IEEFA India: Coal-dependent power producers should prepare for climate transition risk
Climate change has created financial risks for business. These can be broadly categorised as physical and transition risks.
Physical risk is easier to understand. It is essentially the impact of a changing climate on revenues as well as costs. A simple example is higher real estate operating costs due to increasing damages from floods under a 5C increase in average global temperature by 2100. For a real estate portfolio, this could result in lower valuations due to anticipated higher costs.
Transition risk, on the other hand, is the financial risk due to changing policies, technologies, and markets. For example, a business may be planning to operate under a 4C scenario by 2100, whereas future policy changes may result in a 2C scenario by 2100, which may impact the planned revenues and costs. This is true for power producers reliant on coal power generation, as we discuss below.
In the Indian power sector, a transition scenario is 450GW of renewable energy capacity by 2030
In the Indian power sector, the business-as-usual scenario is typically the National Electricity Plan prepared by the Central Electricity Authority (CEA). The last national electricity plan of 2018 predicts a renewable energy capacity of 275GW by 2027, with plans for significant coal capacity additions (to the order of 50GW) during 2017-2022 as well as 2022-27.
However, at the same time, India has started to commit to more ambitious renewable energy targets, adding to the current target of 175GW of renewable energy capacity by 2022. The most recent one is the target of 450GW of renewable energy capacity by 2030, first highlighted at the UN climate summit in 2019. This may be in line with India getting to net-zero by 2050.
For coal power producers, transition risk impacts financials via reduced operating incomes
Thus, for India, we already see a climate transition scenario of 450GW of renewable energy capacity by 2030, when power generation companies may be planning for a business-as-usual scenario of 275GW of renewable energy capacity by 2027 based on the National Electricity Plan. This transition scenario would essentially mean no more investments in coal power generation capacity.
For India, we already see a climate transition scenario of 450GW of renewable energy capacity by 2030
If this transition scenario of 450GW of renewable energy capacity by 2030 is realised, given that higher renewable generation would end up displacing coal-based power in India, it would negatively impact assumed revenues and costs from the sale of coal-based power as assumed in the business-as-usual scenario. This would impact equipment suppliers, generation asset owners and consumers paying the bills, as well as the financial institutions supporting these now stranded or underutilised assets.
The financial impact can be captured in reduced operating income, also known as earnings before interest, taxes, depreciation, and amortisation (EBITDA). Reduced EBITDA then means reduced cash flows, reduced operating life and hence reduced valuations. In recent research, we calculated this negative impact on India’s leading power producer NTPC’s valuation by up to 16%.
Transition risk would result in reduced capacity to pay debt
In addition to reduced valuations that are of interest to equity investors, reduced EBITDAs also have an impact on the capacity to pay back debt. In practice, the ratio of EBITDA to the debt service requirement – i.e., principal plus interest – is used as the debt coverage service ratio (DSCR). Reduced EBITDAs essentially mean reduced DSCRs and reduced minimum DSCR over the duration of debt.
For NTPC, strong DSCRs have historically manifested in a positive outlook by credit rating agencies, resulting in an investment grade – i.e., AA domestic – rating. Investment grade rating is typically the minimum credit rating where institutional investors would invest. This threshold is important given that it indicates that the investment is somewhat safe.
However, in recent research, we find that the minimum DSCR for NTPC drops from 1.31 under the business-as-usual scenario to 1.13 under the transition scenario, i.e., a 13.7% drop. For NTPC, a reduced capacity to pay debt puts at clear risk its investment grade status, with multiple implications.
The impact of reduced debt payment capacity is two-fold – lower credit rating and lower leverage
One, credit rating would go down. For any given leverage, or fraction of debt in company value, which equals equity and debt, reduced DSCRs mean reduced distance to default, or higher probability of default, and finally lower credit rating. A reduced credit rating would raise the cost of debt and, therefore, the cost of capital.
NTPC and others need to recognise this transition risk and think about strategic responses
To explain this a little more, default essentially means inability to pay back debt. Distance to default is a metric that measures how close to defaulting a particular company is at a point in time. A lower distance to default then means a higher probability that a company would default on its debt obligations. A higher probability of default translates to a higher risk perception and a lower credit rating.
Two, leverage would go down to keep the same minimum DSCR. Banks typically limit the amount of leverage such that minimum DSCR does not fall below a threshold. So, if the DSCRs fall due to falling EBITDAs, banks may reduce leverage of a company to make sure that minimum DSCR does not fall below this threshold. Again, cost of capital would go up due to lower leverage.
Transition risk would result in higher cost of capital
Thus, transition risk results in not only reduced valuations for a coal power producer but also a higher cost of capital. Therefore, coal-dependent power companies – e.g., NTPC and others – need to recognise this transition risk and think about strategic responses that reduce this risk, e.g., by investing more in renewable energy and reducing investments in coal-based generation capacities.
Gireesh Shrimali is a Precourt Scholar, Sustainable Finance Initiative, Stanford University
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