Stranded energy asset risk is still very real
Fossil fuel assets were set to become obsolete in the transition to net zero. But the war in Ukraine is forcing European governments to secure alternative energy sources and driving demand for coal, oil and gas back in the wrong direction. With the global energy transition seemingly pitched against national energy security agendas, banks are trying to navigate a difficult path through the turmoil.
In Luckenwalde, power generation is a colourful affair. Just 50 kilometres south of Berlin, the capital of Germany’s Brandenburg state is home to a coal-fired power plant dating back to 1913. For 60 years, the Luckenwalde facility produced and supplied energy for the surrounding industrial community. It was a communist state-owned enterprise until 1989, when it was subsequently bought by a West German electricity company. The power plant shut down after the Berlin Wall fell and remained dormant for nearly 30 years.
Today, the piles of black coal are long gone and the facility generates Kunststrom: a form of electricity produced from and for artworks or artistic methods. Run by German art collective Performance Electrics, E-werk Luckenwalde is a venture with an impressive 10,000 square metres of exhibition and studio space. The Kunststrom is sold back to the national grid as an additional source of income.
Luckenwalde is one of many examples around the world of repurposing obsolete power generation assets to bring them back into the fabric of the economy. In Europe, the real estate and commercial sectors have capitalized on the architectural integrity of redundant power stations. London’s Battersea Power Station, which was bought by a Malaysian sovereign wealth fund for £1.6 billion in 2018, now houses luxury apartments, shops and other amenities.
Repurposing projects often incurs high costs when decommissioning obsolete energy assets. This is a prominent risk factor for bank lenders: as new and improved sources of energy become a more important part of the global mix, old infrastructure, technology, unusable resources and redundant businesses become financially stranded assets.
This phenomenon is not new. For banks and investors with exposure to the fossil-fuel sector, the financial cost of stranded assets is already at $1 trillion, according to Carbon Tracker’s latest findings.
“In its simplest form, the difference between the fossil-fuel reserves owned by listed companies and governments and the remaining carbon budget available to stay below two degrees [Celsius] will be stranded assets,” says the think tank’s founder, Mark Campanale.
Carbon Tracker first reported on the risk of stranded assets in 2011. That year, the Unburnable Carbon report showed that private investors are at a much greater risk of stranded assets than state-owned companies because of their exposure to oil and gas projects. Ten years on, the updated findings state that there are 3,000 gigatons of CO₂ sitting in reserves of fossil fuels globally, compared with the 300 gigaton global carbon budget to keep global warming at 1.5°C above pre-industrial levels.
The upstream financial implications for investors are huge. In a 2018 report, Carbon Tracker modelled demand for oil, gas and thermal coal under the International Energy Agency’s (IEA) 2°C and 2.7°C scenarios. It found that Russia – the world’s second-largest petroleum exporter – would lose $57 billion in gas-related investments and $85 billion in oil-related investments in a 1.75°C world, compared with a 2.7°C one.
Exporting countries like Russia would need to diversify their income stream quickly or face massive economic turbulence. What the report couldn’t predict, however, was Russia’s invasion of Ukraine in February 2022 and the widespread energy crisis that followed.
Germany’s 2020 coal phase-out plan projected that its 63 operational coal power plants would be fully decommissioned by 2030. Last year, coal represented 17.9% of the country’s energy mix, half of which originated from Russia.
The war in Ukraine prompted the German government to lift all restrictions on coal power plants as alternatives to Russian imports of fossil-fuel energy. Elsewhere in Europe, coal-fired power plants are being kept alive to secure energy sources for winter. Now that energy security, availability and affordability have been prioritized, European decommissioning plans risk being delayed – and with them, interim emissions targets.
“We have always been committed to ensuring efficient decommissioning of these sites,” EDF Energy’s transformation director, Rachael Glaving, tells Euromoney. "The question is if there is any value to these assets beyond what they have already provided through power generation .
"The land, grid connection and water access can be reutilized for net-zero development and repurposing."
Nobody expected transition pathways to be linear and those commitments were done before the war and the rising inflation. The macro environment is very different, we have to take that on board
EDF Energy confirmed that the UK government had requested to extend the life span of coal-fired power station West Burton A through the coming winter for reasons of energy security.
The impact of the decision on EDF’s share price has been limited as the company is set to be fully nationalized this year with the French government's offer to buy the remaining 16% of the firm that it does not own.
If decommissioning plans are delayed and coal-fired power plants remain active, large energy corporates and their shareholders will maintain some exposure to coal. Most banks have, however, committed to exclusion policies since the Paris Agreement, which limits the probability of new private investments in coal.
CaixaBank, for example, excludes lending to companies with more than 25% of their turnover derived from thermal coal electricity generation or 10% from thermal coal extraction. The Spanish bank says the extension of coal-fired power plants’ life in Europe does not impact their policy.
“Few are thermal coal plants still running in Spain, so it’s not an issue for us,” says CaixaBank’s head of climate risk, Stefan Rodia García-Petit. "Our transition away from coal has been going on for a while."
Gill Lofts, global head of sustainable finance at EY, says: “In general, we have not yet seen banks move away from the phasing out of coal”, before adding that the shift has been in projections on fossil-fuel energy sources generally.
The fossil-fuel push goes beyond politically driven decisions on coal. Since the war in Ukraine started, the energy security agenda has focused on finding and funding alternative sources of oil and gas.
For now, it seems, the urgency of the stranded assets problem for banks has been postponed.
“It will be interesting to see how many reach a 50% reduction in emissions by 2030,” says Lofts. "Nobody expected transition pathways to be linear, and those commitments were done before the war and the rising inflation. The macro environment is very different, we have to take that on board."
Banks model their stranded-asset risk through scenario analysis according to the IEA’s pathway to keep global warming at 1.5°C. Yet projected demand and use of fossil-fuel resources and the price of oil and gas suggest something different.
The US Energy Information Administration forecasts that the combined production of US fossil fuels will continue rising in 2022 and reach a record high in 2023, having increased by 2% in 2021 to 77.14 quadrillion British thermal units. The price of oil hit $103 a barrel in August but had fallen back to $88 by early September.
Europe still relies on imports for about 60% of its energy consumption. Now that its primary supplier, Russia, has turned off the taps, governments are rushing towards other markets, including Saudi Arabia for oil and Canada for liquified natural gas.
“Alternatives to fossil fuels are not where we need them to be, so the risk of stranded assets has been postponed,” says Mark Wade, head of sustainability research at Allianz Global Investors, pointing to historical underinvestment in the European energy sector.
He believes lenders will face greater demand for transition-linked capex from clients if the global energy mix doesn’t change soon.
“Seventy-one percent of total energy mix is fossil fuel; if we get down to 40% by 2030, that’ll be quite a good outcome” he says.
We don’t think the banks are incorporating the reduction in value of the collateral of the fossil fuel system
A 31-percentage point reduction requires deep cuts in global fossil-fuel consumption. Most investors advocate for the IEA 1.5°C scenario in their net-zero commitments, which require that no new investment is needed anywhere in new exploration or production licences.
Yet no big oil and gas company has committed to ending expansion beyond existing fields, according to the Banking on Climate Chaos 2022 report.
The largest energy companies still spend billions annually on exploration. ExxonMobil, for example, reported $12.3 billion in capital and exploration expenditures in 2021, and expects to spend $20 billion to $25 billion annually through 2025.
The firm announced $17.9 billion in earnings and $4.6 billion in investments in exploration in the second quarter of this year.
“Our ability to maintain and grow our oil and gas production depends on the success of our exploration and development efforts,” it said in its annual report.
Energy firms are clearly capitalizing on the current price disruptions, but the upward trend in upstream oil and gas activities suggests some of these corporates and their financiers expect that fossil fuel will continue to be profitable in the long term.
“It is difficult to predict the future, but oil and gas is a cyclical industry” says DNB’s global head of oil and gas, Espen Kvilekval. "Right now, demand is outweighing supply."
DNB still assesses stranded-asset risk through traditional lending parameters. The bank considers the marginal cost of production, cash-flow projections, loan duration and the breakeven commodity price level for each client. From that perspective, current dynamics in the energy markets point to favourable lending conditions.
The rapid changes in the energy sector – resulting from both political crises and climate change – make stranded-asset risk a core element of transition risk. For banks, this could lead to much higher loan default rates.
Identifying obsolete corporates is one thing, but banks must also be able to identify business models for which the cost of transition will be too high. Risk teams have no choice but to go through the balance sheet on a client-by-client basis.
“We first needed to disaggregate the value chain to understand the impact of this transition risk,” says Garcia-Petit.
Even in a successful transition scenario, new oil and gas investments will be required for the next 20 to 30 years
For large oil and gas clients, CaixaBank no longer grants special purpose credit facilities for upstream activities beyond the very short term. For them, the return on investment doesn’t justify the risk.
This is not the case for fossil-fuel exporting countries. The Norwegian Petroleum Directorate's estimates, for example, indicate that oil and gas production is expected to increase until 2024 – and predictions such as these are reflected in the lending strategies of banks.
“Even in a successful transition scenario, new oil and gas investments will be required for the next 20 to 30 years,” points out Kvilekval.
“It’s an important industry in Norway,” he adds. "We have clients who are conducting new explorations and developing new fields, and our approach is to finance the production of oil and gas, with as low emissions as possible."
It all comes down to risk appetite. And since the materiality of this transition risk is not yet clear in corporate balance sheets, it can be tempting to be complacent.
“If you look at a typical bank book, the average tenor of the loans is three to four years, and the stranded-asset risk stretches way beyond that,” says Michiel de Haan, global head of energy at ING.
The bank, which committed to limiting its coal-fired power exposure to 5% for utilities clients by 2025, has identified key industries in which the transition risk posed by stranded assets is too high.
ING has set specific parameters and limitations for its fossil-fuel energy book to make sure that the risk is recognized. For example, since the EU is banning internal combustion engine (ICE) vehicles by 2035, lending commitments lasting 10 to 15 years into an ICE storage unit in Europe would be too risky, it says.
The shift away from brown energy sources has been unusually swift in one sector: automobiles. There has been a deep change in vehicle manufacturing over the last three years due to a rapid change in consumer behaviour. This shift is reflected in the capex of companies in the sector, which is largely concentrated on adapting manufacturing lines to make room for electric vehicles.
In its report, ‘Oil and Gas Companies Struggling to Come up With Credible Transition Plans’, Fitch Ratings predicts oil demand in the transport sector will fall dramatically as consumers opt for electric vehicles.
The EU ban on fossil-fuel cars from 2035 shows how as consumer behaviours change, policies follow. Not only must corporates demonstrate a business model resilient to transition costs and liabilities, but they also need to demonstrate an ability to stay relevant or adapt quickly in the face of rapid and extensive policy change.
For ING’s energy book, the biggest risk is an event risk.
“Scenarios help determine our risk appetite,” explains De Haan. "The one that is potentially the most impactful is the one where you see rapid technological and governmental change in the system."
Governments are firefighting … The only way to become energy independent is to use resources that are close by
So, banks face the challenge of mapping the stranded-asset risk for each individual market, the long-term impact of this and what regulatory changes to expect.
“We are doing a deep dive into each client in these high-emitting sectors and we consider the credibility of their transition strategies,” says Garcia-Petit. "Each new transaction will be assessed through this climate risk lens from now on."
Central bank stress tests have been encouraging the integration of scenario-based analysis in banks’ credit-risk frameworks, but Carbon Tracker research associate Amy Owens questions the efficacy of these models.
“We don’t think the banks are incorporating the reduction in value of the collateral of the fossil-fuel system,” she says.
If traditional risk-analysis models cannot adequately capture long-term impacts, banks cannot expect high emitters to set the right kind of decarbonization objectives. To fully quantify the scope of stranded assets in the energy sector, such models must give a negative terminal value to coal, oil and gas assets by accounting for the cost of decommissioning, dismantling and scrapping them.
“Modelling is based on assumptions and is a representation of what we think could happen,” says Kvilekval. "We include a certain level of conservativism to be on the safe side, but there can always be some surprises down the line."
He adds that DNB is not concerned about its oil and gas clients’ ability to pay back debt because of the short loan duration of their books.
For ING, the resilience of collateral assets is something that needs to be considered in the energy sector.
“We set our risk appetite via our portfolio limitations, then we table it with clients as an important topic of discussion,” affirms de Haan. “The stranded-asset risk tells you that if you have an asset that in itself is very valuable but is in the wrong location, you have an issue.”
Europe’s energy war is bringing this to the fore. Gas facilities are not stranded by nature, but their location is a crucial component of their business model’s durability. A storage facility in Sicily will not be able to compete with one in Rotterdam when it comes to feeding oil into the German industrial heartland, for example.
If carbon emissions continue to rise, stranded-asset risk will evolve from a transition risk to a physical one as well. Energy infrastructure will be subject to catastrophic weather events more frequently and supply chains will be continually disrupted.
These physical implications are already visible. In July, water levels in Europe’s Rhine River dropped to record lows following a Europe-wide drought, preventing cargo vessels from transporting raw materials, including shipments of coal, to Germany. If such disruptions become more commonplace, shipment costs will increase and impact other markets.
Higher insurance costs will also impact production and operation costs.
“When we talk to companies, we also think about those physical risks and their ability to counter those risks,” says Wade at Allianz. "All companies need to insure themselves. In the same way that the cost of insurance goes up if your house is near dry woodlands in a hot area subject to heat, the cost of insuring infrastructure assets in high-risk areas will go up."
From coal to nuclear: repurposing plants for SMR
One of the ways in which coal-fired power plants could be repurposed is through nuclear power. The facilities themselves could provide key infrastructure for small modular nuclear reactors (SMR) as a low-carbon alternative source of energy.
EDF’s Nuward SMR design, for example, is designed to supply 340 megawatts electrical (MWe) of power. The technology is “a complementary solution to renewable energy sources, aimed at replacing ageing coal-fired plants in the 300MWe to 400MWe range,” the company says.
EDF’s model will act as a test case for safety authorities as European governments work towards harmonizing SMR licensing and regulation.
Several other designers and vendors are considering SMR models to replace aging coal-fired power plants, due to the similar power capacity this technology can provide.
“The green energy transition ...supposes that... we need to replace polluting old plants with something without any greenhouse gas emissions,” says one expert. "This [SMR] is a significant option because it could provide the same power capacity and electricity to the grid but in a cleaner way."
This kind of repurposing could facilitate the energy transition in Poland and Germany, which represent 51% of total European coal energy consumption.
Polish energy group Ze Pak has already entered into an agreement to explore the construction of four SMRs at the Pątnów coal-fired power plant as the company plans to phase out coal by 2030.
By building a nuclear plant on an obsolete coal power facility, companies can use much of the existing infrastructure. This ensures economic continuity after the decommissioning process.
Rolling out these kinds of projects will depend on the availability of assets and technological developments. Few SMRs are yet in operation as most models are still under development or in a stringent licensing and certification process. Real-world demonstration of SMR technology is expected in the second half of this decade, and mass deployment will come some time after 2030.
EDF expects commercialization of Nuward as early as 2025, with a target to build a reference plant in France before the end of this decade.
The energy security and energy transition agendas seem to be at odds with one another. Most European countries are reverting to dirty energy sources as a short-term measure to maintain political sanctions on Russia, hoping that they can make up for it through offsetting later. Meanwhile public funding is being redirected to fossil-fuel energy providers to keep consumer prices manageable.
The European Commission has approved €8.4 billion of state aid in Spain and Portugal to lower the input costs of fossil fuel power stations.
“The Spanish and Portuguese measure is justified by the particular circumstances of the Iberian wholesale electricity market,” a European Commission spokesperson tells Euromoney. "In particular, the limited interconnection capacity of the Iberian Peninsula, the high exposure of consumers to wholesale electricity prices, as well as the high influence of gas in price setting for electricity have led to a particularly serious disturbance to the Spanish and Portuguese economies.
“The Commission recognizes that there is a need for certain temporary measures in view of the high energy prices as a result of Russia’s continued unjustified war against Ukraine that caused a serious economic disturbance in the EU. This makes reducing dependence on fossil fuels and fast forwarding the green transition even more important and urgent.”
The decision of the EC speaks to the sensitive nature of dealing with the short-term implications of a just energy transition.
“There needs to be balanced policy response,” says Garcia-Petit. "We need to decarbonize, but there are social consequences to writing off entire industries. A disruptive transition would be problematic."
The current energy mix points to increased emissions in the short term, but banks feel confident in their ability to manage the transition to mitigate the risk of assets becoming stranded – but not completely.
“Governments are firefighting,” says ING’s de Haan, "but the current issue around the need to decarbonize is pointing towards low-carbon rollout across Europe. The only way to become energy independent is to use resources that are close by."
Opportunities in the hydrogen space are a prime example of how capital can be deployed to projects with an attractive return on investment, while supporting clients that are committed to decarbonizing.
Oil and gas clients facing acute climate-related transition risks are understandably the most focused on mitigation. DNB has seen increased interest from such clients in offshore wind, carbon capture and storage technologies, and hydrogen.
“Our bigger clients are instrumental in the transition, given their industrial capabilities, balance sheets and cash flow,” says Kvilekval. "They have the capital to develop projects and bring them to scale."
Energy firms and their investors are clearly motivated to do more with existing assets and to avoid transition costs.
“At EDF, we are looking at what we have across the entire portfolio of our assets” says Glaving.
West Burton, for example, has been shortlisted in the fossil-to-fusion competition of the UK Atomic Energy Authority.
But not everyone will survive the transition. An international, soon-to-be fully nationalized corporate such as EDF can absorb the cost of transition while benefiting from government-run decommissioning mechanisms. For smaller corporates that might be operating at lower margins, support will be needed.
Back in Luckenwalde, the art centre is getting ready to host a Kunststrom-powered music festival called Currents. The decommissioning costs have long been absorbed and the asset is profitable once again. Meanwhile, the German authorities have identified 16 coal power plants for reactivation, but operational issues such as technical maintenance and coal supply disruptions are slowing down the process. In the private sector, energy companies are recording record profits as energy prices soar.
The risk of energy assets becoming stranded seems to have been postponed in the short term, but it is still very real. Banks face a formidable challenge in balancing their green ambitions and the market conditions in which their energy-sector clients find themselves.
Future-proofing energy assets
When Carbon Tracker first pointed out that investors and banks would be left with stranded assets as a result of the transition to a green economy, it referred to reserves owned by private and public companies and governments.
In 2012, the think-tank found that $674 billion had been spent on unburnable fossil-fuel reserves. Investors were exposed to these resources through passive funds that track the market and active funds benchmarked against market indices. Today, the value of unburnable carbon is estimated to be $1 trillion.
The problem goes beyond fossil-fuel resources in a global CO₂ emissions budget. Downstream energy assets such as coal-fired power plants and oil and gas infrastructure will also lose value.
“Stranded assets is a basket concept,” says Michiel de Haan, global head of energy at ING. "We recognize its existence, but we need to apply the knowledge and scenario-based analysis to understand what it really means for each individual market."
This is especially true for smaller clients for whom the transition towards renewable energy holds the threat of rendering them obsolete.
“There are certain business models that just won’t work in 10 or 20 years and ones whose transition will be too expensive,” says Helen Droz, vice-president of MSCI’s climate research team. "The risk of loan defaulting there is significant."
If a company specializes in producing the pumps used on oil drilling locations, for example, its entire business model is threatened.
“Any company part of the oil and gas supply chain is vulnerable,” Droz says.
Investors need to consider how energy infrastructure will react to climate change and how much that could cost.
Stranded assets are included as part of transition risk assessments, but as climate change accelerates, real assets become more exposed to physical climate risks.
“Weather impacts could risk leaving some infrastructure operationally stranded, as there will be a physical risk to running these types of activities as well,” says Mark Wade, head of sustainability research at Allianz Global Investors.
The war in Ukraine has reinvigorated demand for coal, oil and gas, but corporates that capitalize on this demand by expanding their fossil fuel activities in the short term may find those assets becoming uninsurable in the future.
Despite the energy crisis in Europe, insurance companies are pulling back from underwriting fossil fuel projects or including climate risk in insurance pricing.
For example, since January 2022 Lloyd’s of London has ceased to provide new cover for thermal coal-fired plants, thermal coal mines, oil sands and Arctic energy exploration activity. It also committed to phasing out existing cover by 2030, according to its 2021 environmental, social and governance report.