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Climate risk is more than just regulatory risk

June 7, 2018

  • Determining your exposure to climate change risk is an important part of business strategy

  • Climate change risk is not just regulatory in nature - other risks such as technology risk (which is also a great opportunity for companies) must be considered and analysed

  • To learn more about climate risk, please join us at a training course next week in Singapore, hosted by the Sustainable Energy Association of Singapore

When companies start on their climate risk journey, it's pretty easy to just concentrate on regulatory risk. This is a fairly tangible risk that's easy to understand - plus you can have a relatively good idea as to what may happen in the future in the regulatory environment by working back from the goals of the Paris Agreement and analysing the national contributions of the countries in which your company operates to determine gaps to the overall emissions reduction aims. Policies to fill those gaps can be postulated though the effect of regulatory risk is likely to be felt through a direct or indirect carbon cost.

 

Regulatory risk is not the only risk that companies will face however. There are a number of other risks which should also be considered and, depending on the organisation, may be more material than the regulatory risk. A journal article published in Nature this week discusses the stranded assets theory for fossil fuels - and the macroeconomic impacts of this scenario. The stranded assets theory is not new and, to date, has theorised that the Paris Agreement and other regulatory drivers will erode demand for fossil fuel products such that high cost assets may become stranded. Basically, the erosion of demand reduces commodity prices and high cost assets such as oil sands, deepwater or arctic production and some tight oil/tight gas operations may become uneconomic. To date, the response from the fossil fuel industry is that demand is going to increase for certain products due to a number of factors and that they have flexibility in their portfolios to adapt relatively quickly - therefore the risk of stranding assets is relatively low.

 

Which brings us to the the article in Nature. The article explores the possibility that there is also a strong technology driver for fossil fuel demand. The article presents a case that a continuation of the trend for technological advancements such as renewable energy and electric vehicles, and modelling of disruptive uptake rates for newer technologies, results in erosion of demand for fossil fuels that will also contribute to potential stranding of assets. This happens in spite of any additional regulation for emissions. In other words, the technology risk is potentially material for some sectors and should be considered when assessing exposure. 

 

A good way to at least qualitatively explore the exposure to technology risks is to examine the types of technology that will have an impact on the company and consider the relative impact on that technology and how long until a tipping point in uptake occurs. When exploring scenarios, it is also possible to include a technology axis and having at least one scenario where technological advancement is faster than business as usual and/or disruptive technology is considered. Of course the technologies associated with action on climate change may present significant opportunities as well as risks. Analysis of technologies impacting a particular sector could result in a company pursuing that as a business line or a business venture.

This is already happening to some extent with fossil fuel companies increasing investment in electric vehicle charging infrastructure, electricity network operations, renewable energy such as solar and wind, and battery storage. This diversification of portfolio goes some way to ameliorating their exposure to climate change risk. Currently these investments are relatively small when compared to total capital expenditure by these companies but it's also important from the companies' point of view to start small and "test the waters" in the short term.

 

What the Nature article then highlights is the potential macroeconomic impacts of what's called the "Technology Diffusion Scenario" - which is the article's way of describing the expected uptake of relevant technology. The technology impact is not enough to meet the overall Paris Agreement goals so they have modelled another scenario in which the technology diffusion scenario is supplemented by additional policy drivers to achieve an overall model goal of a 75% probability of staying under 2 degrees temperature rise by 2100. Interestingly, a further sensitivity to the 2 degree scenario is also modelled called the sell-out scenario, in which countries with low cost of production maintain production levels in spite of depressed commodity pricing - to preserve market share. The projected long term oil and gas pricing under both the technology diffusion scenario and the 2 degree scenario would likely be a cause for concern for companies to consider - particularly compared to where their assets sit on the supply cost curve.

 (Mercure, J.F. et. al. Nature Climate Change 4 June 2018)

Obviously this is the result of one model, and one modelling effort - and any model is only as good as its assumptions. What is does highlight, that may be more important that the actual model outcomes, is that technology risk and technology opportunity should definitely be considered by companies as part of their overall consideration of climate change risk.

 

If you're based in Singapore and keen to learn more about technology risk, regulatory risk - and a number of other aspects of climate risk - engeco will be delivering a training course on climate risks and opportunities next week (14 June), in conjunction with the Sustainable Energy Association of Singapore. Registrations are still open for this course and you can have a look at what's on offer at the SEAS website - https://www.seas.org.sg/index.php?option=com_events&view=eventdetails&Itemid=113&id=585

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