The pace at which power companies align their portfolios of assets to net-zero targets will increasingly affect their access to capital markets and their cost of capital. Immediate climate action to meet these targets can mitigate negative impacts and preserve credit quality. Delayed action can lead to greater investment requirements to reach net-zero, along with higher financing costs.
Stronger global climate commitments, as well as shifting economics in the electricity market, put more pressure on power companies to decarbonise in what might be challenging timeframes.
Financing power companies in Europe has long come with challenges. In 2008, the top European power companies had a combined market capitalisation of more than €1tn, which has fallen to a current value of approximately €500bn. Moody’s has reported that the sector’s median credit rating fell from A2 to Baa2 over the same time period. The causes of this can, in part, be attributed to the energy transition, along with the global financial crisis and subsequent sovereign crisis, regulatory change, mergers and acquisitions, and changing commodity and electricity prices.
In general, European energy utilities are heavily reliant on debt financing. They are the largest bond issuers of any sector in Europe. According to Dealogic, since 2016 they have issued $405bn of bonds.
Credit ratings are important to power companies, especially investment-grade ratings, because they ensure financing is available at competitive prices. As power companies refinance their debt in the future, persuading investors that the money can be returned will be critical to keeping financing costs to a minimum as they approach net-zero.
The recently released ‘Fit for 55’ legislation package by the European Commission (EC), supports its commitment to reduce net greenhouse gas emissions by at least 55% by 2030 and the prospect of the bloc’s goal of climate neutrality by 2050.
Cashflow management issues could arise for corporations that align with net-zero targets. The early obsolescence of infrastructure that produces emissions, combined with the need to replace that infrastructure with green technology, is the source of this. Lost future cashflows from emitting sources need to be replaced, and the scale of annual investment required to replace those cashflows can impact both the bottom line and the cash available to pay off debt or interest. This can make refinancing difficult and more expensive than before.
The EC, in its ‘Clean planet for all’ report, expects that the electricity system could grow by 280% by 2050, with a 936% increase in wind and solar generation relative to today's levels, representing more than 80% of all generating capacity by 2050. There will undoubtedly also be significant investment opportunities in the digital technologies that will support these levels of renewables, such as demand-side management and peer-to-peer trading.
EC analysis also suggests that carbon-emitting sources of power generation could cease operation by 2040, without a significant change of land use. It also predicts an estimated carbon price of €350 per tonne of carbon dioxide by 2050. Europe’s carbon price is currently €60 per tonne of carbon dioxide, which far exceeds the EC’s estimate of €38 per tonne by 2030. Modelling shows that the amount of time these plants operate throughout a year could fall to 40% of today’s levels by 2040.
Aligning with net-zero
Early obsolescence of carbon-emitting power plants will put pressure on European power companies to find the money to pay off their outstanding debts due to lost cashflows or stranded assets. Fortunately, these companies have 20 years to work on this issue and there are ample investment opportunities that are aligned with net-zero currently available.
It is conceivable that these companies could use the cashflows that are generated from emitting plants today to invest in renewables and other technologies that help get us to net-zero. It is a question of timing: future cashflows are discounted and worth less than those generated today. The longer these companies put off replacing lost cashflows with net-zero aligned cashflows, the more they need to invest and more uncertain the outcome. Transitioning companies over a shorter time period also increases the annual investment requirements, which leaves less money available to repay debt and interest payments.
In their most recent annual review of the sector, Moody’s notes that significant capital investment would be necessary to facilitate the energy transition: utilities will gain from growth opportunities, but higher capital expenditure could negatively impact their credit metrics. In addition to the pace of the company’s transition, the initial composition of emitting and non-emitting cashflows the company is starting from can also be a key risk factor. Ultimately, power companies must generate 100% of their cashflows from non-emitting sources by a certain point in time.
This problem was quantified for 29 of Europe’s (including the UK’s) largest power companies (all the European power utilities rated by Moody’s), in a paper I co-wrote and published in the Journal of Corporate Finance. In order to better understand the sector’s financial capacity to align with net-zero targets, we took an asset-level approach, looking at the expected lost cashflows of each plant and aggregating them to each company. The consequences of those lost cashflows, as well as the investment required to replace them with green sources of income, were then assessed using the quantitative parts of a Moody’s credit rating methodology.
We estimate closing all emitting plants by 2040 could create industry-wide stranded assets or lost cashflows of between €98bn and €130bn. For some power companies, lost cashflows from premature shutdowns equated to 40% of the value of their current total assets. These numbers also include lost cashflows from the reduced running hours of power plants between today and 2040.
However, we also found that a significant majority of companies in the sector could have the financial capacity to shut their carbon-emitting power plants early, if they start reinvesting today, with minimal impacts on credit ratings. But if they delay action for just five years, 14 of the 29 companies analysed would experience declines in credit ratings related to having enough money to pay interest payments on loans. Credit ratings fell for 12 companies, based on having less money available to pay back their loans, including one which was rated as high-risk.
There are wider implications of delayed action outside of financial sustainability, including for pensions, jobs and asset owners further up the investment chain. It is also uncertain and debatable as to what extent governments should be involved in compensating power companies for these lost cashflows. For example, Germany is currently using compensation mechanisms and auctions to accelerate this process; however, this is not the case for most of Europe.
Outside of policy and market dynamics, financial intuitions that typically hold European power-sector debt and equity are also likely to have their own net-zero target for their portfolio. In some cases, these could arise before the EC’s 2040 deadline. Supervision of financial institutions by central banks through climate stress testing, the Sustainable Finance Disclosure Regulation and other policies may drive such action.
Financial products in the form of sustainability-linked bonds and sustainability-linked loans may also be used to further incentivise and accelerate the decarbonisation of power companies. Enel, Europe’s largest power company, has issued sustainability-linked bonds that link its cost of capital to its progress on reducing emissions.
There is also a growing trend by credit rating agencies to monitor the progress of utilities on carbon-transition risk. The Carbon Transition Assessment (CTA) developed by Moody’s includes a 10-point scale to measure power companies’ progress with the energy transition. Moody’s most recent CTA analysis of 41 European utilities found more than half were moderately or poorly positioned. The CTA grades are based on seven factors, including how quickly companies expect to reduce their fossil-fuel generation in the next five years, and how much of their capacity may be shut down in a rapid transition scenario in 10 years.
Relative to power companies internationally, European utilities are generally ahead in their decarbonisation efforts. At this point it is not clear whether the scale of lost cashflows globally can be managed effectively with immediate action. Sectors outside of power generation can have much more limited decarbonisation options or reinvestment opportunities. For example, steel, cement, aviation, shipping and agriculture can commonly be referred to as hard-to-abate sectors. The distributional impacts of those losses and impacts on their respective capital markets requires further research.
The framework developed in this paper can support investor and policy engagement to address these questions, but ultimately makes the point that delayed action makes the transition significantly more difficult, expensive and riskier than it needs to be.
Conor Hickey is a research fellow in Scenarios and Business models for the transition to Net-Zero. He co-authored the study alongside John O'Brien, Ben Caldecott, CelineMcInerney and Brian Ó Gallachóir.
This article first appeared in the October/November print edition of fDi Intelligence. View a digital edition of the magazine here.