Title: Carbon: Risk Management
1Carbon Risk Management Financial Instruments
- Carbon as a Commodity Corporate Impacts
- Conference - London - January 2003
Gareth Hughes Marsh Marine Energy
2Risk Management Axiom
- Not managing risk can be the greatest risk of
all.
--Enron Risk Management Manual, 2001
3Financial Opinions
- Climate Change is a Major Emerging Risk
Management Challenge for Financial Institutions - Dresdner Bank
- March 2002
4Climate Change- Its Real, Its Here, It will
have MAJOR Financial Impacts
- Points to Consider
- In a carbon-constrained future, climate change
becomes a financial issue- John Fitzpatrick,
CFO, Swiss Re - Climate change will lead to a resurgence in
infectious disease unseen since the 19th
century- Paul Epstein, HMS - World-wide economic losses due to natural
disasters appear to be doubling every ten years,
have reached 1trillion over the past 15
years. - Munich Re (3/2002) - US electric utilities could have to spend 2 -
65 of their market cap on carbon mitigation-
Innovest
5 Global Temperature the Past 20,000 Years, the
Next 100 Years
IPCC (2001) forecast 2-3oC, with band of
uncertainty
Black Death
Holocene Optimum
21st century very rapid rise ??
Medieval Warm
1940
Little Ice Age in Europe (15th-18th centuries)
-2
-3
-4
Younger Dryas
-5
10,000
2,000
1,000
300
100
Now
100
20,000
Number of years before present (quasi-log scale)
6Question is Not IF Temperature Will Increase,
But HOW MUCH...
7Costs of Extreme Weather Events
8Extreme Weather Events by Region 1991-2001
9Why this is important?
- Climate change is a reality
- Climate change is increasingly being accepted as
(critically) important to corporate profitability - OPEC, World Petroleum Congress, World Economic
Forum, World Energy Council - Government Policy and Regulation
- Kyoto Protocol
- UK, Germany, Netherlands, Denmark, Australia
- Commercial demand
- Institutional shareholder activism / Litigation
- Chicago Climate Exchange
- But.Not just driven by extreme weather events
10Why Should Markets Care?
- Carbon efficiency is usually related to energy
efficiency - Energy costs directly affect bottom lines of most
operating companies, but also entire industries
such as utilities, autos, oil gas,
petrochemicals - Climate Change will affect both underwriting
losses and equity returns for insurers - There will be winners and losers within
industries, as well across sectors
11How Do You Find Winners Losers?
- Handling Climate Change Risk is no different than
managing other business risks - Thus, the winners will be the companies with
superior management that can handle change
successfully - The investment world is starting to realize that
a companys environmental/social performance is
an indicator of overall management quality, and
thus measuring that performance has value to
investors - This has led to a number of performance rating
systems being developed and used by investors
12CDP Concerns
We want to better understand possible material
impacts on investment value driven by climate
change related - Taxation and
regulation - Technology innovations - Shifts
in consumer sentiment
13What are Investors starting to focus on ?
- Regional Impacts Adaptation Capacity
- Regional Mitigation Policies
- Industrial Sector Impacts
- Corporate Strategy and Capability
- Company Impacts and Abatement Costs
- Company Risk Management Expertise
14Climate Risk creates Business Challenges and
Opportunity
- via EARNINGS AND CASH FLOW
Insurance Conditions
Debt financing
Credit Risk Ratings
Discount Rates
- via INVESTMENT AND CORPORATE STRATEGY
- via STOCK MARKET/BRAND PERCEPTIONS
15At Different Investment Levels.
- At Project Level
- At Company Level
- At Sector Level
165 Forces Analysis showing the implications of a
carbon constrained economy on market dynamics
THREAT OF NEW ENTRANTS Regulatory barriers
Competences Stranded Assets
RIVALRY Cost of Capital Competitive advantage
BARGAINING POWER OF CUSTOMERS Social
Responsibility
BARGAINING POWER OF SUPPLIER Abatement
technology
THREAT OF SUBSTITUTES Low carbon intensive
alternatives
17Financial threats by delaying activity
- Supply chain implications, a late reaction to a
trend is more expensive than an early one - Demand for products
- Lose out on early external abatement opportunities
18Financial Implications
- Innovest EcoValue21TM found exposure on 25 U.S.
SP 500 electric utilities as measured as a
percentage of market capitalisation ranges from
2 to 65 - Potential EPS impact on 25 U.S. SP 500 electric
utilities varies from 32 cents to 14 per share - Climate change issues have already negatively
affected the valuation of coal-based electric
utilities..Scotia Capital Equity Research,
January 2000
19Value at Risk From Climate Change
Results of recent benchmarking exercise in the US
energy sector...
Source Value At Risk, CERES/Innovest, 2002
20A Changing World for Corporate Decision Makers
Company Image Brand Value
Directors Officers Liability/Management
Responsibility
Balance Sheet Management
Erosion of Public Trust
Legislation and Regulation
Environmental Disclosures
Shareholder Value
Market Demands
21The Purpose of Research/Ratings
Uncovering Hidden Value in Companies
22What does this mean ?
- Strategy
- Business Processes
- Investment
- Risk
- Brand
23One Possible SolutionMore Integrated Corporate
Risk Management
Legacy Management
Operations Management
Strategic Management
- Risk Identification Liability Quantification
- Asset Recovery
- Claims Resolution
- Natural Resource Damage Assessments
- Risk Finance/Transfer
- Environmental Audits
- Third-Party Evaluation
- Environmental Management Systems
- Training
- Regulatory Advice
- Risk Finance/Transfer
- Sustainability Reporting
- Enhancement of Shareholder Value
- MA Strategy/Diligence
- Business Systems and Strategy Integration
- Risk Finance/Transfer
24Transforming Clients Strategic Vision into
Appropriate Action
- Analysis of strategic options
- Identifying core competence's
- Assessment of resources available
- Strategic Change Management
- Business Processes
25Integrated Carbon Management
- Identify Analyse Carbon Exposure
- comprehensive enterprise wide risk identification
analysis.and risk management - carbon profile modelling
- company
- industry
- global
-
26Carbon Risk Profiling
- The objective in reviewing the process for
development of the Groups business strategy
regarding climate change is - to maximise return on asset investments and
projects by considering threats and opportunities
arising out of climate change policies and
developing best practice responses.
27Objectives
- Improved awareness and understanding of the high
priority risks associated with the Climate Change
Policies - Enhanced decision making through a comprehensive
understanding of the risks faced by wide range of
stakeholders. - Improved opportunities for developing appropriate
solutions to manage critical risks. - Development of a common risk language and
perspective to allow consistent collaboration
across interdependent stakeholder groups. - Improve awareness of the opportunities for energy
management, renewable energy and emissions
trading - At the participant level, opportunities to
support and / or influence the development of
future policy responses to energy management and
Climate Change on a local, regional and global
basis
28Workshop Process
- A Climate Change Workshop will assist
participants to- - Identify through the workshop process, what the
key risks are facing stakeholders - Identify which assets present the greatest risk
or opportunity - Define materiality of negative consequences of
risks - Quantify and prioritise all key material risk
exposures to stakeholders - Uncover differing perceptions of risk
- Identify both positive negative risk
correlations - Facilitate an effective decision making process
to enable the development of control measures and
risk management solutions for selected high
priority/impact risks.
29Workshop Deliverables
- Tangible output from the process is typically a
written summary report. Including - Benchmarking Industry Data developed for the
Workshop - Comparative analysis of how the risks differ for
Climate Change Policies in different Host
Countries and potential linkage - A summary of the key risks perceived by
participants to be the most material (greatest
financial impact and likelihood) - Transparent prioritisation and evaluation of
material risks - Quantification of these, in terms of a risk
likelihood and impact assessment for each
material risk exposure - Analyses of potential control measures / risk
management responses and recommendations on
appropriate risk management strategies - High-level strategic planning recommendations
and preparatory data for future workshops
30Integrated Carbon Management Benefits
- Deliver Implement Integrated Strategic Carbon
Solutions - emissions reduction options (internal/external
abatement, trade, invest) - operational consulting e.g. project
selection/appraisal - auction strategy
- deal facilitation / realisation
- investment in renewable generation
- active involvement in policy and
multi-stakeholder discussions - research and development
- improved energy efficiency and operating costs
31Other Benefits
- Enhanced Shareholder Values Appreciation
- Intellectual Property
- Knowledge Management
- Influence Policy Process
- Better Recruitment / Retention of Staff
32Why should an organisation participate ?
- Best Case
- Enterprise positions itself as a leader in its
space and as a consequence influences the policy
direction, both globally and in key markets,
secures relative competitive advantage and
derives new sources of value for its shareholders - Worst Case
- Enterprise is reactive, is driven by regulation
(rather than driving it), is unprepared for
change and loses its competitive position in key
markets
33What Are The Opportunities
- Emissions Trading
- Emission Reduction Projects
- JI
- CDM
- Carbon Funds
- Renewable Energy
- Hedge against compliance risks
- Revenue opportunity from existing / planned
activities - But there are risks..
34Corporate Responses to Emissions Trading Programs
- Recent NERA Survey of Corporate Responses to
Emission Trading - Context how companies can take advantage of GHG
trading - Key Results
- Emissions trading changes the firms evaluation
of emissions from its facilities - Changes from compliance view to market view
35Corporate Responses to Emissions Trading Programs
- Business decisions under market view for
facilities with caps - What are options for internal reductions?
(Marginal costs) - Should I be a buyer or a seller? (price, initial
allocation) - What are trading options? (markets, project-based
credits) - Uncertainties affect many elements of these
decisions, creating additional risk management
considerations - e.g., price volatility for allowances, products.
36Key Conclusions Regarding JI/CDM and Company Risk
Management
- Business experiences with previous emissions
trading programs provide good indications of how
companies will evaluate GHG emissions trading
alternatives, including JI/CDM projects - Emissions trading leads to a shift in business
view of its emissions from a compliance view to
a market view - This market view includes the need to consider
various market risks and thus develop a risk
management policy - JI/CDM projects will be attractive as part of an
overall GHG risk management portfolio if they
provide a homogenous product with minimal
transactions costs
37Business Strategies Under Two Basic Responses
Under emissions trading, a facility would receive
a GHG allocation (that is, the right to emit a
certain amount of GHG emissions) 1. Compliance
view control GHG emissions so that emissions are
equal to that allocation
2. Market view control GHG emissions so that the
facilitys marginal cost equals the GHG market
price
38Advantages of Market Response
Company can gain from participating in the
emissions trading market.
- If seller gains money from sales
- If buyer gains money from purchases (relative
to reducing all itself)
39Three Basic Factors Determine the Best Market
Strategy
- 1. Marginal Cost Schedule (or Curve) for
Reducing GHG Emissions
2. Initial Allocation
3. GHG Allowance Market Price
40First Factor Marginal Cost
/Ton
C
30
B
20
A
10
80
70
75
CO2 Emissions
41Second Factor Allocation
/Ton
Step 2 Allocation
CO2 Emissions
42Third Factor Allowance Price
/Ton
Step 2 Allocation
Step 3 Allowance Price
CO2 Emissions
43These Three Factors Determine Whether the Firm is
Buyer or Seller
- Firm will buy allowances if
- Marginal costs are high
- Allocation is low
- Market price is low
- Firm will sell allowances if
- Marginal costs are low
- Allocation is high
- Market price is high
44Illustration Non-Market Response Control to
Allocation of 80 tons
/Ton
A1
P 30
Control Costs
80
CO2 Emissions
45Market Response Gain from More Control and Sale
of Allowances
/Ton
A1 Seller
P 30
Net Gain From Sales
Additional Control Costs
Control Costs
70
80
Sell 10 Allowances
CO2 Emissions
46Illustration Non-Market Response Control to
Allocation of 60 tons
/Ton
A2
P 30
Control Costs
60
CO2 Emissions
47Market Response Gain from Less Control and
Purchase of Allowances
/Ton
A2 Buyer
Net Gain From Purchase
P 30
Permit Payments
Control Costs
60
70
CO2 Emissions
Buy 10 Allowances
48Risk Management Issues Add to the Complexity of
Market View
- Many risks complicate determination of the best
market response - Financial risks created by volatility of fuel
input (e.g., natural gas), product (e.g.,
electricity) and GHG allowance prices - Additional risks related to value of
co-benefits (NOx, SOx), - These risks affect the evaluation of market
alternatives (e.g., /ton CO2 for
repowering--coal to gas CC--can vary by a factor
of three) - Risk management procedures can be applied to GHG
markets - Identifying and assessing
- Quantifying/modeling (e.g., Monte Carlo)
- Hedging/insurance/financial products
49CDM Projects Provide Another GHG Market
Alternative
- CDM and JI credits add to GHG market alternatives
- Credits for emission reductions
- Key difference need for pre-certification
- Risk management concerns suggest key attributes
for successful CDM/JI projects - Homogeneous product
- Low transactions costs
50Reasons for Optimism Regarding CDM Credits
- Successful experience with key baseline
determination in other programs - World Bank Prototype Carbon Fund (PCF) and other
efforts - Create portfolios and develop experience
- Possible rating procedures for GHG credits
- Create homogeneous products and reduce
transactions costs
51Conclusions and Implications for CDM Projects
- Corporate demands for CDM credits will be
incorporated into a general analysis of how to
gain from emissions trading - Previous experience provides a guide to the key
factors that affect Corporate decisions on GHG
trading - Initial allowance (how determined)
- Marginal cost curve for internal GHG reduction
options - Prices for GHG allowances
- Prices for certified CDM credits
52Conclusions and Implications for CDM Projects
(cont.)
- Uncertainties in all of these factorsincluding
CDM/JI creditsmake risk management tools
important - Risk management tools allow firms to analyze
relevant risks and determine optimum emissions
trading portfolios, including CDM/JI credits - Corporates may have demands now for CDM credits
as part of a risk management strategy in light of
emerging GHG regulatory programs - CDM/JI projects will be more valuable as elements
of firms risk management portfolios to the
extent that the projects - Develop more homogeneous products (e.g.,
aggregation of projects, project rating
procedures) - Provide lower transactions costs
53Carbon Project Risk Management Financial
Instruments
54Risk Management should be considered throughout
the lifetime of the project
Issue of Carbon Credits ROCs
Carbon Assessment
Carbon Transaction
Validation Registration
Verification Certification
Feasibility Assessment/ Financing
Project Implementation / Commissioning
Construction / Erection
Permit Delivery
Project Design
Potential Risk Existence
Credit Risk
Permit Quantity Risk
Verification Risk
Counterparty Risk
Technology / Efficacy Risk
Business Interruption
Natural Peril
Permit Price Volatility Risk
Political Risk
Carbon Related Project Cycle
Conventional Project Cycle
It should be noted that many of the above risks
may exist individually or in
combination throughout the project cycle
55The Risk Transfer Challenge
56Existing Insurance Solutions
- Property Damage and Business Interruption (BI)
- Contractors all risks and Advanced Loss of
Profits (ALOP) - Efficacy or Performance guarantees for technology
failure / machinery breakdown - Environmental Impairment Liabilities
- Credit
- Political
- All can be extended to include GHG related
activities and revenues but singly do not provide
protection against the non delivery or shortfall
of permits
57Adjusting Risk And Insurance To A Changing World
?
New Risks
Extend Claim Triggers (?Definitions?)
Conventional Insurance CAR, ALOP BI, PD
Extend Mitigation (but match the loss?)
Existing Risks
New Consequences
Existing Consequences
58Characteristics of Demand
- GHG Emissions Reductions Projects are currently
typically - Small (relatively)
- Marginal returns
- Innovative
- technology
- companies
- Forward sales
- Limited bankability for Carbon Credits
- Host Country location
59The Supply-side Barriers to Risk Transfer
- Structural problems with the insurance market
- Types of Risk
- Efficacy / Technology Risk
- Credit Risk
- Political Risk
- Insurers understanding of the GHG markets
- Market conditions
60The needs to be met
- The risks associated with ER projects are wide
and vary in complexity - Monetising GHG returns improves economic
viability of projects - Reduce the Permit price risk discount -
particularly for forward streams of permits - Insurance products / markets currently limited in
ability to respond to the risks associated with
ER projects - Allow JI / CDM investors to diversify away any
specific risk
- Permit Delivery Guarantee
61Emission Permit Delivery Guarantee
TRADE Immediate Settlement (10/tCO2e)
Potential Forward Transaction
Carbon Transaction
Validation registration
Carbon Assessment
Issue of Carbon Credits ROCs
Project implementation/ Commissioning
Feasibility Assessment /Financing
Construction/ Erection
Surplus Credits
Verification certification
Permit Delivery Guarantee
Emission Reduction Project
Credit / Counterparty Risk
Political Risks
Hazard Risk
Added value 8 t/CO2e
Delivery uncertainty Discounted carbon price
2tCO2e
Permit delivery / volume uncertainty
Business Interruption
Audit error omission
Technology / Efficacy Risk
Permit Price Risk
Insurance Wrap
It should be noted that many of the above risks
may exist throughout the project cycle.
For a trade of nominal value 10 /tCO2e
62PDG Enhanced Trade
Phase 4 - GHG Trade Offer
Phase 3 -Insurance Wrap
INSURER (80 Delivery Guarantee
Enhanced Permits (Primary insurance)
Co-insurance
Insurance wrapping
Phase 2 - Portfolio Development
10 buffer zone
Project Portfolio
Potential forward transaction
Phase 1 - Project Selection and Risk Management
Issue of Carbon Credits ROCs
Carbon Assessment
Carbon Transaction
Validation Registration
Verification Certification
Feasibility Assessment/Financing
Project Implementation/ Commissioning
Construction /Erection
Project Design
Permit Delivery
63The Structure Of The PDG
- Maximising the number of projects
- Essential to pooling of risk is that the
insurance pool encompasses a large number of
independent and identically distributed events
that may cause a random loss - Bundling of risks will offset those less
attractive risks with more palatable risks - Portfolio diversification
- Type of Kyoto mechanism
- Abatement technology (renewable, energy
efficiency, fuel switch etc.) - Type of GHGs
- Country
- Self insurance and co-insurance
- Bundling of buyers and seller will reduce
transaction costs - Data quality
64The Benefits
- Guarantee to the buyer / financier that
contracted permits will be delivered - Delivery risk transfer to insurance market
- Enhanced access to, and reduced cost of capital
- Opportunities to access additional capital to
finance growth potential - Premium / added value to permit selling price
- Enhanced marketability ( price comparability,
transparency) - Accelerated implementation of project through
improved economic feasibility - Reduced transaction costs
65Developer Benefits of credit enhancement include
- Reduced development time and costs
- Reduced debt-service cost
- Use of longer-term debt
- Higher yields
- Access to more and larger sources of capital
- Increased leverage opportunity
- Facilitation of Off-Balance-Sheet financing
- Conservation of corporate capital (through
improved debt/equity ratios)
66General Market Benefits
- More projects in-the-money
- Facilitate project investment
- Increased market liquidity
- Increased market efficiency
67Users Of The PDG
- Wide range of buyers and markets that could be
potentially interested to take out PDG coverage. - Institutional Multilateral e.g. World Bank PCF,
IFC, Asian Development Bank - Public Sector Unilateral e.g. Dutch ERUPT
programme - Private Sector
- Bilateral transactions
- Kyoto / non Kyoto markets (UK ETS, CCX)
- Renewable energy markets (RECs, ROCs, Green
Certificates)
68OUTLINE CONCEPTMARKET RISK PROTECTION FOR A UK
WIND PARK PROJECT DEVELOPMENT
- A facility (Structured Risk Finance Product)
arranged for the purposes of protecting the debt
finance structure of the project against 'Market
Risk' which could prevent the servicing of the
debt as scheduled. -
- The facility will have two components 'a Market
Risk Surplus Reserve and a Market Risk
Subordinated Loan'.
69OUTLINE CONCEPT - MARKET RISK PROTECTION FOR A
UK WIND PARK PROJECT DEVELOPMENT
- Market Risk Surplus Reserve (MRSR) - a percentage
of the (quarterly, biannual or annual tbd) excess
surplus after payment of the scheduled debt will
be paid to RFCo and held specifically as the
first layer for payment of any triggered losses. - Market Risk Subordinated Loan (MRSL) - is a
subordinated loan (maximum amount tbd) with terms
arranged at inception and which can be drawn
after exhaustion of the MRSR by the same
triggered loss. - Drawdown from either the MRSR or MRSL will only
be made in line with the Scheduled Debt Service
Insufficiency (a formula will be provided once
the terms of the senior debt are known). - Interest to be paid on the MRSR and charged on
the MRSL rates (to be determined)
70OUTLINE CONCEPT -MARKET RISK PROTECTION FOR A UK
WIND PARK PROJECT DEVELOPMENT
- A Commitment Fee will be charged in relation to
the amount of MRSL and a management fee will be
charged on the MRSR. - Term of the total facility is to be discussed
once senior financing terms are known. - The balance of the MRSR plus accrued interest
will be paid back at the end of the facility
term. - The MRSL will have a defined maturity date if
triggered. - Prepayment of the MRSL can be made without
penalty. - Collateral for the MRSL will be in the form of a
second lien/charge.
71OUTLINE CONCEPT - MARKET RISK PROTECTION FOR A
UK WIND PARK PROJECT DEVELOPMENT
- Market Risk covers Power Pricing
Regulatory/Political Risk - Credit/Default Risk by Off-taker can be included
as defined event - In that there is an obligation to repay any
amounts that would be drawn down the product is
really more of a Financial 'Risk' Product rather
than an insurance product. - However in that the RiskFinCo would be taking
ultimate default risk on the insured arising out
of covered 'event' there should is sufficient
risk in this that it should satisfy contract for
insurance purposes. - Liability strands which would include technical
performance risks can be wrapped around the core
product which if structured properly would
support 'contract for insurance' treatment to
enable tax relief for the 'premium' and also
capital growth tax deferral until a claim or
profit commission event.
72JI Project Credit Delivery Guarantee Example
- Company owns and operates a number of thermal
power stations in CE Europe. - Proposed Project to integrate modern gas turbine
generators into the existing thermal cycle of the
power station, both generating additional 'clean'
electricity and improving the overall efficiency
of the power station. Total project cost c55m,
additional capacity 65MWe. - Through JI, the company wishes to sell the
overall carbon savings generated by the project
to the Dutch government through its ERU-PT
scheme, and intend to offer the project to the
Dutch in the current tender round (closes January
30th 2003). - Initial estimates are that the project will
generate 1,500,000 ERU's between 2008-2012. At
approx price of 5/tonne 7,500,000 funding
through JI.
73JI Project Credit Delivery Guarantee Example
- Risk Profile focused on the contractual risks
related to non-delivery of ERU's during the
period 2008-2012. - Risk of non-delivery is directly related to
operating risk - if the plant runs it delivers
ERU's, but nevertheless, the possible exposure
could be significant as the Dutch are requesting
a penalty of 5 times the offer price for non
delivery. - For this type of power risk using known
technology with well defined financial limits
terms can be secured for a 'traditional' risk
transfer solution on the basis of covering the
non delivery penalty to the Dutch based upon
failure to deliver due to "normal property,
mechanical breakdown or technology non
performance risks" .
74JI Project Credit Delivery Guarantee Example
- This would be structured with the option either
to pay the penalty or deliver equivalent
acceptable reduction certificates. - The aim would be to have the trigger at the end
of the compliance period when a final
certification of the amount of real reduction
achieved can be calculated. - Pre-Kyoto ratification coverage for non delivery
due to political and financial credit risks, if
required, it will be more difficult to arrange
and it would have to be on a structured risk
finance basis i.e. largely 'funded' out of free
cash-flow and or secured by some other means.
75Gareth.Hughes_at_Marsh.com44 207357 1721