer than any other sector. This presentation to the Executive Committee of an electric utility in North America walks through the key issues and questions in developing an effective risk management strategy.

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Electric Utility Risk Management in the Face of Climate Risk

  1. 1. This presentation was delivered to the Executive Committee of an electric utility. Its purpose is to explore climate change risk in the absence of clear climate change policy. Observers commonly conclude that without policy there’s little risk for utilities, but that is a particularly risky assumption for utility executives to make.
  2. 2. 2 Source: 2011 World Economic Forum Global Risks Survey Climate change has been repeatedly identified by the World Economic Forum as a leading risk facing business.
  3. 3. 3 This graphic flags the interactive nature of key elements of climate change risk, pointing out the key question of what will come first, the chicken(s) or the egg(s).
  4. 4. 4 To set the science stage - the temperature of each planet in the solar system is determined by the same small set of well understood variables.
  5. 5. 5 We know (no debate) that naturally occurring greenhouse gases (GHGs) keep the Earth 59o F warmer than it would otherwise be. Without GHGs, the Earth would be a frozen planet.
  6. 6. 6 Nitrous oxide Water vapor Carbon dioxide Methane Sulfur hexafluoride We know how GHGs warm the earth’s atmosphere. Note that water vapor is a powerful greenhouse gas, but the amount of water vapor in the atmosphere depends on temperature. There is no way to intentionally influence water vapor levels, which is why policy targets the others.
  7. 7. 7 278 ppm = = 59o F The term “greenhouse effect” suggests an almost solid wall of GHGs. In reality, the pre- industrial CO2 concentration of 278 parts per million is the equivalent of just one of the red dots shown here against the total surface area of the slide. In other words, one dot of CO2 per “slide area” of atmosphere is responsible (a bit simplistically) for the planet being 59o F warmer than it otherwise would be. That’s known, and suggests a planet quite sensitive to GHGs. The uncertainties surrounding climate change involve what will happen to temperatures as CO2 becomes two, three, or four dots on the slide. It’s by no means a linear relationship, and it’s a complicated question to answer in detail. But the common sense answer is obvious, and the basic physics have been understood for more than 100 years (see next slide). = ?o F+
  8. 8. 8
  9. 9. 9 A Changing Atmosphere 150 100 50 0 Thousands of Years ago Predicted Level of Business-as- Usual Scenario in 2100 Current Level Pre-Industrial Level Current Temperature There is no controversy regarding the rate of accumulation of CO2 in the atmosphere, or the nearly vertical nature of today’s CO2 growth rate when put into the context of the ice core record of the last 200,000 years.
  10. 10. 10 2 Required Reductions: 20 GT From Today’s Levels? 50 GT From Business as Usual Emssions in 2050? What would it mean to try and stabilize the atmospheric concentration of CO2? It would mean shifting global emissions from the trajectory on the left to the trajectory below (ultimately a >90% reduction). That’s not going to happen soon, and even if it did the concentration of CO2 would stabilize at about 450 ppm (up from 400 ppm today).
  11. 11. 11 One Gigaton (a GT or 1 billion tons) is equivalent to more than 15x all the CO2 avoided each year by all the world’s wind farms. A GT is a big number, and today’s CO2 emissions exceed 30 GTs.
  12. 12. 12 A Tragedy of the Commons occurs when multiple parties have an incentive to over-use a resource. Such tragedies are common – fisheries are a great example under “catch it or lose it” thinking. Climate change is another, where contributors bear only a fraction of the costs of their actions. Allocating common property rights is one solution, and underlies the notion of fishing quotas and emissions permits.
  13. 13. 13 Climate change is far more than a Tragedy of the Commons. Several characteristics of the climate change issue and discussion are reflected in this Wordle chart.
  14. 14. 14
  15. 15. 15 Number of Days Over 100ºF Recent Past Higher Emissions Scenario, 2080-2099 Lower Emissions Scenario, 2080-2099 One measure of climate change is how much more common will hot days become in the U.S.
  16. 16. 16 Many scientists say climate change is progressing more rapidly than predicted just 15 years ago. Source: 2011. Degrees of Risk – Defining a Risk Management Framework for Climate Security
  17. 17. 17 Source: 2011. Degrees of Risk – Defining a Risk Management Framework for Climate Security We tend to assume uncertainty cuts both ways. But the distribution of risk is actually much more skewed, as also suggested by the acceleration of key “climate change indicators.”
  18. 18. 18 Source: 2011. Degrees of Risk – Defining a Risk Management Framework for Climate Security The best case “today” is 2-3o C of global temperature change by 2100, but “business as usual” is much higher (5-8o C).
  19. 19. 19 “Black swan” is a metaphor for big but generally unanticipated outcomes. When it comes to climate change, scientists say we should expect a lot of “black swans.”
  20. 20. 20 We’ve seen many environmental black swans, from the London Fog to burning rivers and the ozone hole. Many led to fundamental policy and regulatory change.
  21. 21. 21 Last time T was 2ºC above 1900 levels, sea levels were 4-6 m higher than today. Last time T was 3ºC above 1900 levels, sea levels were 20- 30 m higher than today Source: IPCC No one is predicting that sea levels will change so dramatically in the near term, but they could rise much faster than generally anticipated.The worst case is currently put at about 16 feet by 2100. 70% chance already committed to 2ºC. Committed to 3ºC by ???
  22. 22. 22 Earth’s climate has fluctuated over the last 500,000 years, with generally through natural “forcing” variables like solar intensity that act over thousands of years. Today, the “forcing” by GHGs is more than an order of magnitude greater than anything seen before. What will happen?
  23. 23. 23 Our societies, agricultural systems, and other support systems have evolved within an extremely narrow global temperature range for 10,000 years. By moving outside that band, black swan events become more likely and more damaging.
  24. 24. 24 Climate Impacts Climate Policy Permanent Change One way to think about the accumulation of GHGs in the atmosphere is as “climate stress.” As in earthquakes, this stress must eventually be released, in this case through climate change. But the impacts will be permanent. Will climatequakes cause major shifts in climate policy?
  25. 25. 25 There are many ways that climate change and climate policy can materially affect electric utilities, although their regulated status adds a layer of complication to assessing risk.
  26. 26. 26 Climate Risk Impacts on Utility Welfare (Stock price or other measure) As discussed earlier, societal climate risk is best visualized as a risk distribution. The same idea applies to climate risk at the corporate level, but different utilities will face quite different risk (and opportunity) distributions (based on generation mix and many other variables). __ +
  27. 27. 27 NPV of Strategy Climate Change Near Term? Policy Scenario Carbon Price? Climate Change (Future) $$ $$ $$ $$ $$ Decision Tree analysis is a useful way to analyze complex risk patterns. What’s notable about climate risk is how few of the potential branches we tend to focus on (the purple cells here – shown in next slide).
  28. 28. 28 Most corporate climate strategies are premised on a very small number of the potential branches shown in the larger decision tree. The boxes shown here are the purple boxes from the prior slide. Most corporate climate strategies assume little change between the past and the future, both in terms of climate change itself, and climate policy. Assuming that the future will mirror the past is a common psychological trait, and a common shortcoming of risk management strategies.
  29. 29. 29 • No/Little Climate Change • No/Modest GHG Targets • Low/Modest Carbon Prices What If We Considered Scenarios in which Climate Change is Actually Tackled?
  30. 30. 30 Electric utility outcomes that would be interpreted as Black Swans include more severe droughts, cooling water shortages, disruptive technology breakthroughs, aggressive climate policy, civil disobedience aimed at fossil fuel generation, and surprise litigation outcomes.
  31. 31. 31 Source: 2011. Degrees of Risk – Defining a Risk Management Framework for Climate Security Key climate change “tipping points” scientists have identified are shown here. But many of them are not reflected in climate modeling forecasts because they are not well enough understood to be reliably modeled.
  32. 32. 32 The politics of climate change, so intractable today, could turn on a dime under Black Swan outcomes. What’s considered politically realistic tomorrow could be radically different from what is considered politically realistic today. That’s what scenario planning is for.
  33. 33. 33 Physical Impacts? • Direct temperature impacts • Direct ocean acidification impacts • Feedback mechanisms (albedo, clathrates) • Supply chain disruptions • Complex interactions (food, refugees, security) Brand/Stakeholder Impacts? • CSR and sustainability expectations • Corporate and product footprints • Investor perceptions • Greenwashing risk • Market share and competitiveness Policies and Measures Impacts? • Carbon pricing (taxes, cap and trade) • Emissions reduction mandates • Efficiency and renewable energy mandates • Technology incentives/mandates • Land use management incentives/mandates • Indirect supply chain impacts Three categories of climate risk are briefly profiled here. Any one of the many variables listed can lead to material corporate impacts.
  34. 34. 34  How May Climate Change and Climate Change Policy Evolve?  Will I Win Or Lose In A Carbon-Constrained World?  When and How Will I Be Regulated?  How Much Will Compliance Cost?  Do I Face Brand-Related Risk or Opportunity?  Can A Carbon Management Strategy Materially Reduce Risks?  Which Risk Management Measures are Likely to be Most Robust?  Can I Position Myself At Reasonable Cost (Relative To Benefit)?  What Are The Risks If I Act Too Early Or Too Late?  How Much Risk Is There In Making Long-term Capital Deployment Decisions?  Can I Create Competitive Advantage For Myself, And How?  What Are the Uncertainties I Need to be Aware of? These are some of the key questions we have found companies face when considering how to manage climate risks, and develop change mitigation and adaptation strategies. There is no one-size fits all assessment of risk or opportunity. And no one-size fits all answer to “what to do?”
  35. 35. 35 Framing the Risk Management Environment Climate Change ERMBusiness Continuity RM Project RM RM One way to frame climate change risk is to relate it to other risk management (RM) paradigms, including Enterprise RM, Project RM, and Business Continuity RM. Climate risk is best thought of a “cloud risk.”
  36. 36. 36 Customized Climate Risk Formula (0-10 Continuum) 0 10 Various responses, from offsets to R&D Ramp-Up of Technology Plays Technology interventions, from efficiency to CO2 injection Planning and strategy development Operational adjustments, including contracting changes Risk-Based Milestones (Triggers) and Pre-Approved Responses Tracking Climate Risk Signposts (Policy, Science, Opinion, Technology) Risk management outputs above are linked to changes in the risk environment. Different companies will develop very different positioning strategies based on their own risk environment.
  37. 37. 37 Can We Mitigate Tail Risk? Will This Reduce Material Climate Change and Policy Impacts in Near Term? Will This Deliver Near-Term Shareholder Value? Impact on Corporate Welfare (Stock price or other measure) Risk cannot be eliminated, but the distribution can be changed, reducing bad tail risk, and potentially creating new opportunities on the other side of the risk distribution. Too much is unknown about the future to be positive how a specific risk management strategy will play out, but risk management makes a lot of sense.
  38. 38. 38 Impact on Corporate Welfare (Stock price or other measure) Generation Mix Positioning Strategy SmartgridAdvanced Efficiency Advanced Efficiency Smartgrid Electric Transport Climate Branding Pro-active Adaptation Technology Tracking Stakeholder Education Stakeholder Communications Low Carbon Teaming Carbon Pricing Swanwatching The most productive climate risk management will often focus on the “tails” of the risk distribution. It is usually much easier to cut off the most dangerous part of the “tail” than to fundamentally shift (or eliminate) risk. Shown here are a variety of measures that can shorten tail risk. Some risk management measures can shift the risk distribution to the right.
  39. 39. We hope you’ve found this presentation useful and interesting. We welcome your questions and suggestions. To further explore risk and climate risk please visit our website and blogs.

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