from Energy Security and Climate Change Program

Climate Risk Impacts on the Energy System

Examining the Financial, Security, and Technological Dimensions

Hurricane Harvey off the coast of Texas as seen from the International Space Station, on August 25, 2017. NASA/Reuters

Insights From a CFR Workshop

June 14, 2019

Hurricane Harvey off the coast of Texas as seen from the International Space Station, on August 25, 2017. NASA/Reuters
Report

In March 2019, the Council on Foreign Relations’ Energy Security and Climate Change program convened a workshop to examine the financial, regulatory, security, and technological dimensions of climate risks to the U.S. energy system, and to advance understanding of the implications for energy security, technology development, and business. The workshop was held at the Council on Foreign Relations (CFR) and was made possible through the generous support of the Alfred P. Sloan Foundation. The views described here are those of workshop participants and presenters only and are not CFR or Sloan Foundation positions. The Council on Foreign Relations takes no institutional positions on policy issues and has no affiliation with the U.S. government.

Introduction

As climatic changes continue to make themselves painfully obvious across many geographies, U.S. energy infrastructure is increasingly at risk. The United States is ill prepared for this national security challenge. Climatic disruptions to domestic energy supply could be large, entailing huge economic losses and potentially requiring sizable domestic military mobilizations. Yet, public debate about emergency preparedness is virtually nonexistent. To explore the challenges of climate risk to the U.S. energy system, the Energy Security and Climate Change program at the Council on Foreign Relations convened a group of forty-four experts at the Council’s New York office on March 18–19, 2019, for the workshop “Climate Risk Impacts on the Energy System: Examining the Financial, Security, and Technological Dimensions.”

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During their deliberations, workshop participants discussed the presenters’ papers and explored how climate-related risks to U.S. energy infrastructure, financial markets, and national security could be measured, managed, and mitigated. Discussions began with assessments of the current state of climate research and the pressing need to improve data on localized effects, which could differ widely from global and regional averages. The workshop also investigated new energy technologies, financial tools, and changes to disclosure regulations that could enable the United States to reduce risks and mitigate consequences of climatic shifts.

Physical Climate Risks to U.S. Energy Infrastructure

Participants agreed that climate change affects virtually every aspect of the U.S. energy system; however, specific challenges vary by geography and intensity. For regional challenges, participants noted that energy facilities, military bases, and communities on the U.S. coast of the Gulf of Mexico are particularly exposed to sea-level rise. This rise is partly due to changes in expected sea currents combined with local land subsidence (that is, the sinking of ground through natural erosion and the removal of underground materials such as water, oil, and gas during commercial oil development). Scientists estimate that the region could experience up to four feet of additional sea-level rise by 2100. This makes Gulf Coast refining, which is 44 percent of total U.S. oil-refining capacity, highly vulnerable to flooding events and dangerous ocean surges during severe storms and hurricanes. Refineries on the Gulf Coast serve the entire country through a network of major pipelines that transport gasoline, jet fuel, and heating oil over the entire United States.

Several of the nation’s largest ports are also located on the Gulf Coast and host the majority of terminals used to export U.S. oil and natural gas to global markets. In addition, participants mentioned the high risk of damage to much of the petroleum- and hazardous waste–storage tanks in the region. If significant damage occurred to those facilities, Rice University researchers estimate that as much as ninety million gallons of oil and hazardous substances could be released into nearby neighborhoods. The volume of such a spill—seven times larger than the Exxon Valdez spill—would be catastrophic.

Particularly in the western and southwestern United States, drought combined with high temperatures has exposed electricity networks to damage from wildfires. Workshop participants noted that U.S. infrastructure for electricity, fuel, and information are highly interdependent, and a failure in one part of the system can have cascading effects on telecommunications, data centers, transportation, hospitals, and other vital services critical to the U.S. economy. Widespread loss of electric power could shut down the entire fuel supply chain: oil pumping, pipelines, oil refineries, and retail fuel distribution at gasoline stations. Droughts can disrupt the electricity system by decreasing the availability of hydroelectric power or curtailing thermal and nuclear electric power generation, which depend on water for cooling operations.

Workshop participants noted that the increase in deployment of renewable energy; smaller, distributed electricity grids; and electric vehicles has helped make the wider U.S. electric system more resilient. During several recent severe storms in the United States, electric car drivers reported being able to charge their cars at public charging stations in areas not experiencing outages, or from micro-grids powered by solar arrays. So-called virtual power plants that aggregate power from rooftop solar panels, electric cars, and building-level battery storage and deploy the excess capacity to the wider grid are easier and faster to restore than large centralized power stations. As a result, they are more likely than traditional facilities to bounce back from storms and other kinds of climatic events. Renewable energy is also more geographically diverse than oil and natural gas production, reducing the chances of huge supplies being cut off at once.

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The U.S. energy system needs to be designed for resilience to climate change.

Workshop participants concluded that the U.S. energy system needs to be designed for resilience to climate change. Climate adaptation strategies now focus on hardening existing energy facilities by constructing seawalls, raising critical equipment to higher ground, increasing use of portable generators, and pre-positioning inventories of transport fuels. For example, government officials in Texas are debating a multibillion-dollar publicly funded program to build a seawall to protect its coastal oil refineries, which are responsible for nearly 27 percent of U.S. military-grade jet fuel and 13 percent of gasoline production. But going forward, more system-wide planning will be needed that considers water recycling and reuse technologies and methods, construction of more advanced backup generation systems, and relocation of critical services to regions less prone to weather-related interruptions. As more of the U.S. transportation network electrifies and power demand increases, backup generators and battery systems require expansion through more purposeful design to handle the potential loss of electricity services to a greater number of users and applications.

Financial and Disclosure Risks Related to Climate Change

Financial markets have been slowly incorporating information about climate change into valuation of some products, but the fate of energy company stocks, bonds, and oil and gas commodity derivatives is uncertain, according to several presenters. One noted that the Bank of Canada, Bank of England, and Norwegian Government Pension Fund Global, among others, are concerned that more systemic risks could loom if unexpected changes in valuations come about quickly, and added that a cascading effect could occur if physical damage to corporate assets and facilities, legal liability risks, or regulatory risks emerge suddenly.

One way climate change can affect the financial performance of stocks and bonds is through sudden physical damage to privately held corporate energy assets. Participants discussed at length the situation of the private California utility PG&E Corporation, whose faulty equipment caused several costly wildfires last year, demonstrating the risks that can emerge with little warning from rating agencies or financial analysts. As one presenter explained, California’s courts have ruled that under the principle of inverse condemnation, PG&E is strictly liable for tens of billions of dollars in wildfire damages because the company destroyed life and property while performing its public function. PG&E, which still serves sixteen million customers in Northern California, now has no access to capital markets, constraining its ability to invest in future infrastructure or even to inspect, repair, and upgrade existing facilities—which could cost from $75 billion to $150 billion. The company was forced to declare bankruptcy, creating large, unexpected losses for investors in PG&E stock and bonds. Workshop participants noted that California now faces difficult questions about how to resolve the bankruptcy. They agreed that the lack of political consensus in California and across the United States regarding either who should pay for current damages to energy infrastructure or how to fund future adaptation is a serious public policy challenge that is not being adequately addressed.

Beyond the financial losses to investors, PG&E’s massive liabilities are also threatening the continued functioning of California’s insurance market, according to several presenters. Private utilities in California used to be able to access both direct insurers and reinsurers to cover their potential liabilities. Now premiums are rising, and state officials and private sector leaders are concerned that private insurance markets could fail. California has set up a commission to investigate how to insure against climate risks. However, the funding sources for catastrophic risks such as wildfires are unclear. One participant mentioned that widespread residential flooding in Canada has presented similar problems for an insurable housing market, leading policymakers to intervene to try to incentivize reducing risks to housing developments.

Even with the PG&E crisis, rating agencies have not sufficiently downgraded credit to the U.S. utility sector, some workshop participants argued. Bond rating agencies have begun to downgrade cities based on frequent climate events, but they apply less rigorous climate-rating procedures for credit risk to electric utilities and other energy companies. Large pension funds and other large institutional investors have tried to involve energy companies to increase transparency on how the companies plan to incorporate climate risk into investment decision-making. But throughout most of the United States, power-generation companies still have unfettered access to financing, regardless of known climate-related risks to physical facilities.

Power-generation companies still have unfettered access to financing, regardless of known climate-related risks to physical facilities.

Workshop presenters provided evidence that stock prices of large U.S. energy companies do not reflect the full risk that the commercial net worth of carbon-intensive assets—such as coal mines, proven oil and gas reserves, or related processing facilities—will depreciate unexpectedly or even become obsolete or nonperforming (that is, become stranded assets) as a result of a transition to cleaner energy sources. Other participants pointed out that investors and credit analysts still assume that fossil fuel companies will be able to recover their returns on capital expenditure in the ten- to twenty-year time frame typically under analysis. However, as participants noted, this sanguine view ignores the possibility that sudden changes in valuations could take place. Already, some energy producers and electric utilities have seen their cash flows hampered after facilities get damaged in storms or wildfires. More similar cases are likely in the future. A court ruling or environmental legislation can also change cash flow expectations for businesses. One presenter suggested that since climatic risks are localized, it is difficult for markets to extrapolate climate risk for businesses in more than one location.

Participants expressed concern that the U.S. Securities and Exchange Commission (SEC) does not ensure that disclosures of material risks related to climate change are accurate or sufficiently detailed. Company filings to the SEC that mention carbon-related transition risks typically use boilerplate, generalized language that is not company specific. The SEC received an active slate of shareholder proposals for more disclosures on climate risk this year but dragged its feet on initiating any guidelines beyond those provided in 2010. One participant explained that the agency lacks the funding and resources to generate guidance rules internally. Another reported that the SEC is seeking a market-driven way to guide future formal rulemaking, but so far the agency’s response has been slow as it remains bogged down in debate on the best way forward.

Participants discussed innovative financing mechanisms that could be used to facilitate more investment in adaptation. One is the nascent market of social impact bonds, which attract a thematic class of investors that are willing to finance, for example, adaptation projects and forest preservation. Participants at the workshop also debated whether a prediction derivatives market could provide aggregated information for investors and add transparency to how market participants price the probability of scientific projections, such as future sea-level rise or heat-wave incidence.

Finally, participants discussed public-private hybrid finance structures. Aggregating affected businesses’ savings from new infrastructure, such as seawalls or levees, can reduce the need for business-interruption insurance and other liability costs. These insurance savings can then create a revenue stream that, in combination with federal funds or loan guarantees, pays for the new infrastructure.

Climate Risks and U.S. National Security

The U.S. Department of Defense (DOD) is a large energy consumer, spending about $3.5 billion a year on natural gas and electricity and $12.5 billion on fuel, including for aircraft moving supplies. Workshop participants noted that resilient energy supply is necessary to meet the DOD’s core mission to defend the homeland. Climatic disruptions to domestic energy supply could entail huge economic losses and potentially require sizable domestic military mobilizations. The DOD concluded in a congressionally mandated 2018 study that over half of its 3,500 installations faced some sort of climate change exposure, such as hot weather days that prevent aircraft use or risk of wildfire where live ammunition is stored.

Participants agreed that climatic disruptions to civilian energy systems should be considered a national security risk in their own right because of the emergency response required. One participant noted that deploying troops to assist with humanitarian climate disaster events can affect readiness, since units have to be resettled and retrained when they return. Moreover, the U.S. military is the largest customer of the U.S. electricity grid, which for the most part is operated by the private sector. The U.S. military also relies on many local services such as data centers, food production, and medical facilities that depend on reliable electricity services.

The U.S. military is the largest customer of the U.S. electricity grid.

The DOD has incorporated energy resilience preparation into its core readiness exercises. In North Carolina, for example, when Hurricane Florence downed local power lines, a U.S. military base used backup generators to keep operations running. However, as climatic risks to the grid grow in important locations, DOD will have to acquire additional backup systems that are resilient to external fuel supply disruptions. The DOD has been looking at different ways to install affordable backup energy, such as adding micro-grids or building-based virtual power plants using renewable power and battery storage systems at its facilities. The rationale is not related to carbon emissions policy but rather focuses on the benefits of such systems to build resilient energy services. Still, financing such facility upgrades has faced federal appropriations constraints. Participants mentioned loan-financing arrangements in which private-sector investments in energy infrastructure built on military bases could be paid back from budgets for ongoing energy supplies. But more work on innovative financing of upgrades to energy systems on U.S. military bases needs to be explored, presenters suggested, given that funding for more basic repairs and maintenance is the major budget focus.

Recommendations

Climate risk to U.S. energy infrastructure represents a major threat to the U.S. economy and national security. Recognizing this, participants argued that policymakers need to pay more careful attention to policy options that identify, anticipate, and mitigate this risk. Participants agreed that the role of federal, state, and local governments will be critical but that the private sector also needs to offer innovative financial and technological options that can distribute the costs of preventive action efficiently and equitably across society. To address the gaps in knowledge that are thwarting more effective responses, participants offered the following policy recommendations.

  • Congress should require the Department of Homeland Security and the Federal Emergency Management Agency (FEMA) to update risk-assessment mapping by geographies, infrastructure type, and specific climate hazard (such as drought, heat wave, flooding, or severe storm). Those agencies could then identify future climate-related vulnerabilities to the U.S. energy system, in general, and to energy supplies to U.S. military bases and operations, in particular. The assessments should include corollary issues such as energy supply to nearby support function infrastructure such as data centers, hospitals, and food production. Congress and state governments should use the data to assess and initiate infrastructure projects and emergency readiness procedures that address damage from climate change.
  • The U.S. Army Corps of Engineers and FEMA should conduct local and regional scientific studies to define future patterns of heat waves, sea-level rise, droughts, and wildfire risk to critical infrastructure, including energy and water resources and facilities. These organizations should use the studies as a basis for planning capital expenditures for adaptation and evacuation. State governments and the National Science Foundation should increase funding to regional university centers to complete these assessments, which should include a range of probable global warming scenarios.
  • States and the federal government should work together to update building standards for seawalls, levees, and storage tanks that reflect accurate scientific projections for future risks and address the specific vulnerabilities of Gulf of Mexico refineries, terminals, and energy distribution infrastructure. Regulators in states along the U.S. coast of the Gulf of Mexico should require refineries and the petrochemical industry to compile and maintain an inventory of hazardous chemical volumes that are stored on-site or near their facilities.
  • Credit agencies should consider risk from climatic events when calculating credit ratings to improve the analysis of risks to profitability and performance. They should factor in risks to corporate inventories of hazardous chemicals that are stored on-site or near energy production and manufacturing facilities, corporate histories of environmental performance, and safety records, including spill records and any history of fires and explosions related to faulty equipment.
  • States and the federal government should standardize and tighten water-usage reporting and risk-disclosure requirements for energy corporations and utilities. Companies and communities cannot address water scarcity risks that could affect energy production if they do not have access to accurate data about how much water industry and competing local consumers use. Reported data could be used to promote sustainable water practices in regions that experience water stress. An assessment of local requirements could facilitate cooperation in water stewardship for the region by energy companies, communities, and regulators. Such cooperation can be critical to prevent water shortages from triggering energy and electricity outages or supply constraints.
  • The SEC should establish permanent disclosure standards for climate-related risks to the operations of publicly traded energy companies and utilities. To start, the SEC should participate actively in fact-finding forums to gather information from energy firms, institutional investors, financial analysts, and other relevant market participants about the kinds of company-specific material risks that need to be identified and disclosed. The SEC should then institute a system for large publicly listed companies to voluntarily disclose individual corporate climate risks for a fixed period of three to five years to inform a transition to a permanent standard. The program should be structured to provide both incentives for participation and a credible threat of possible actions for nonparticipation.
  • A major research organization or university should establish a climate risk prediction market. A well-designed climate prediction market could provide aggregated information for investors and add transparency to how market participants price the probability of climate change outcomes, such as sea-level rise or incidence of heat waves. Charitable foundations and organized financial commodity exchanges, such as the New York Mercantile Exchange and CME Group, should provide financial and technical support for the project.

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