Pricing Climate-Related Risks of Energy Investments
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Abstract
This paper presents a framework for pricing the climate resilience of an energy infrastructure project through assessing the value of its required debt and equity investments. Integrating climate scenarios into an asset valuation model provides useful and specific insights for risk management, but there is a lack of academic and market tools that effectively address this need. The critical barrier is that climate-related risks (physical and transition) are typically indirect variables in the cash flow calculation, and they should be computed based on the direct variables such as revenue, capital expenditures (CAPEX), operating expenses (OPEX), and financing costs. The implementation of this framework shows how to delineate climate-related risks that are assetspecific and transforms them into financial risks. Using cash flow simulation and scenario analysis, it estimates an energy infrastructure asset's probability of default due to climate-related risks and the size and timing of the losses for any given default. To demonstrate the framework's application, we simulate the price climate-related risks of a utility-scale electricity generation facility (i.e., a downstream energy asset) powered by natural gas. Highlights: • The framework consists of three parts. First, it identifies the climate risks that an individual energy project would be exposed to under a multitude of feasible climate risk scenarios and economic trajectories • Second, it prices the identified climate risks at the level of the individual energy project's cashflows by downscaling and translating climate risk information • Third, it calculates the probability of default and identifies the largest potential gains and losses due to the identified climate risks for an individual project
Key takeaways
- To the best of our knowledge, none of the extant literature prices climate risks based on the value of an "individual asset," particularly the value of its required debt and equity investments.
- Key reasons for this are likely because (1) climate data needs to be transformed into a readily applicable form to the financial models used by asset owners and managers; (2) there are no standardized metrics to estimate climate risks that go into financial models; and (3) neither the providers of the data (e.g., environmental scientists and environmental or socioeconomic modelers) and nor the user of the data (e.g., investors) understand the various mechanisms through which various climate-related risks affect the financial resilience of the asset.
- Physical risks of climate change include risks due to chronic climate change and acute weather events.
- We can provide specific insights for investors on how to evaluate the resilience and returns of a project with respect to asset properties (e.g., system size, generating capacity), leverage (debt vs. equity), upfront spending on climate resilience (higher upfront CAPEX vs. OPEX), and financial terms (e.g., cash flow margin, debt tenor, amortization schedule, DSCR covenants, equity IRR expectations).
- Given the To evaluate the potential impact of climate risks, we created 12 climate risk scenarios that test a single risk factor or a combination of multiple risks, summarized in Table 3.
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