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EY on stranded assets: get out while you can – the analysis is shifting to longer term

Victoria's Yallourn power station.

Here’s more evidence that investors in the fossil fuel based energy sector face growing risk. A report from Ernst & Young finds a perfect storm of disruption – from technologies such as renewable energy storage and generation, pricing, debt and project finance, and global sentiment on climate change. And financial analysis is catching up, with longer term perspectives that factor in these risks.

A report by Ernst & Young on stranded assets has highlighted the competition renewable energy poses for long-term investors in traditional coal-fired, centralised energy generation.

The report, which aligns with a growing body of analysis on the sector, highlights four areas of potential disruption that can make the fossil fuel-based energy sector assets effectively “stranded” as unprofitable, risky and in some cases obsolete. These assets include not only the coal deposits and gas fields, but also the power stations, distribution networks and associated infrastructure such as coal loading facilities.

The four “x-factors” are: disruptive technologies such as renewable energy storage and carbon capture and storage technology; price competitiveness and uptake of renewable energy generation; debt and project finance; and global and domestic climate change policy.

The report says that while the sustainability community has identified that shifting the financial sector away from unsustainable assets would be the most effective catalyst for overall change, the sector has proved to be “a hard nut to crack”.

The shift to longer term analysis is under way

“Although recent years have seen a substantial increase in the integration of environmental, social and governance data forming part of investment analysis, the continued emphasis on short-term results and incentives has pushed longer-term environmental risks, such as climate change, outside of the boundary of risks contemplated by mainstream analysts. That is, until recently,” the report says.

In 2014 there was “a remarkable increase in the analysis of environmental and associated geopolitical risks in the wider financial community, the primary focus of which was on the suddenly credible prospect of ‘stranded assets’ in the fossil fuel sector.”

Disruptive technologies

Electricity storage costs are falling rapidly making distributed storage a feasible alternative to transmission capacity upgrades that can also allow for increasing the use of variable output electricity generation technologies such as wind and solar.

The report cites figures from the International Energy Agency that forecast a 15-fold increase in wind power generation and around a 60-fold increase in solar from current levels if global warming is to be limited to within 2°C in 2050.

“Electricity storage will likely be a fundamental enabler of this massive re-alignment of global electricity generating capacity,” the report says.

“At the same time, achieving a 2°C climate scenario could see a 40 per cent fall in demand for gas, 70 per cent fall in demand for coal, and over 95 per cent fall in demand for oil in global electricity generation by 2050.

“However, this must be put in context: with overall global energy demand increasing (in particular from developing nations) the total quantity of fossil fuels needed will equate to a predicted increase in their extraction, despite making up a smaller percentage of the energy equation overall.”

Price competitiveness and uptake of renewable electricity generation

Renewable energy is rapidly heading towards grid parity – the threshold at which an emerging electricity generation technology is able to compete favourably on price against grid electricity from coal and gas-fired generators without incentives or subsidies.

The analysis shows that solar photovoltaic costs have fallen 80 per cent over past five years, and that in sunny regions generation costs are falling below $100/MWh, while retail electricity prices are at a record high of $250/MWh. This retail price is comprised largely of transmission and distribution costs, as wholesale coal fired power is at a record low price of $40/MWh.

The report states that decreased demand from traditional electricity sources would not only undermine the large-scale generation market but could also impact on the ability of transmission and distribution operators to recover costs.

“Under current tariff arrangements, retail prices are dominated by energy costs, yet the underlying price structure is dominated by fixed costs. Were energy sales to fall, fixed capital costs would be spread over lower energy demand, raising prices. The electricity industry has referred to this as the “death spiral” with higher unit costs for electricity driving further reductions in energy demand, which in turn increase unit costs for energy further,” the report says.

“Research by global investment bank UBS suggests that the average Australian household could find it cost-competitive to go off-grid as soon as 2018. But achieving grid parity does not necessarily spell the end of the grid, and there may also be different impacts for network operators and traditional generators.

“For network operators, grid parity may drive a transition from energy delivery to energy services, acting as a ubiquitous battery that provides energy whenever demand outstrips renewable output. For generators, grid parity offers greater challenges.

“Renewables directly substitute for energy delivered by generators, reducing demand. At the same time, widescale adoption of storage could deliver peaking and reserve services usually provided by conventional generators. Being not only cost competitive, but also operating at virtually no marginal cost, these technologies could guarantee access to competitive markets by outbidding traditional generators.”

The analysis goes on to state that grid parity is not the end point, and that prices for renewable alternatives may continue to fall, taking them below parity and creating a compelling financial case for consumers to make the switch – leaving assets stranded and “an entire industry facing significant challenges.”

Debt and project finance

Climate activism has been focused on the fossil fuel sector, particularly coal, with a call for banks to disclose their risk exposure in terms of investments in the sector, particularly potential stranded assets. Policy uncertainty is also identified as a consideration in terms of long-term investment risks.

The report says the extension of the divestment campaign to include banks and project finance could ultimately result in less project finance being available to support large investments in new fossil fuel energy sector projects.

It also points out that while most Australian banks have public policy positions that recognise climate change science and the need to transition to a low-carbon economy, this may not mean abandoning coal entirely in the energy sector.

“…despite a lower overall predicted share of the global energy market, actual coal demand is predicted by most to increase out over the next 40 years. This makes for interesting analysis, where certain forms of coal will likely outperform others, due to their thermal calorific values, ash and sulphur content. In a carbon-constrained world then, not all coal is created equal.”

Global and domestic climate policy

While multilateral agreement at this year’s Paris climate talks is not certain, there is a growing trend of regionalism and bilateral policy in tackling climate change. China, for example, is about to roll out an Emissions Trading Scheme that will be over twice the size of the European ETS, and is also limiting coal imports and placing new restrictions on stationary power generators.

The Chinese policies remove one of the barriers to other nations taking action, as the US stated at Kyoto it would not commit to emissions reductions unless China committed to comparative reductions. With both now taking action, this puts pressure on nations such as Australia that have refused to set firm targets until the bigger emitters did so.

“An accord between the world’s two remaining superpowers has a certain gravitational pull which smaller States are likely to be drawn towards, including Australia,” the report says.

“Meanwhile, unlikely sources of support for climate science, and refocussing investment, are emerging. Already a central figure in the lives of over 1.4 billion people, Pope Francis is increasingly popular in secular circles: his comments in support of climate change mitigation have the potential to re-wire the attitudes of a portion of the US electorate historically unmotivated by climate policy.

“Meanwhile, the Rockefeller Brothers Fund and other investors publicly stated their intention to divest $50b from fossil fuel investments, in a move that is likely to add fuel to the stranded assets debate.

“That climate change policy has remained elevated on the global policy agenda, despite the wane of the multilateral ideal confirms that, as an x-factor in the consideration of long term investment decisions, climate policy it is most certainly here to stay.”

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