Three critical issues emerged at the UN Climate Change Conference in Doha, Qatar, which closed last Friday (7 December). Probably the most important was the need to agree to a second commitment period to the Kyoto Protocol, since the first period expires on 31 December this year. Under this protocol, 37 countries committed to reduce their greenhouse gas emissions by 5 per cent against 1990 levels.
The second issue was to give clarity on how finance commitments pledged by industrialised countries of up to £60 billion a year until 2020 will flow to developing countries from 2013. And the third issue was to lay out a roadmap to obtain a global climate agreement by 2015, the year that scientists believe needs to be the peak of greenhouse gas emissions if global warming is to be held to two degrees centigrade. Above this point, scientists predict catastrophic climate change.
The negotiations took place against a backdrop of ever more stringent environmental regulation related to climate change, especially in the utilities sector, which is responsible for around half of all industrial emissions worldwide. In western Europe, for instance, utility companies will shortly be operating under the third phase of the European Union Emissions Trading System (EU ETS), which takes effect on 1 January 2013. From that point, utilities will no longer receive EU carbon emission allowances for free – they will have to bid for them at auction.
Standard and Poor’s believes this move will increase carbon liabilities for all western European generators. Although they have cut their carbon costs as a percentage of Ebitda (earnings before interest, tax, depreciation and amortisation) significantly over the past year, we predict they will have to purchase allowances beginning next year. What is more, we have commissioned a study of nine European utilities we rate that, assuming a carbon trading price of €14 (£11) a tonne, finds carbon liabilities could cost these companies up to £2 billion a year extra in 2014 and 2016, compared with 2011.
Even assuming that companies will, on average, be able to pass on 80 per cent of this cost to customers, their carbon payments could cost up to 20 per cent of Ebitda in 2016 for some companies, and between 0.3 and 5 per cent for others, depending on the amount of carbon dioxide they emit. We believe this financial exposure could increase even further depending on the outcome of policy changes currently being considered by the European Commission to increase the price of allowances.
It is not just carbon restrictions that are affecting utilities. Another consequence of climate change regulation is an increased emphasis on renewable energy. Ambitious targets for clean energy generation in the EU have put renewable energy at the forefront of discussions about how to meet Europe’s future energy needs. And political reactions to the recent nuclear crisis in Japan – which prompted Germany, for example, to shift its energy policy toward renewables and away from nuclear – are also fuelling the interest in renewable energy.
Despite the momentum behind renewables, Standard and Poor’s sees signs that regulatory risk is becoming a bigger issue for these projects. Budgetary constraints in the public sector and the need to implement severe austerity measures in some countries are calling into question the sustainability of financial support for renewable energy development in Europe. One example is the decisions by the Spanish and Czech governments to adjust their regulatory support frameworks, including subsidies, for existing renewables projects, in part retroactively. These actions served to increase investor anxiety and hamper confidence.
Although we expect next year’s tougher regulations to eventually put pressure on utility profits, low current carbon prices may delay the day of reckoning for a while. In fact, carbon emission prices have fallen from about €25 a tonne before the financial crisis to about €7-€8 a tonne now.
Nevertheless, the EU ETS is a politically sensitive market and is unlikely be left to its own devices. We understand EU officials have held initial discussions on how to reduce the oversupply of carbon certificates. Such a structural reform could permanently cancel allowances of up to 1.2 gigatonnes of carbon to reduce oversupply and support a higher price. It is more likely, however, that the Commission will use a different tactic: limiting the number of allowances coming to auction during the first three years of the third phase to support a higher price, then increasing the number in the final years (2018-20) – so-called backloading. According to Deutsche Bank, the backloading of 1.2 gigatonnes should be enough to push prices back towards €15 a tonne over the 12-18 months following such a decision.
A factor that has offset the effect of tougher climate regulation has been power generators’ ability in liberalised energy markets to pass through costs. Utilities in heavily-regulated markets, by contrast, have to negotiate with regulators to pass on costs.
To date, European utilities’ credit quality has held up well because they can recoup costs. What’s more, lower carbon dioxide emitters such as utilities that generate power from nuclear, hydro, and renewable sources have benefited from rising power prices without incurring pollution-related costs.
Whatever happens in the next year or two as Europe crawls out of its recession, the long-term trend seems clear. The rules governing utility carbon emissions are tightening. Sooner or later, utilities, or consumers, or perhaps both, will end up paying the price. While the Doha talks aim to reach a deeper global consensus on reducing the effects of climate change post 2013, the utility sector is shouldering tougher environmental regulation due to its carbon intensity, which in turn weighs on credit quality. This may lead to new opportunities for the renewable energy sector, although the regulatory environment for clean energy has its own uncertainties due to the amount of public subsidies still required to make it economically viable.
Michael Wilkins is managing director, infrastructure ratings, at Standard and Poor’s
This article first appeared in Utility Week’s print edition of 14th December 2012.
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