Banks need to beware of sustainability risks in the power sector

Sustainability factors such as water, land, GHG emissions, and fuel availability are slated to pose the greatest risks to power plants. These risks will not just impact plants on a physical and operational level, but they will also have significant financial implications. The risks will be applicable for all energy generation technologies – coal, hydro, wind, bio-mass, solar, nuclear.

Events in recent months have highlighted the growing importance of sustainability factors in operating power plants. Several power projects in India have faced delays or project closures because they had not adequately addressed mitigating their impact on environmental and social factors.

The delays and closures fall under three categories: violating pollution control norms, availability of fuel and other raw materials like water, and land acquisition and other stakeholder issues.

•   In April 2011, the Maharastra Pollution Board shut down 8 units of MahaGenCo’s coal based power plants for violation of GHG emissions norms.
•   In the same year, Coal India missed its coal production targets by 6% because it did not get environmental clearances for expanding its operations.
•   In Andhra Pradesh alone, power and mining projects to the tune of INR 40,000 crores have been put on hold due to protests by local communities and environmental organizations.

In many cases, like that of East Coast Energy, work on the commissioning of power plants has been halted despite the company being granted environmental clearances because the plant was not able to adequately obtain a “social licence to operate” (something that is less regulation and more stakeholder engagement).

A similar story is being played out in Jaitapur, Maharashtra at a nuclear plant being built by Areva.

Delays due to environmental and social factors has resulted in Private Equity firms reconsidering lending terms to power and infrastructure projects since these delays can have a substantial negative impact on the rate of returns.

The RBI says that there was a 36% decline in FDI coming into India in 2010 due to stricter environmental regulations.
While the culprits in the examples presented are the traditional ‘villains’ of the power sector (coal and nuclear), it is not difficult to foresee similar challenges being faced by renewable energy projects. These projects also consume natural resources (water, biomass) or acreage in large proportions.

Given these circumstances, should PE and other investment firms, reduce their power and infrastructure portfolios? Perhaps. But a more prudent approach would be to incorporate the evaluation of sustainability risk into their investment parameters, so that they can accurately estimate actual rates of returns, investment horizons and potential roadblocks for projects where they have already invested.

Investment firms need a way to evaluate the environmental and social impact of a project that goes beyond the traditional ‘Environmental, Health, Safety, and Social’ (EHSS) Due Diligence.

While EHSS Due Diligence can inform investors about the compliance readiness of a project, it fails to evaluate the potential sustainability risks that will arise in the future. It also fails to inform investors about the scale and probability of those risks. Specialized Sustainability Risk Assessment tools and analytics are better suited to conduct these analyses.

For the power sector, such tools should be able to assess impact on the following factors:
1. Water: Power plants use approximately 6m3 of water per hour for every MW produced. In a country where the availability of clean water is often times a challenge, such large demand can produce a significant backlash for local communities who also compete for the same water resources. Additionally, changing rainfall patterns or drought years can also result in decreased or non-availability.

2. GHG Emissions: India has a goal of reducing its GHG emissions intensity by 20-25% by 2020. To meet these targets, regulation is clamping down on GHG emissions from power plants. Indian power plants face a greater challenge due to the higher amount of impurities found in India coal, making investing in GHG emissions limiting technologies more important and in some cases more costly.

3. Fuel Availability and Supply Chain Volatilities: Most thermal power plants have long supply chains when it comes to procuring fuel. These supply chains have their own environment/social risks and failure to address them can severely jeopardize fuel supply, thereby risking power plant operations. Whether it is non-availability of coal due to delays in environmental clearances or the decline in bio-mass supplies due to seasonality, demand from other sources, or price fluctuations, environmental and social factors have a significant impact and need to be managed accordingly.

As India gears up to meet energy targets of over 15,000 MW of new capacity every year, the power sector will see a large interest from financial institutions. With most power sector projects having a 70:30 debt-to-equity ratio, the stakes for funding institutions are very large.

In such a scenario, it becomes essential for investment managers to have robust sustainability risk assessment tools. Only then will they be able to prepare accurate rate of return that account for ‘sustainability shocks’.