Climate Change Risk and Opportunities in the Utilities Sector

The utilities sector has generally been viewed as a “safe haven” by investors during periods of market volatility and slowing growth. This is due to the sector’s traditional defensive nature and stable revenues during all phases of the business cycle. However, as the financial risks from climate change grow, some utilities may be challenged to generate a steady rate of return for shareholders. Competitors with fewer risks related to fossil fuels may outperform peers by taking advantage of greater opportunities for renewable energy and technology development.

We believe a comprehensive understanding of the risks and rewards associated with climate change is critical for investors to assess and manage portfolio risk. In the coming decades, businesses will face increasing pressure to reduce their emissions as countries around the world pledge to become carbon neutral by 2050. There will likely be a policy response that will put some companies at risk if they are unwilling or unable to align with the goal of “net-zero.”

A Multitude of Risks

Organizations that fail to adapt to climate change face a host of potential risks.  The public, for example, generally associates climate change with physical risks, which is true, but incomplete. Customers and investors are also pressuring publicly traded companies to explain how they plan to transition to a clean energy future. International and regional regulatory authorities are demanding specific disclosures regarding how utilities plan to meet net-zero goals. Meanwhile, power demand continues to rise in concert with the buildout of electric cars.

Physical risk. Climate change is associated with rising temperatures and an increase in the severity of natural disasters. This has resulted in economic loss for some businesses due to damaged infrastructure and disruptions to supply chains and operations. In the last two years alone, the US experienced more than 40 weather-related incidences that resulted in at least $1 billion in damage per occurrence [1].

The utilities sector has the highest exposure to physical risk, leading other capital-intensive sectors, such as industrial manufacturing, oil and gas and real estate [2]. More extreme hurricanes, wildfires and heatwaves continue to impact every aspect of the grid, from generation, transmission, and distribution, to demand for electricity. For many utilities, this has meant reduced efficiency, higher operating expenses and more frequent power outages. Capital expenditures to maximize infrastructure resiliency in the face of climate change is becoming a critical component of sustainable business models.

High Exposure: Utilities Rank Above Other Sectors for Long-Term Physical Risk

*Composite sensitivity-adjusted physical risk scores for 2050 under a moderate climate change scenario. Sector averages weighted by market cap. A score of 100 represents maximum risk exposure. Source: Trucost; S&P Global Market Intelligence, as of September 20, 2021.

Transition risk. The financial risk associated with an uncertain path to a decarbonized economy is called transition risk. The electric utility and transportation sectors, which make up at least half of all US carbon emissions, are the most exposed to transition risks, which range from reduced access to financial capital to new federal and state regulations [3]. Insurance-related risks include higher operating costs and insurance premiums associated with compliance, increased carbon emission pricing, climate-related reporting requirements and restrictions on existing products and services. An increasing number of banks and insurers say they will no longer back companies with shares of coal generation above 30%. 

Regulatory risk. The SEC proposed new climate-related disclosures in March 2022 in recognition that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions. The proposed rules would require disclosures on Form 10-K about a company’s governance, risk management, and strategy regarding climate-related risks. Moreover, the proposal would require disclosure of any targets or commitments made by a company, as well as its plan to achieve those targets and its transition plan, if it has them. 

Opportunities in Climate Mitigation and Adaption

To address the physical impacts of climate change, some utilities are increasingly investing in new technologies and climate strategies to strengthen the grid, reduce costs related to service disruptions and take advantage of the growth in clean power.   

Green savings. The US electric power sector has reduced carbon emissions 40% since 2005, primarily by retiring coal plants and replacing them with natural gas, wind and solar [4]. Despite the obvious environmental and reputational benefits of decarbonization, the driving force behind the shift to renewables has been a lower cost structure and new growth opportunities as companies seek cleaner energy. Utilities that are decreasing their dependence on fossil fuels and investing in wind and solar have been able to realize higher margins and earnings per share, boosting their competitive advantage and ability to earn a sustainable return on equity. 

Grid hardening. Grid hardening ranges from upgrading transmission and distribution systems to moving lines underground. Distributed energy resources (DER) is another example that encompasses residential solar, energy storage and microgrids to ensure consistent service when power is down. Utilities are also utilizing smart meters and other management systems that can reduce demand during an emergency, combined with flexible load programs.

Clean power. The growth of clean power, and the global effort to decarbonize transportation, buildings and manufacturing, has also created growth opportunities for electricity producers. According to the International Energy Agency (IEA), the investment required to meet the world’s net-zero goals is estimated to be ~$27 trillion, with the greatest opportunity in batteries (60%) due to rising demand for electric vehicles and grid storage, followed by wind power, fuel cells and solar PV [5]. Utilities with expertise in areas like renewables, energy storage, hydrogen and charging stations are expected to see structural demand growth and rising market share in the coming years as the transition gains momentum.

Between 2010 and 2020, the global cost of electricity from utility-scale solar PV (photovoltaic) fell by 85%, onshore wind by 56% and offshore wind by 48%. In the US, 61% of the sector’s coal capacity costs more than renewables. Retiring these coal plants and replacing them with cleaner alternatives would cut expenses by an estimated $5.6 billion a year [6].

Government incentives. In addition to massive corporate investment, President Biden’s 2021 Infrastructure Investment and Jobs Act (IIJA) has earmarked billions of dollars to increase grid resiliency, develop next-generation clean energy technologies, accelerate electric vehicle adoption and fund nuclear and green hydrogen investments.

Managing Climate Risk & Opportunity

At Fiduciary Trust International, we believe climate change is an important factor to consider when assessing risk and opportunity in a portfolio. Our goals is to weigh the investment implications of government responses to climate change in the form of new federal and state regulations, public investment and carbon taxes, as well as shifts in consumer and investment sentiment and rising costs from natural disasters.

Companies at the forefront of change are already setting ambitious climate goals and investing in more sustainable solutions and incorporating stakeholder considerations in their business models.  Progress is evident in capital investments to ensure more durable infrastructure and a greater willingness from companies to incorporate climate factors in company disclosures. This includes emissions (both direct and in its supply chain), exposure to physical risks such as flooding and wildfires, and climate mitigation and adaption measures to address these risks.

Applying a Climate Change Lens to Utility Investment Decisions

When assessing the utilities sector, we start by looking at publicly available information. Company disclosures are used to determine the percentage and growth potential of renewables in the business model and whether there are capital investments planned in low emissions products, services and energy efficiency management.

We also monitor the carbon intensity of operations, both absolute and relative to peers, and the amount of revenues derived from providing clean energy solutions, such as wind and solar power. Companies may have a high carbon intensity but either reflect high transition potential or play a significant role in reducing real world emissions by developing low carbon solutions, highlighting the challenges posed to investors when assessing climate risk in a portfolio.

We believe proactive utility companies will enhance their return potential over time as they work to manage the downside risks inherent in climate change, access new growth opportunities and customer segments and improve their economic and physical resilience.