Hedging against the hothouse

Regardless of the degree to which we believe that changing climate patterns are the result of increased greenhouse gas emissions and other human activity, they cannot be ignored. The most elementary due diligence requires that infrastructure investment decisions that will endure for decades account for possible climate impacts that could affect the financial performance of the asset. These could include: more frequent or more violent storms; more or less rainfall; changing wind patterns or sun exposure; or the impact of sea level rise, storm surge, and coastal flooding on facilities and operations. How well climate change impacts are anticipated and addressed could have a profound effect on a project’s financial performance over its lifetime.

Such foresight may not be optional. Recent guidance  issued by the US Securities and Exchange Commission (SEC) recognises that climate change may pose significant risks to a company’s financial and business performance that must be disclosed to shareholders and other investors and it does not take a great leap of faith to believe that such scrutiny could also be applied to listed funds and the SPVs that implement projects. At the same time, tort claims in US courts by parties aggrieved by emissions of greenhouse gases and other impacts of climate change have been adjudicated for and against the defendant institutions allegedly responsible. Obviously, the incentives for investors to be as well informed as possible regarding the risks posed by climate change will only continue to grow.

Infrastructure investment is inherently risky and investors are well versed in pricing in the perils of: political instability; construction delays; price increases, revenue, currency, and interest rate fluctuations; and force majeure. Climate change presents a unique set of issues that don’t appear on the typical pro forma, but the prudent investor (GP, LP, or creditor) will be wise to consider them before closing a deal.

In addition, although risk is ubiquitous to all infrastructure projects, developing countries, where infrastructure offers possibly the greatest investment potential, pose particular challenges. Many of these countries are less likely to possess the financial, technological, institutional, and human resources necessary to address these complex issues and the risks associated with them. In this article, I identify some of the possible impacts of climate change on infrastructure and propose a risk management strategy to hedge against their occurrence.

The risk and consequences of climate change

Assessing the risk of climate change requires that we think about what’s likely to happen in regard to changing climatic conditions, how likely is it to happen, and how might these changes impact an infrastructure investment. Leaving aside ideology and contrarian opinions, recent observed trends suggest continued warming over land at most high northern latitudes, contraction of snow cover, and decrease in the extent of sea ice which will be accompanied by globally rising sea levels. An increase in the frequency of hot extremes, heat waves, and heavy precipitation is also likely and a poleward shift of extra-tropical storm tracks will bring changes in wind, precipitation, and temperature patterns.

All in all, there are any number of potentially nasty surprises lurking in the future and, unfortunately, it is far easier to describe what is likely to happen than it is to say how likely it is to occur. One of the major challenges to developing effective risk management strategies for climate change is the high degree of uncertainty that exists regarding these possible changes. Fortunately, however, the ability to determine precisely the likelihood of a specific event is not necessary to make informed and pragmatic decisions regarding risk management.  An appropriate strategy will often present itself when one examines the potential consequences.

There are a vast number of potential scenarios that can be played out regarding the changing climate and weather patterns described above, but only a few need to be discussed for the purpose of this article.  Depending on the source of the estimates, over the next several decades sea level is expected to rise anywhere from a few millimetres to as much as a few metres. While the former case would barely be cause for notice, the latter would impact the lives of tens of millions of people and be economically devastating, particularly in the developing world. Near-shore assets such as seaports and road, rail, and pipeline networks could all be affected to some degree and will need to take some mitigating action. These actions could range from floating quays to flood walls to major relocations, and all will require capital outlays well beyond those typically set aside for normal maintenance and repair.

How such disruptions and expenditures could affect the financial performance of, for example, a port concession, a highway supported by tolls or availability payments, or a natural gas or petroleum pipeline must be factored into feasibility studies and, at the very least, preliminary engineering and revenue estimates should be developed for various scenarios.

With CO2 emissions seen as the primary culprit in climate change, renewable energy in the form of solar, wind and hydroelectric projects has become an investment class in its own right. Ironically though, these projects may be more vulnerable to climate change than the thermal plants they aim to replace. Surmise for a moment that increased cloud cover reduces long-term sun exposure over solar arrays by 10 or 20 per cent, or that decreased wind intensity reduces the output of a wind farm by an equal amount. How will this affect revenue projections? What will be the cost of addressing the shortfall in renewables with auxiliary natural gas?

In a similar vein, what if hydrologic projections prove faulty and a reservoir fails to fill or refill as anticipated? In this case, both hydropower and water supply could suffer. How much will depend on the assumptions made, but only the reckless would ignore the potential for significant impacts absent an analytic determination to the contrary. This latter example is not hypothetical. Numerous hydropower projects in South America are currently underperforming and the hydrologic assumptions underlying the massive water management investments in the US Colorado River basin have been called into question.

Managing the risk of climate change

Management options for addressing climate change risk can be grouped into five general categories:

1. Avoid the risk by locating somewhere else. In the case of coastal areas, locating new facilities and infrastructure out of the possible inundation zone associated with rising sea level or storm surge is perhaps the wisest choice, though certainly not an option for ports and related facilities and infrastructure already existing within these zones. However, as facilities age and major reconstruction becomes warranted, consideration could be given to relocating those facilities that could be moved to elevations above expected flood levels.

2. Reduce the risk through physical counter-measures. When relocation is not feasible, flood-protection works such as levees and floodwalls and hazard-resistant construction can be employed.

3. Spread the risk by providing redundancy. Although duplicate facilities are rarely cost-efficient, there are other options for ensuring redundant capacity. In the case of renewable energy, for example, the size of auxiliary power generation could be increased to provide a safety margin or power purchase agreements executed for back-up deliveries. Similarly, contracts for back-up water supply could be executed as a hedge against reduced output.

4. Transfer the risk through insurance or other related products. Although insurance can be an effective risk management tool, climate change is not currently recognised as an insurable event such as fire or flood. The insurance industry is adapting to this situation and in the not-too-distant future it is likely that coverage will be available to address potential direct losses from climate change. Coverage can also be obtained for wind farms and solar arrays that fail to deliver the output anticipated. Catastrophe bonds are increasingly used by insurers as alternatives or supplements to traditional catastrophe insurance or reinsurance for low probability/high consequence events.

5. Retain the risk. In light of the preceding points, investors may have no choice but to accept a portion of the consequences of climate change and price this risk into the deal. For example, below a pre-determined level, the cost of addressing climate change would be included in normal operations. Above a particular threshold, various forms of third-party involvement would come into play through insurance/reinsurance or catastrophe bonds. At a further trigger point, the cost of insurance and other counter-measures compared to the likelihood of very extreme impacts (for example, the need to abandon an asset) becomes overly burdensome and a decision to accept the consequences must be made.

Although these sorts of risk management decisions are routinely made, they are often implicit, leaving the full costs out of the pricing structure. Such costs that are incurred to manage these risks will be borne by a combination of increased user fees and charges and reduced profitability, and decisions on whether and how to proceed will be made on the basis of a project’s expected financial performance. Many, if not most, projects will proceed only slightly altered, if at all.

However, the discipline of adding climate change to the risk management process can pay huge dividends in the form of reduced anxiety on the part of investors, creditors, and rating agencies by increasing confidence that the full complement of risks has been identified, considered, and addressed. Effective risk management strategies will need to be both prudent and flexible and try to ensure that whatever is done today places minimal constraints on what may need to be done (or not done) tomorrow.

Richard G. Little is director of the Keston Institute for Public Finance and Infrastructure Policy and a Senior Fellow at the University of Southern California. He is a certified professional planner and was elected to the National Academy of Construction in 2008