Companies
By
Research Center for Green Finance Development, Tsinghua University1
Abstract
This chapter presents an analytical framework for measuring the impact of key transition factors (e.g., demand reduction, development of renewable energy technologies, carbon price increases, and funding cost increases) on the credit risks of thermal power companies. We apply this framework to the estimation of average probability of default (PD) of representative Chinese companies in the thermal power sector under various climate-related transition scenarios. We find that under a 2-degree scenario, the average PD of major thermal power companies could rise to 10% in 2025 and 23% in 2030, up from about 3% in 2020. We also conclude from our case study that compared with demand reduction and carbon price increases, price competition from renewables will likely be the most significant driver for the growing credit risks of Chinese thermal power companies.
Keywords: transition risk, thermal power, probability of default, credit risk
1 Background
Climate transition and its financial impact
The financial risks associated with climate change have attracted considerable attentions and sparked extensive discussions recently in the financial sector (Bank of England, 2018; Jun Ma et al., 2017; Jun Ma et al., 2018; NGFS, 2019). These risks include potential financial losses from climate-related physical events (e.g., extreme weather events and sea level rises) as well as climate-related transition factors, including public policies and technological changes facilitating the transition to a low-carbon economy. Climate-related transition risks mainly result from human efforts to prevent or mitigate climate change.
In the climate transition process, actions to mitigate climate change could result in wide-ranging impacts on companies in industries such as energy, transportation, manufacturing and construction. These impacts on the sectors of the real economy could be transmitted to financial institutions (FIs) engaged in financial transactions with them, thus lead to financial risks and losses. These losses and impacts received by the financial sectors could be enormous as estimated by several central banks and research institutions (EIU, 2015; PRA Bank of England, 2015; Regelink et al., 2017). From a financial stability perspective, to better anticipate
1 The authors of this chapter are Dr. MA Jun, Director of Research Center for Green Finance Development at Tsinghua University, email: maj@pbcsf.tsinghua.edu.cn; Dr. SUN Tianyin, Senior Research Fellow, email: sunty@pbcsf.tsinghua.edu.cn;
ZHU Yun, Economist, email: zhuyun@pbcsf.tsinghua.edu.cn. The authors would like to thank PENG Weijian from Tsinghua University and Dr. QI Yuandong from University of Maryland for their contributions.
and mitigate the potential risks and losses resulting from climate transition, the international financial community has called for actions to have FIs integrate these risks into financial decision-making. The most noticeable efforts are the G20 Green Finance Study Group (G20 GFSG, 2017), the Network for Greening the Financial System (NGFS, 2019) and the Taskforce for Climate-Related Financial Disclosures (TCFD Financial Stability Board, 2016).
Recent developments in methodologies
To effectively manage climate-related transition risks, the key step is to quantify the impacts of climate transition on financial risk metrics, such as the probability of default (PD) of loans and bonds and the valuation of securities, properties, and infrastructure assets. PD, as a crucial risk indicator for banks and bond investors, describes the probability that a borrower will be unable to meet its debt obligations.
Battiston et al. (2017) conducted a stress-test study and assessed the potential losses in banks’
equities for major European banks by mapping the assets, which the banks hold and are exposed to fossil fuel production sectors and energy-intensive sectors, to the potential devaluation impacts under various climate scenarios (Battiston et al., 2017). By accounting both a bank’s direct exposure to these sectors and the indirect exposures from holding financial products exposed to the aforementioned sectors issued by other institutions, they find that for the 20 most-severely affected EU listed banks, 8% to 33% equity losses could be expected.
Commissioned by the UNEP Financial Initiative, Oliver Wyman (OW) developed a transition risk analytical approach, having been trial-used, by 16 international banks to analyze their transition risks (UNEP FI, 2018). Based on data from a subgroup of these 16 banks, the research shows that the PD for bank loans to the energy utility sector under the “2 degrees (2DS) by 2040” scenario could be 2.3-2.4 times greater than under a baseline scenario (no efforts taken to mitigate climate change). The University of Cambridge Institute for Sustainability Leadership (CISL) also developed a transition risk analytical framework for asset management (ClimateWise, 2019).
Researchers of 2 Degrees Investment Initiative(2ii) developed a framework for measuring the impact of abrupt late economic decarbonization scenarios. They incorporate disorderly transition scenarios that do not strictly follow the conventional “smooth” transition scenarios generated by Integrated Assessment Models (IAMs) (Hayne et al., 2019). They find that probabilities of default of bonds issued by climate-sensitive sectors in 2035 could rise by 2-3 folds under a “too late, too sudden” transition against to that of business-as-usual scenario.
Our approach: incorporating price competition and funding cost increases as additional risk drivers
Most studies in this area attempt to estimate the changes to revenues and costs of the affected companies or assets due to demand reduction and carbon price increase during the transition of energy sources. These estimated changes are then used to derive changes in valuation of securities and/or credit risk metrics. However, these studies have not explicitly considered declines in renewable energy prices (which put downward pressure on fossil fuel prices) and increases in funding costs (due to credit rating downgraded, changing regulations and banks’
internal credit polices). We believe that these factors (price competition and funding cost increases) are highly relevant, and possibly more important than carbon price increases, to companies’ financials and the resulting increase in credit risks. Failures to consider these factors may lead to significant underestimation of the financial risks faced by banks and investors.
Assessing the Impact of Climate-Related Transition on Default Probabilities of Thermal Power Companies
In our analysis presented in this chapter, we explicitly modelled the impact of price competition and funding cost increases, in addition to the usual transition drivers such as demand reduction and carbon price increases, on financial performance and credit risks of Chinese coal-fired power generation (hereafter thermal power) companies under various climate-related transition scenarios.
The remainder of this chapter is organized as follows: Section 2 introduces the methodology and general framework of our analysis and its modules, Section 3 presents a detailed case study on Chinese thermal power companies, and discusses the results, while Section 4 concludes with comments on policy implications and future work.
2 Methodology
Risk drivers
In this study, we took a comprehensive approach to analyzing the credit risk impact of climate transition on Chinese coal-fired power generation companies (hereafter thermal power companies). Our analysis considered five risk drivers in assessing the financial impact on thermal power companies and their credit risks during the transition to achieve a 2-degree climate outcome:
First, the impact of climate-related transition on demand for thermal power companies.
Compared to baseline scenario that assumes no changes in current policies and technologies, the 2DS scenario requires a substantial reduction in the consumption of electricity generated by coal-fired power plants. This reduced demand will affect future revenues of thermal power companies.
Second, the impact of renewable technology changes on thermal power tariffs. We expect that due to technology progress, the cost (per kW) of renewable energies such as solar and wind will continue to decline rapidly in the foreseeable future. This will exert competitive downward pressure on thermal power tariffs, thus reducing revenues of thermal power companies.
Third, the impact of carbon prices on the costs of energy firms. China’s national carbon emission trading system (EST) is expected to cover all major thermal power companies in 1-2 years and all major oil & gas companies in the next 2-4 years. According to IEA forecast, under the 2-degree scenario, China’s carbon price will have to rise by about 10 times in the 10 years through 2030 (IEA, 2019). As a result, these companies will have to pay for carbon emissions at a rapidly rising price for a growing proportion of their output.
Fourth, the impact of financial deterioration on funding costs of the affected companies.
Due to the declining revenues and rising costs caused by reasons stated above, these companies’ financial metrics (such as cash-flow) will deteriorate and thus their credit ratings will likely be downgraded by banks and credit-rating agencies. Such rating downgrades will result in higher funding costs for the firms.
Fifth, the impact of a possible increase in risk weight for environmentally unsustainable assets on funding costs of the affected companies. As mentioned earlier, the on-going policy discussions in China of changing risk weights for bank loans to “environmentally unsustainable”
and “green” companies may also result in higher borrowing rates for fossil fuel companies. We estimate that a 50-percentage-point increase in risk weight (from 100% to 150%) for
“environmentally unsustainable companies” could lead to an increase in average lending rate of about 50bps for companies in thermal power industry.
Framework of climate transition risk analysis
Our analytical framework for climate transition risk assessment integrates the following drivers of energy transition that impact companies in the thermal power industry: changing demand, progress in renewable technology, changing carbon price and rising funding cost. We use this framework to quantify the impact of energy transition on Chinese thermal power companies under the baseline scenario and the 2DS climate scenario. More specifically, we apply this analytical approach to estimating the differences in companies’ financials among alternative climate mitigation scenarios and the changes in probability of default (PD) of these companies receiving financing from banks and the bond market.
As shown in Figure 7-1, our framework of climate transition risk analysis consists of four steps, with three of which referred to as “modules”. These four steps are: setting climate scenarios, transition impact evaluation, corporate impact analysis, and financial risk assessment. In the following section, we provide a detailed description of these steps and the linkages between the modules.