Climate Risks and Utilities: A Story of Confusion
In the fall of 2013, the Intergovernmental Panel on Climate Change (IPCC) released its fifth assessment report confirming the reality of climate change and the critical role of human activity in causing it. Importantly, curtailment of the climate change process through drastic CO2 reductions has been downplayed, and governments and businesses worldwide are now focusing on adaptation.
The importance of the climate agenda for utilities is difficult to overstate. Besides being a major source of greenhouse gas pollution, the industry’s vast, capital-intensive infrastructure makes it likely to bear the brunt of the resulting changes in physical environments. With current utility planning cycles beginning to approach the mid-century mark, at which IPCC predicts the majority of climate change impacts to materialize, utilities now have to place their bets while making critical capital allocation decisions.
But do utilities recognize the physical risks to their infrastructure and revenue base? To find out, ScottMadden analyzed the most recent voluntary Carbon Disclosure Project (CDP) submissions of 22 major utilities in the United States. In reviewing the U.S. utilities’ responses to the CDP questionnaire, an inconsistent picture begins to emerge. While many utilities are aware of the short- and long-term climate-related risks, there is a distinct gap in the levels of understanding and acknowledgement of the impacts they are likely to face. Even among utilities that formally recognize particular climate risks, a large number indicate significant uncertainty around their timing, magnitude, and likelihood. Some utilities chose not to respond altogether but of those who submitted a response, almost a quarter did not follow CDP format and included generic references to physical climate risks without an assessment of specific risk dimensions, such as likelihood or magnitude. The figure below includes such responses to show the total number of utilities recognizing that a particular risk exists.
Percent Reporting Utilities Recognizing Specific Climate-Related Risks
In contrast to the impacts highlighted in the IPCC report, such levels of utility uncertainty appear almost artificial particularly in areas where scientific consensus points to relative certainty of impacts. For example, out of the 22 reporting utilities, only three utilities stated that changes in mean temperatures were at least “more likely than not” to pose a risk in the future, only five thought so of increases in temperature extremes, and only four considered rises in sea level an appreciable risk factor. The remaining utilities considered these factors either too uncertain or insignificant.
In comparison, the IPCC panel considered “warmer and fewer cold days” and “warmer and more frequent hot days” to be “likely” in the short term and “virtually certain” late in the 21st century; duration, intensity, and extent of heat waves and warm spells are projected to increase in both the short and long term. Increased incidence and/or magnitude of extreme high sea level is considered “likely” in the short term and “very likely” in a few decades.
Persistent uncertainty around physical risks hampers organizational decision-making, increases the long-term cost of capital, and potentially leaves utilities unprepared to deal with future operational challenges. Uncertainty around the probabilities and magnitude of changes in the physical environment may have a paralyzing effect on organizations—particularly ones not yet directly exposed to the upcoming environmental changes.
Given the dangers of prolonged uncertainty, utilities need to take steps to reduce it. Based on the IPCC findings, this can be accomplished without waiting for environmental changes to begin presenting themselves. It is important to understand that changes will not be uniform as there will be much regional, and even local, variation. However, it will be critical to start planning for them now. Some questions that should be asked:
- What is the company’s exposure to climate-related risks as indicated by regional climate models?
- Are climate-related risks to infrastructure understood, assessed, and managed as part of the enterprise risk management framework?
- Are changing climate factors adequately reflected through the integrated resource planning process, including long-term temperature trends with revenue impacts?
- Is access to critical natural resources, such as water availability, likely to become limited due to climate change?
- What organizational changes are needed to prosper in the increasingly volatile, resource-constrained environment?
In the long term, there is a need for utilities to develop integrated risk management frameworks involving both regulatory and physical climate-related factors. Operationalization of climate risk assumptions and their integration in modeling process is a necessary next step in this direction. This process will have to systematically account for second- and third-order impacts and compounded vulnerabilities. Even more importantly, such comprehensive approaches will need to balance a focus on catastrophic loss prevention vs. mitigation of the long-term impacts of gradual changes in mean temperatures in the context of integrated resource planning. While potential climate-related impacts on operations appear to be easier to assess, revenue impacts—if unaddressed—will further erode utilities’ business models.
Additional Contributing Author: Valentina Fomenko
Based on CDP submittals by the following companies: Duke Energy (2013), Sempra Energy (2013), Ameren (2013), CenterPoint (2013), FPL Group (2009), CMS Energy (2013), Pepco (2013), Southern Company (2012), Dominion (2012), Exelon (2013), American Electric (2013), PG&E (2013), First Energy (2009), Consolidated Edison (2013), Edison International (2011), Xcel Energy (2013), Northeast Utilities (2013), Entergy (2013), DTE Energy (2013), Wisconsin Energy (2013), AES (2013), NRG Energy (2013)
Source: Carbon Disclosure Project responses, ScottMadden analysis
Out of 22 utilities in the sample, 16 have generation or distribution footprint in coastal areas
Intergovernmental Panel on Climate Change. 2013. A Report of Working Group I of the Intergovernmental Panel on Climate Change. Summary for Policy Makersview more