Investors need to robustly assess the impact of climate change on their assets, says Arjun Infrastructure Partners’ Rhyadd Keaney-Watkins
As the real-world implications of climate change become ever clearer, from devastating heat events to major storms, it’s essential that owners and operators of vital pieces of infrastructure assess the climate-related vulnerabilities of their physical assets.
For investors, that will mean doing a deep dive on the various climate risks facing every infrastructure asset in their portfolio, argues Rhyadd Keaney-Watkins, head of ESG at Arjun Infrastructure Partners. The firm, which manages more than €5.7 billion of capital, targets the mid-market infrastructure space with a core and core-plus approach.
In such a set-up, Keaney-Watkins says, the mission is to integrate quantitative climate analysis and ESG factors generally, to deliver against both investment objectives and key sustainability targets.
Q What are the key climate risks that investors need to manage?
Climate risks fall into two broad categories: physical and transition. Transition risks arise from the shift to a low-carbon world, and generally fall into a few different buckets. In the regulatory risk bucket, for instance, there are the headline-grabbing policy changes that drive greenhouse gas emission reductions, such as closing coal-fired power stations or the ban on new internal combustion vehicles, as well as less well-known moves like tightening limits on the venting of fugitive emissions of methane in the oil and gas sector.
Then there is technology risk. This is to do with the risks around technological advancements and innovations, such as the future role of green hydrogen and the general substitution of existing products and services with lower emission options. Market risks also exist, such as increased production costs and the risk of carbon taxes.
Lastly, among the transition risks, there is reputational risk. Institutional investors are increasingly keen to ensure they are putting their capital to work in a way that aligns with stakeholders’ net-zero and other non-financial ambitions. Many are seeking sustainable long-term returns and, fundamentally, this requires a long-term vision for how transition risk may affect the investment case.
Physical climate risks, on the other hand, are the potential threats arising from acute climate change-related weather events that cause damage or disruption. These include the likes of heat stress, extreme wind, flooding, precipitation, drought and wildfire. Chronic events also count here, including long-term, gradual changes in climate patterns that can have a significant impact over time, such as rising sea levels.
Q Are physical climate risks particularly important for infrastructure investors?
Absolutely. Infrastructure assets generally operate in fixed locations and are usually physically exposed. This makes them potentially vulnerable to operability issues or, in the worst-case scenario, damage. From a service perspective, these assets are relied upon for the day-to-day functioning of society. So, as responsible owners of these assets, we need to make sure that they are dependable.
Infrastructure assets are also of long duration. We intend to hold investments for the long term, which means we could see extreme weather increasing in frequency and intensity during our investment period.
To deliver our financial objective of reliable risk-adjusted returns over the long term, physical climate risk needs to be understood and managed.
Q How should investors bring climate risk assessment into deal origination and due diligence?
We have to believe that the assets we acquire today are physically resilient and that the business model will remain viable in a low-carbon economy.
We wouldn’t necessarily exclude carbon-intensive businesses from the outset, but we need to have conviction that these businesses can be transitioned and will remain essential. We have to understand the commercial and technical viability of transitioning assets, as well as what is currently costed and provisioned.
The assets we’re talking about here are naturally capital-intensive. They can’t simply be abandoned due to being regarded as ‘brown’ or relatively carbon intensive assets. I think the brown into- green transition, where we can measurably improve the sustainability performance of assets, is where the biggest real impact and value creation can occur. It’s also where institutional investors can play an important role, being relatively long term and patient owners of assets.
For physical climate risk, we use climate scenario analysis software built by climate scientists. We run analysis across a number of different potential climate scenarios – everything from the best-case Paris-aligned future to a worst-case ‘business as usual’ future.
Q Are there limitations to such analysis?
Yes, of course. It’s important when you select a software provider that you meet them and understand their models and the inherent uncertainties. For instance, there are many questions to be answered around resolution – the degree to which a model can be location-specific.
But that’s not to say that we should not use a tool if it is not completely perfect. We deal with uncertainty all the time, whether it’s interest rates or power curves.
It’s also worth noting that we have seen significant heat risk events in recent years, so this is not just forecasting. We are able to look at what has actually happened at a particular site during some of those events.
Q Is it possible to mitigate climate risk as an infrastructure investor?
It’s not only possible, but essential. Mitigating risk is all about the active management of assets when it comes to physical climate risk.
Last year, we completed a portfolio-wide climate risk assessment, which enabled asset directors to engage with portfolio company management teams to consider commercially viable engineering solutions.
For example, we manage a large energy plant located just outside London. Like many infrastructure assets, the plant had been affected operationally during extreme heat events. So, we looked at how we could improve its resilience, using our climate scenario analysis and developing commercially viable engineering solutions. This included modifying ventilation and cooling ducts to make them more effective, and installing water sprayers within the fan coolers.
Active asset management is also the answer when it comes to transition risk. By helping portfolio companies actively assess and plan for the transition, the risk of unexpected costs, as well as missed opportunities, can be minimised. And we have achieved this even where we are a minority shareholder, which illustrates our commitment to tackling climate change.
“All investors should be concerned about how physical and transition risks are being managed”
Q Which are the most important physical risks investors need to be aware of?
We look at the full range of future physical hazards: heat stress, flooding, drought, extreme rainfall, extreme wind and wildfires. For European infrastructure assets, heat stress and flooding are particularly important. For instance, we’ve seen record-setting heat waves over the past couple of years, as well as the devastating flooding across western Europe in 2021.
But there are two different elements to this: the projected change in the hazard over time, and also the vulnerability of particular assets to each physical hazard. If you are dealing with a business dependant on water resources, then naturally you should be concerned about drought, but probably not if you’re assessing an operational wind farm.
Q What keeps you up at night?
It’s the physical climate risks. I think the market is going to see a shift in the insurability of some of these assets. In extreme cases, you may see some elements of physical risk becoming uninsurable. In others, you may see insurance premiums go up. That clearly is an issue when you have a leveraged asset, especially where you’re seeking refinancing on an asset. I think that’s the real risk that has started to emerge.
It raises many difficult questions. Are we comfortable with the risks? Do we think a potential future buyer is going to be comfortable with them? Do we think an insurer is going to be comfortable with them?
I remember from my consultancy work one client who said: “We don’t expect this asset to be gold-plated, but we do want it to be bulletproof”. It’s worth remembering that you can over-engineer an asset. You want to do everything you can to make it resilient, but you might still reach the point where it’s not commercially viable to go any further.
Q Does climate change also present any opportunities?
Mitigating climate change will require a transformation of our infrastructure systems, across energy, transport, social and digital infrastructure. This provides an opportunity for businesses that can support and contribute towards this change.
A good example from our European fund series is our Danish biogas platform, Bigadan. Earlier this year, Bigadan won a contract with the Danish Energy Agency to capture 25,000 tonnes of biogenic CO2 each year. This CO2 is then delivered to Gas Storage Denmark, the first onshore storage facility of its kind in Denmark. This is a very exciting and value-enhancing opportunity. It’s also an excellent demonstration of how a technology-based solution can provide verifiable carbon removal offsets.
Q Overall, what practical approach should investors take towards climate risk?
This depends on the investment objective – financial and non-financial – of the investor. All investors should be concerned about how physical and transition risks are being managed, since this can fundamentally affect returns. Challenging managers to provide examples of how this is being addressed practically through asset management is key.
Perhaps a more difficult question is how investors can support climate action. This will depend on what type of impact they are seeking and whether it is compatible with the preferred risk-return profile. Investing in operational renewable assets can be low-risk but low-impact, whereas providing the capital for businesses to transform could be viewed as higher-risk, with higher risk-adjusted returns.
I think our core and core-plus risk strategies balance this well, featuring a mix of operational assets, development platforms underpinned by operational assets, and essential assets underpinned by strong sectoral fundamentals, which can be improved during the ownership of the asset. Ultimately, a blended approach is well suited for institutional investors seeking impactful returns, at a risk-return profile appropriate for long-duration liabilities.
Extract from Infrastructure Investor November 2024 issue magazine
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