MANAGING CLIMATE-RELATED FINANCIAL RISK - LESSONS FROM ADANI

Just last Friday – while the nation was continuing to debate the merits of Adani building a mine in a brand new thermal coal basin in Queensland - the Australian published an article headed ‘South32 dumps thermal coal, citing uncertainty and climate change’. Matt Chambers wrote that the BHP spin off is getting out of thermal coal ‘because it is becoming less attractive to investors, has an uncertain future that does not support long-term investment and because the world needs to decarbonise’.

 

In late 2016, Blackrock - the world’s largest asset manager, with almost $5 trillion US under management - issued a memo ‘Adapting Portfolios to Climate Change’ - in it, they advised subscribers that ‘investors can no longer ignore climate change. Some may question the science behind it, but all are faced with a swelling tide of climate-related regulations and technological disruption’. The leading ratings agency, Standard and Poors, reported as early as 2014 that climate change would soon start to place downward pressure on the credit ratings of nation states due to the economic and financial impacts. And, in 2016, the IMFreported that ‘climate change is expected to significantly impact the global economy in the coming decades’, while the World Bank warned that ‘climate change is a threat to [its] core mission’.

 

Here in Australia, APRA has recently entered the climate debate – not without some trepidation I imagine, given the toxic nature of the Australian debate. Geoff Summerhayes, who has taken the lead for APRA, said a couple of months ago ‘climate change and – here’s the crucial bit – society’s responses to it are starting to affect the global economy’.

 

The overall objective of climate change policy is to safeguard the natural environment - for its own sake obviously, but also so that future generations canenjoy healthy lives and good living standards. But this isn’t a traditionalexample of environmental protection. For one, the sheer scale and timeframes involved in climate policy dwarf anything we’ve confronted before. But – more importantly for tonight’s discussion – the response is essentially one of economic restructuring, touching pretty much every sector of our economy, in contrast to the usual work of government environment departments. That’s why Bill Shorten decided to separate Labor’s management of the climate and energy portfolio, which I hold, from the more traditional - and still critically important - environment and water portfolio, which Tony Burke holds.

 

As we all know, Australia has signed on to the Paris Climate Agreement which commits the world’s nations to keep global warming ‘well below 2 degrees’ above pre-industrial levels, and to pursue more qualified efforts around a 1.5 degree limit. Meeting that commitment will be a monumental challenge for all nations,developed and developing alike –particularly for an economy as carbon-intensive as Australia’s. And, like any deep economic shift, it will present huge risks, as well as many opportunities. While politicians usually prefer to dwell on the sunny side of economic change, tonight I want to talk about the way in which companies and governments are starting to manage the risks associated with both the physical impacts of climate change and the economic impacts of de-carbonisation.

 

The most compelling advocate about the economic and financial impacts of climate change has been Mark Carney, Governor of the Bank of England. Carney also chairs the Financial Stability Board – set up by the G20 after the Global Financial Crisis to monitor risks and vulnerabilities in the global financial system. He identifies three categories of climate-related risk to economies and business. 

 

The first – physical risk - arises directly from the impact of climate change on infrastructure, assets and agriculture,through things like the increased frequency and severity of extreme weather events, sea level rise and such like. These impacts are already being felt across the world, and will accelerate even in the face of a concerted effort to mitigate future global warming. They will hit some business sectors more severely than others, but the Actuaries Institute of Australia warned late last year that there is a low level of preparedness generally in Australia for the impact of increased temperatures and extreme weather on company balance sheets.

 

In the finance sector, the physical impacts of climate change are being most deeply felt in the insurance and reinsurance sectors. Carney makes the point that the industry is coping at present with an increase in claims from climate-related events, largely through its ability to revise liabilities and premiums on an annual basis. But access to affordable insurance is a key foundation of regional economies. Not too long ago, we saw the impact in Lismore of businesses not being able to access affordable flood insurance. This sort of thing can have a chilling effect on investment in affected regions. Carney has warned that traditional insurance models will be put under increasing strain as the frequency and intensity of climate-related events continue to rise – to the point where ‘in time, growing swathes of our economies could become uninsurable absent public backstops’ - that is to say, taxpayer support.

 

The second risk identified by Carney – ‘transition risk’ - is perhaps the most complicated to navigate for governments, businesses and investors. This risk focuses on the shift away from emissions-intensive operations to a low carbon economy, a shift that will take many years and be far from linear. Innovations in low carbon technology continue to surprise, but exactly how fast they can be deployed at scale is often difficult to predict. The reality of the transition, though, is undeniable. 

 

The third risk Carney points to is ‘liability risk’ – the likelihood that litigation will become more common to recover damages for losses incurred as a result of climate change from people who should have prevented those losses from occurring. Damage might arise from the physical impacts of climate change, or reflect economic losses associated with the transition to a low-carbon economy. 

 

Litigation around climate risk is already beginning in the United States. Members of the company pension funds operated by Peabody and other major coal companieslaunched cases against the directors of those pension schemes - based on the charge that the directors should have known that the share prices of those coal companies (which formed a large part of the funds’ investment portfolios) were likely to drop as demand for coal was driven down by climate policy.

 

Litigation has also been initiated by an insurance company against the City of Chicago on the basis that the City didn’t take reasonable steps to protect the community against the physical risks associated with climate change – in particular, more intense storm damage and flooding - which would have reduced the insurer’s liabilities. None of this litigation has yet been taken through to a decision, but it seems only a matter of time. 

 

More recently, San Francisco and Oaklandin California have initiated cases against five big oil and gas companies – BP, Chevron, Exxon, Conoco and Shell – to make them pay for infrastructure the citiesneed to build to protect coastal assets against sea level rise. Just last month, New York Mayor, Bill De Blasio, filed a similar case against the same five companies claiming $20 billion in damages. And, at the same time, the New York Attorney-General is investigating whether Exxon committed securities fraud by intentionally misleading investors about the impact of climate change on company profits.

 

This is not just a risk in the notoriously litigious United States. In Australia in late 2016, Noel Hutley SC, then President of the NSW Bar Association, published legal advice entitled ‘Climate Change and Directors’ Duties’. Hutley’s advice centred on the legal duty of company directors to take account of all ‘foreseeable’ risks when making decisions about the company’s affairs, and stressed that it was likely that a court would soon find climate change to be such a risk. Early last year, Geoff Summerhayes from APRA told the Insurance Council that climate risks were no longer future concerns, but were ‘foreseeable, material and actionable now’.

 

There is currently a concerted push to have companies undertake greater disclosure of their exposure to climate-related risk. In 2015, the G20 leaders established the ‘Taskforce on Climate-related Financial Disclosures’ and appointed billionaire businessman and former New York Mayor, Michael Bloomberg, as its Chair. The Taskforce report last year set out standard obligations and frameworks to be considered by governments, regulators and companies. In Australia, the TCFD guidelines have already been endorsed by the Australian Council of Superannuation Investors, BHP, AGL and the NAB – to name a few. The International Association of Insurance Supervisors is currently considering adopting its guidelines as a global standard for insurers and re-insurers. Some are going even further. France’s Energy Transition Law, for example, requires all listed companies and institutional investors to disclose the contribution of their portfolios to the achievement of the Paris Climate Agreement objectives.  

 

Generally, the disclosure of climate risk remains voluntary – but there is a vigorous non-government campaign underway to pressure big investors to commit to such voluntary schemes. The best known of those is the Asset Owners Disclosure Project – an international project chaired by former Liberal Party Leader, John Hewson. The Project rates and ranks the world’s 500 biggest investors and 50 largest asset managers on their management of climate risk. The annual report of the Project has consistently ranked Australian superannuation funds highly, with four Australian funds ranking in the top twenty asset owners in 2017, including Local Government Super which comes in at number one. More broadly, though, transparency and good practice around climate risk are still very patchy.

 

The fifty largest asset managers manage $43 trillion of assets – 70 per cent of the world’s managed assets. Only three of the fifty are in the Asia-Pacific, including one Australian company, Macquarie Bank. The nature of the local debate around climate risk appears to influence the performance of these large asset managers. All five of the British companies, for example, rate in the global top ten – while Macquarie comes in at number 33. That correlates with the release last month of the results of an internal survey on climate risk management by Colonial First State, the wealth management arm of the Commonwealth Bank. Less than half of their asset managers thought climate change to be an investment risk and less than one in five measured their portfolio’s carbon footprint – leading the company to warn that ‘we might remove managers…because they’re not identifying risks that we think are material to portfolios’.

 

The other trend emerging from projects like the G20’s Taskforce is a greater emphasis on scenario analysis and planning. Some companies have been using this as part of their business planning for decades. For others, it’s a newer concept. Scenario analysis allows a business to shape its planning around a range of possible futures – and to stress-test the business against those variables. Against a backdrop of the commitments contained in the Paris Climate Agreement and market changes being driven by those commitments, scenario analysis is at the same time vitally important and devilishly complex. 

 

The energy and resources sectors are struggling with this – and they’re not being helped, in Australia at least, by the analysis from Government about likely trends in a decarbonising world. Some significant Australian companies are helping lead the way. BHP, for example,published a Climate Change Portfolio Analysis before Paris which included portfolio impacts in a 2 degree world; and then updated the analysis after the Paris Conference.

 

But other resources companies have rightly attracted attention and criticism for presenting business plans that actively assume the world fails to take action consistent with the Paris Agreement. At its AGM in 2017, for example, SANTOS Chairman, Peter Coates, was questionedabout the company’s climate risk assessments and scenario analysis. He responded that ‘the pathway we adopt is the four degree pathway’ – that is to say, a pathway that sees the world consume resources in such a way that leads to four degrees of global warming, a scenario that would have catastrophic consequences for future generations. He went on to say ‘there’s been no nationally determined commitment to the two degree scenario and even the four degree scenario is not funded. So I think what we’re doing is very sensible and consistent with good value’. Whitehaven Coal also attracted criticism last year after it presented its AGM with an assessment of future demand for thermal coal taken from the International Energy Agency’s so-called ‘new policies’ scenario, which assumes there is absolutely no policy change over the next 25 years to respond to climate change.

 

The IEA publishes a range of scenarios in its annual World Energy Outlook and other regular reports to assist governments and business plan for the future. The Outlookfeatures three different scenarios for the energy sector over the next 25 years. No-one pays much attention to the first – the ‘current policies scenario’ - which assumes we essentially continue with business as usual. It’s the contrast between the other two scenarios that crystallises the challenge for business and investors, not to mention the planet.

 

The so-called ‘new policies scenario’ casts forward on the basis of all firmly announced policies, and assumes there is no further policy change anywhere in the world for the next 25 years. Even some policies already announced are still not included. Notably, the latest Outlook acknowledges that China’s recently announced ‘Energy Production and Consumption Revolution Strategy 2016-2030’ is not incorporated in the new policies scenario. That Strategy sets China on a path towards 50 per cent of its electricity coming from non-fossil fuels sources by 2030, an annual cut of almost 500,000 GWh of fossil-fuelled electricity beyond the assumptions in the new policies scenario.

 

The third scenario has gone by different names – usually the two degree or 450 scenario – but is now known as the ‘sustainable development scenario’ as it incorporates assumptions around universal access to electricity as well as carbon levels. For present purposes, it’s modelled on the basis that we meet the Paris commitments.

 

These two scenarios paint profoundly different pictures for the coal-fired generation and thermal coal export sectors. The IEA advises that meeting Paris would require that unabated coal-fired generation– that’s to say, without carbon capture and storage - is ‘all but’ phased out of OECD economies by 2035, and cut dramatically in India and China. Even under the new policies scenario, thermal coal exports – or the seaborne trade – reduce gently from current levels over the period to 2040. Under the two degree scenario, though, exports are slashed by 30 per cent by 2025 and two thirds by 2040. More happily for the gas sector, both scenarios project an increase in gas-fired generation, over the medium-term at least, as China and India in particular switch out of coal. 

 

Any serious analysis of global trends in coal-fired generation bears very little relationship to the picture painted in the IEA’s new policies scenario; or what iscolloquially described as the four degree scenario. In a speech in late 2016, Mark Carney detailed the seismic disruption in asset values flowing from the transition that has been underway in the American coal industry for several years. He highlighted that the combined market capitalisation of America’s four biggest coal companies had plummeted by 99 per cent since 2010, with three of them (Peabody, Arch and Alpha) filing for bankruptcy. Those companies weren’t alone. Forbes Magazine reported in 2016 that Peabody was the 50th coal company in the US to file for bankruptcy in just four years. The decline of America’s coal industry has been driven substantially by switching in power generation from coal into cheap gas, but an increasing number of forecasts suggest the rush out of coal-fired power is becoming global. Geoff Summerhayes from APRA has stressed the scale of this transition, citing a 2016 report from Barclay’s that estimated that implementing the Paris objectives could slash fossil fuel revenues by 33 trillion US dollars over the period to 2040.

 

There is a clear structural shift underwayin the global thermal coal market – driven by a change in the nature of China’s economic growth, and a global shift away from coal-fired power generation. China’s breakneck speed of growth drove thegrowth in coal trade over the last decade, but their imports have started to decline and are projected to keep declining into the future. In part, that reflects a dramatic slowdown in the rate of growth in electricity generation in a country moving more to a services-based economy and aggressively pursuing greater energy efficiency. But China is also moving away from coal-fired power as part of its ‘war on air pollution’. Only a few years ago, China’s demand for thermal coal was expected to grow almost inexorably, drawing on the seaborne trade to supplement its own enormous coal industry. It’s now clear that the world’s biggest market is in retreat.

 

The great hope for the thermal coal industry is India. The Indian Prime Minister, Narendra Modi, was elected on a promise of bringing affordable electricity to all Indians by 2019. But it’s increasingly clear that Modi does not intend to deliver that promise on the back of Australian coal. India’s use of coal imports is a relatively new phenomenon, reflecting a growth rate that ran ahead of the local industry’s capacity to keep up. Now, the Indian Government has imposed production quotas on the local industry (particularly the giant, state-owned ‘Coal India’) that are intended to put an end to coal imports by the end of this decade – a policy only reaffirmed last month by the former Indian Energy Minister, now Minister for Coal and Railways, Piyush Goyal. Thermal coal imports have been declining substantially since 2015, and are expected to continue to do so. If Coal India’s quotas are achieved, local coal production will exceed local demandwithin only a few years. 

 

Around three quarters of the world’s coal is consumed in China, the United States and India. With the US and China reducing their consumption of thermal coal in particular, and India’s prospects as a long-term market for seaborne coal declining fast, it’s hard to see a real-world basis for the IEA’s treatment of thermal coal in itsnew policies scenario. 

 

I pause to emphasise that I’m not dealing here with the outlook for coking coal, which remains relatively robust as industry still searches for cleaner ways to make steel. If anything, Australia is likely to increase its already dominant share of the seaborne trade in coking coal from Queensland. But, the outlook for thermal coal is a different matter.

 

Australian governments – through their resources agencies – have also been consistently bullish about the outlook for thermal coal exports. Labor’s Energy White Paper of 2012 contained an extensive discussion of the different IEA scenarios for energy and resources demand over coming decades, including the IEA’s two degree scenario. But it also forecast that ‘a large expansion in thermal coal exports is expected to increase production by an average of 2.8% per annum’ – over two decades. Coal exports (of coking and thermal coal) were ‘expected to grow strongly’ to between 530 and 690 million tonnes by 2025. And the Paper saidpointedly that ‘increasing demand has meant that an entirely new coal precinct has opened up in Queensland’s Galilee Basin’.

 

The reality today is quite different. Total coal exports are running at around 390 million tonnes –about half of which are thermal coal - and volumes have been flat for several years now. The IEA’s 2017 Outlook points out how utterly exceptional the Galilee Basin development is globally. It describes the Adani Carmichael mine as the only significant export-oriented greenfields project – that is, it’s in a new thermal coal basin - on the face of the planet. There’s no question that the case made a decade ago for opening up thatnew thermal coal basin rested on demand projections that are fundamentally inconsistent with current market trends and the more probable scenarios for future global demand.

 

Unsurprisingly, perhaps, the Energy White Paper prepared under Prime Minister Abbott avoided any substantial discussion of climate change and contained no reference whatsoever to the IEA’s twodegree scenario. Instead, the Paper confidently told Australians that demand for our thermal coal exports would increase substantially, based on the IEA’s new policies scenario. And the same approach continues under Prime Minister Turnbull. The latest outlook for thermal coal exports issued by the Office of the Chief Economist in December again uses the assumptions contained in the IEA’s new policies scenario to predict, for example, that Indian imports will climb in coming years – against all of the statements to the contrary from the Indian Government. Reading those Government reports, one can be forgiven for thinking that the development of the Galilee Basin remains a sensible proposition – from a market-demand perspective, at least, if not from a broader climate or environmental point of view. But those scenarios are utterly at odds with current market trends, and even more inconsistent with the IEA’s advice on what the world needs to do – and, if the signatures on the Paris Agreement mean anything, will ultimately do – to keep global warming well below two degrees. 

 

In all of the many discussions I’ve had over recent years with different interests about the Galilee Basin projects, a consensus view has been put that they are simply not financially viable – that the cost of developing the new mines cannot be recouped from a declining market with a thermal coal price projected to be in the doldrums for years. Adani continues to struggle to get financial backing for the Carmichael mine, most recently seen in the decision of the large Chinese banks to walk away from the project. And, in light of what’s happening in the Indian energy market – including to Adani’s massive power station in the state of Gujarat, the Mundra station – it’s increasingly difficult to see how Adani would get off-take agreements for Carmichael coal. The projects next in the Galilee queue – owned by GVK and Clive Palmer – appear even further removed from financial viability. 

 

There’s clearly a great deal of frustration in Queensland about the constant delays and debate about the Adani project, and whether the promised jobs will ever really happen. In a region that’s been hit hard by the end of the mining boom, job opportunities are crucially important. Bill Shorten isn’t willing to wait on Adani’s continual delays with this project – delays that will likely come to nought anyway. He’s busy talking to the Queensland Government and local communities about other job plans. And he’s putting concrete announcements before the people of Central and North Queensland as we speak – jobs that we guarantee will happen.

 

Now, I and most commentators might be wrong about all that – Adani’s project might notionally go ahead if the Turnbull Government finds some way of throwing a heap of taxpayer money at it. But, the industry itself has been clear that any coal mined from the Galilee to chase a declining seaborne market would simply displace coal and jobs in existing coal regions, like the Hunter Valley – advice contained in a detailed report from the well-known coal industry analysts, Wood Mackenzie. For the life of me, I can’t see how that prospect is in the national interest.

 

That’s not to say that there won’t continue to be substantial demand overseas for thermal coal exported from Australia’s established basins, like the Hunter Valley. That coal is high quality, close to port and seen as a stable source for importers. Even on the IEA’s two degree scenario, those operations will continue to have a market for quite some time to come. But the growth projections that underpinned plans for a brand new basin have disappeared.

 

The Adani debate is just one high-profile example of the impact that the transition to lower carbon energy sources is going to have on Australian business. In the energy and resources sectors, technological change and public policy are putting enormous pressure on traditional business models and assumptions about future demand. The level of risk that this transition inevitably brings to investors is aggravated by the poor levels of disclosure by companies about the impact of different scenarios on their business. And the one-eyed reliance on scenarios that pretend that the world is not changing is simply unsustainable and, potentially, legally negligent.

 

Investors are already voicing their expectations that companies do better in this area. But, government and regulators clearly have a role to play in improving standards as well. APRA is currently working with Treasury, the Reserve Bank and ASIC to improve their shared understanding of these risks. Presumably, like other regulators across the world, that will include a consideration of the recommendations from the G20’s Taskforce on Climate-related Financial Disclosure. But there also needs to be a better approach to scenario analysis within the Commonwealth Government itself. Government cannot continue responsibly to send a message that it expects the thermal coal market to perform in a manner fundamentally at odds with clear market trends and the obligations that the nations of the world signed up to in the Paris Agreement.

 

The transition to a low carbon economy is already underway, and will continue to unfold over decades. It’s a transition that must continue if we are to have any chance of meeting the monumental challenge of keeping global warming well below two degrees, and minimising the impacts of climate change on future generations. While it’s a transition that brings many investment opportunities, it also brings enormous risk. Australian governments, regulators and businesses are not currently managing those risks well. We’re not alone in that, but Australia’s carbon-intensive economy is more exposed to the transition than most other economies. APRA has sent a clear message that we all need to find ways to do better – Labor strongly shares that view and I look forward to a sensible discussion about the way ahead.