The carbon bubble and investment risk – getting capital costs ‘right’ in Europe’s electricity sector transition

The mitigation of climate change and limiting global temperature rise to ‘well below 2°C’ are key priorities for EU and its member countries. Part of the transformation required to meet these goals will be to a dramatic reduction in greenhouse gas emissions from the energy sector.

However, climate change mitigation measures may involve large economic costs, particularly forinvestments. It is therefore, important for policy makers to understand the costs involved and the impacts they will have on wider society.

The ‘carbon bubble’ is a major financial concern, which may arise through the transition into a low carbon economy. Meeting the 2°C target implies that large fossil fuel reserves need to be left untouched. This is a problem for fossil fuel based companies (both those which extract fossil fuels and those which supply energy based on fossil fuels) as their current valuations are dependent on all these reserves being exploited over time. This means that their reserves or capital stocks could end up as a ‘stranded assets’ thus leaving fossil fuel companies overvalued – a ‘bubble’ in their valuation.

Be that as it may, the 2°C target, is exactly that – a target. The 2015 Paris Agreement does not fully establish how this target will be met, and thus leaves uncertainty around when fossil fuel demands will start to decline. This uncertainty and risk is shared by potential investors, and may eventually materialise in economic markets in the form of higher interest rates for investment in fossil fuels (a ‘risk premium’). The fossil fuel sector accounts for 6% of the value of global stock markets, so the economic impacts would be profound.

This implies that, when analysing low carbon transition pathways, the risk of stranded assets might be acknowledged “game changing”, as it may drive up financing costs for fossil fuel investments and thus may change the relative cost of fossil and renewable energy. Our report argues that, when accounting for changes in risk (or risk perception), the economic effects of transitioning to a low-carbon economy may change considerably. This report focuses on both fossil fuel and renewable investment; the former may get more or less risky due to increasing trust in the continued expansion of renewable energy.

Exploring costs through models

To understand the economic costs of transitioning to a low carbon economy in more detail, models are often used to explore the costs societies might face under certain scenarios.

Our report utilises the WEGDYN economic model, a macroeconomic computable general equilibrium (CGE) model. This was used to assess the economic implications of a large scale renewable electricity expansion. This particular model contains a rich set of electricity production technologies and encompasses different global regions. The WEGYN focuses on the EU-28 member states, plus Norway, Liechtenstein and Iceland. These are represented by six regions: Eastern Europe (EEU), Northern Europe (NEU), Southern Europe (SEU) and Western Europe (WEU), Austria (AUT) and Greece (GRC).

Austria and Greece as represented as separate regions as they serve as examples with very different initial conditions for the transition. Austria is characterised by relatively low interest rates (reflecting low investment risks) and a high share of renewables in its electricity generation mix, however with only moderate capacity factors for wind and Photovoltaics (PV: conversion of light to electricity). However, Greece reflects the opposite: it is currently facing high interest rates, a relatively high share of fossil electricity, but promising capacity factors for wind and PV.

maryna-yazbeck-653136-unsplashThe assessment compares two ‘simulation runs’, differing by the expansion rate of renewable electricity.  First, we chose regional shares of renewable electricity from the with a moderate expansion of renewable electricity. The EU reference scenario is a tool created by the European Commission. It provides a benchmark allowing for the analysis of long term effects in the areas of energy, transport and climate action. The second simulation is based on the cost-optimal bottom-up assessment (the electricity mix which leads to the lowest EU-wide cost) with a large-scale expansion which reaches an almost 100% renewable share by 2050.

The two simulations are then compared to each other to isolate the effect of choosing a pathway that enables more renewable electricity. In order to better reflect risks, we vary the assumptions regarding the underlying Weighted Average Cost of Capital (WACC) used in the modelling runs. WACC is the average cost of financing from various sources, for example debt, which is weighted proportionally by its use. Therefore, through varying the underlying WACC in the electricity sectors investment element of the WEGDYN model, we are able to capture the economic effects of investor’s changing risk perceptions.

Results overview

Direct economic effects

From a regional perspective, two distinct geographic groups emerge when we model the effect of greater renewable deployment on average electricity cost development over time: Austria and Greece, and the remaining EU regions. Compared to the costs observed in the EU reference scenario for the first group, average generation costs first rise and then fall again. However, for the second group of the remaining EU regions, the large-scale transition leads to lower average unit costs in all scenario settings (compared to the EU reference scenario). Along the whole transition period of 2011-2050 changes in average generation costs of the regional electricity mix are in the range of -35% to +30%.

The direct effects reveal that, in the long run, large scale renewable electricity expansion is beneficial across all regions. However, during the transition average generation costs of the electricity mix are higher for countries like Austria and Greece, mainly due to relatively higher investment costs (when compared to gas, which is used more heavily in the EU reference scenario).

Economy wide effects

The large-scale renewable electricity expansion in Europe leads to changes in the retail prices of electricity. The relative change in regional retail prices for electricity ranges between -38% and +10% across scenario settings, for the whole transition period of 2011-2050 (these effects are measured relative to the price trajectory of the EU-Reference Scenario).

Price effects are mirrored in the output of the energy sector. In the main scenario, with technology and region specific capital costs, the Northern, Southern and Western European regions benefit (almost) from the start of the modelling period, with a positive long term electricity output and higher GDP. Also for Greece we observe positive long-term GDP effects. When we integrating a risk premium for fossil fuels, the positive effects become slightly stronger.

If we assume increasing trust in renewables, which is reflected by lower capital costs, this leads to higher GDP right from the beginning of the transition for all EU regions. The exception is Austria, where positive GDP effects would emerge only by mid-century.

Labour market effects

3049872814_0e8c12de62_oRenewables are more capital intensive than most fossil fuelled technologies. Consequently, less labour will be required which may lead to higher unemployment rates in the short-term. The pattern of unemployment rates for unskilled and skilled labour is subject to change with the large increase of capital intensities in regional electricity generation. However, our results show that longer-term positive effects on employment levels are possible, due to higher productivity of the overall economy, triggered by lower electricity prices.

 

Our conclusions

Our analysis suggests that investors’ risk perceptions of renewables have more of an impact than the perceived risk of fossil fuels. This is because renewables are more capital intensive, and capital costs therefore have a greater impact.

We find that immediate and substantial economic benefits are possible in all European regions, if we specify the underlying assumption on WACC (or risk) more accurately, price in the risk of a bursting carbon bubble and increase trust in renewables.

We find that de-risking renewables is much more effective than pricing risk into fossil fuel investment, which implies that this might be an effective instrument in climate policy. Therefore, de-risking renewables provides decision makers an additional game changing option for staying within long term climate objectives.


About this article

logoThis article is based on the TRANSrisk’s deliverable D6.4 ‘Identifying Innovation Policy Options in Transition Pathways’ forth chapter ‘The Carbon bubble and investment risk – Getting capital costs “right” in Europe’s electricity sector transition’. This chapter was written by Gabriel Bachner, Jakob Mayer and Karl W. Steininger of the University Of Graz, Austria. The D6.4 deliverable is available on request. This article was written by Ellie Leftley and Ed Dearnley at SPRU (Science Policy Research Unit) at the University of Sussex. For more information about TRANSrisk please visit our website.

 

Photo credits

Photo 1: Photography licensed under Creative Commons CC0

Photo 2: Photography licensed under Creative Commons CC0.

Photo 3: Photo by Oregon Department of Transportation, licensed under Creative Commons (CC BY 2.0)

You may also like...