Putting a Price on Carbon: Risk or Opportunity for Banks?

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Putting a Price on Carbon Risk or Opportunity
for Banks?

• U of T Environmental Finance Workshop
• Sandra Odendahl,
• Senior Manager, Environmental Risk Management
  December 9, 2004

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Overview

• About RBC
• RBCs Carbon Risk Management Project
• Impacts of Climate Change
• Impacts of the Kyoto Protocol, or other climate
  change mitigation policies
• Greenhouse Gas Emissions trading
• Opportunities Financing GHG Reductions
• Case studies
• Risk or Opportunity?

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About RBC Financial Group

• Founded in Halifax in 1864
• 1311 branches, 4151 bank machines, 60,000
  employees, 12 million customers
• Canada, US and 28 other countries
• 448 billion in assets
• Market Capitalisation 40.9 billion
• Profits in 2004 2.84 billion
• Canadas Most Socially Responsible Corp

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RBC Financial GroupEnvironmental Risk Management

• Environmental Risk Management group within
  Corporate Risk Management
• Lead and oversee corporate environmental
  management programs
• Develop lending policies
• Advise on transactions
• Expertise in corporate environmental affairs
• Identify and communicate emerging environmental
  risk issues

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Carbon Risk Emerging Risk issue?

• Global Climate Change poses risks and
  opportunities to business and investors based on
  two factors
• Impacts of physical effects of Climate Change,
  and
• Impacts of policy initiatives to curb emissions
  of CO2
• Shareholders/Investors started asking companies,
  including banks, to disclose their exposure to
  Carbon Risk

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RBCs Carbon Risk Management Project

• Launched in May 2002
• Climate Change Risks and Opportunities
• Climate change impact on sectors
• Mitigation policy (i.e. Kyoto) impacts on RBC
  portfolio
• Portfolio exposure to Kyoto-type policy
• carbon risk in credit risk assessment
• Impact of carbon credits and renewable energy
  credits on wind project financials
• Emissions Trading Risks and Opportunities

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Carbon Risk Management Project1. Climate Change
Effects

• Literature review of info on Extreme and
  Unpredictable Weather Events
• Red flag sectors
• Ag (good and bad effects extreme dry or wet)
• Forestry (drought, new pests, fires, species)
• Tourism (tourists will adapt, but capital?)
• Property Insurance (catastrophe-related losses
  were 15X higher in 1990s than in 1960s),
• Fisheries (sea levels up, lakes down habitat
  change thus species changes),
• Hydroelectric power (changing water levels)

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Carbon Risk Management Project Climate Change
Analysis of Risks

• Credit Risk
• Business interruption in some industry sectors
• Insurance Risk
• Property and casualty insurers adversely affected
  by adverse weather events.
• Operational Risk
• Risk that offices and branches could be damaged
  by more extreme weather events.

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Carbon Risk Management Project 2. Kyoto Policy
Impact on Portfolio

• Collaboration among Environmental Risk, Sector
  Risk and Economics
• Impacts on Sectors considered a function of
  energy intensity and ability to pass on costs
• Impacts on Countries considered a function of per
  capita income and and energy use per GDP.
• Results presented to Board in January 2003

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Carbon Risk Management Project Kyoto Policy
ImpactAnalysis of Risks

• Credit Risk
• Uncertain costs of new technology
• Cash flow impacts of new penalties for
  non-compliance with CO2 targets
• Carbon as asset or liability?
• Operational Risk
• Complex Kyoto accounting rules
• Regulatory Risk
• Canadas federal plan and initiatives to reduce
  CO2 emissions are incomplete

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Carbon Risk Management Project 3.Greenhouse Gas
Emissions Trading

• EU GHG trading to start next month
• Canadas ET system is slated to begin around 2007
• Est. 700 firms in thermal electricity, oil and
  gas, mining, and manufacturing sectors
• GHG emissions trading expected to be gt 1.6
  billion/yr market in Canada
• Identified 5 different business opportunities for
  Capital Markets trading
• Build on existing client relationships

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RBCs Carbon Risk Management Project GHG
Trading Analysis of Risks

• Regulatory Risk
• Canadas incomplete Plan evolving rules
• Operational Risk
• experienced staff?
• Market Risk
• low liquidity in new markets
• Credit risk
• counterparty risk, country risk

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OpportunitiesFinancing GHG Emission Reductions

• Opportunities must meet same business case and
  risk criteria as any other financial transaction
• i.e. must meet risk and return criteria
• Three key financing opportunities
• Venture Capital
• Structured Loans
• Project Finance

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Financing GHG Emission Reductions

• Examples of initiatives that result in lower GHG
  emissions
• Develop a new technology that makes alternative
  energy work better
• Offer a package of retrofits to reduce energy
  consumption at a third partys facilities
• Build a facility to divert waste from landfill
  and generate electricity with lower emissions
• Develop Wind Power projects

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GHG Reduction Initiative 1New Technology for
Power Generation

• Characteristics of the Company
• Very small and relatively new, privately-held
• New technology
• Some manufacturing capability
• Initial growth or expansion stage
• Unstable revenue and cashflow
• No established management team
• Needs money to grow, expand, and profit
• This company needs VENTURE CAPITAL

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What is Venture Capital?

• Financing for privately-held companies
• Generally, investment by VC in the form of equity
  (a share in the company)
• Sometimes invest using long-term convertible debt
  (loans that can be turned into a share in the
  company)
• Venture capitalists raise money and distribute it
  within a portfolio of companies (a fund)
• Financing possible at many stages, from idea
  stage to just before company goes public

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Venture CapitalAvailable Products

• RBC Capital Partners Alternative Energy
  Technology Fund (US50 million)
• lt25 of company, usually convertible pref
• Support company in developing business plan (if
  necessary), management team, strategic planning,
  recruitment etc.
• Sell share after 3-5 years Target ROI is 35
• RBC Ventures Clean Tech Venture Fund
• Direct investment into earlier stage tech
  companies with efficiency or replacement
  technologies

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GHG Reduction Initiative 2Energy Use Reduction

• Characteristics of the Company
• Small Energy Management Firm (lt C10
  million/year)
• Designs, implements, and monitors energy
  efficiency projects for big companies
• Established management team
• Profitable
• Needs money to fund big GHG reduction project for
  a public sector client
• This company needs a specially-structured BANK
  LOAN

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Energy Management Firm Description of Project

• Canadian Municipality wants to reduce energy use
  in public buildings (libraries, fire stations,
  arenas, etc.)
• Energy Management Firm (EMF) proposes
  improvements such as lighting, motors, HVAC,
  controls, water use, etc.
• Capital cost of project is 1.5 million, and City
  will see a payback over 9-10 years.
• City pays the 1.5 million back to the EMF over
  9-10 years, using the money saved
• Problem high fees and balance sheet issues for
  small company to borrow that much

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Energy Management Cashflows Over Time
Energy conservation savings
Construction
Public Sector Client of EMF
EMF
t 0
t 10
Bank
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GHG Reduction Initiative 3Enhanced Wood Waste
Power Generation

• Trans Canada Pipelines
• Plan 35 MW plant in Northern Ontario
• 2/3 of power from 300,000 t/y wood residues that
  would normally be landfilled
• Long term contracts for wood waste
• Project displaces CH4 from wood decomposition
• Generates ½ GHG emissions per unit energy
  compared to traditional electricity generation
• Long term take or pay contracts for electricity
• PROJECT FINANCE

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What is Project Finance?

• Any asset or group of assets financed on a
  stand-alone basis, where cash flow from that
  asset is the primary source of repayment
• Limited recourse to equity participants/ sponsors
• Often separate legal structure for project
• Usually complex structure very specific to
  particular project

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Wood Waste Power ProjectCashflows Over Time
Construction
Power Plant Operation
Power Plant Operator
Sponsor
t 0
t 2
Bank
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GHG Reduction Initiative 4Wind Power Projects
Project Finance

• Three different deals UK, Italy, Texas
• 23 wind farms
• 415 MW total power generated
• Incentives ranged from 45 to 71 of power price.
  Not viable without incentives.
• Incentives affect borrowers projected cash
  flows, which in turn affect debt service coverage
  ratios, risk assessment, project returns, and
  ability to finance projects

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GHG Reduction Initiative 4 - Wind Power Projects
Project Finance

• Finance type and terms
• Long term loans
• Limited Recourse to Parent Co.
• Incentives guaranteed for most of the term
• Long term power purchase agreements with utilities

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Wind Power ProjectsCashflows Over Time
Power Utility
Sponsor
t 0
t 3
Construction
Wind Farm Operation
Bank
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Putting a Price on CarbonRisk or Opportunity?

• Both, of course!
• Top 3 Risks
• Regulatory uncertainty
• Liquidity in Carbon markets
• Credit Risk, esp if small players enter clean
  energy business
• Top Opportunities
• Venture Cap/Clean Tech?
• Emissions trading and advisory services?
• Wind Power finance in Canada?
• Other? Insurance products?

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Thank You!

• www.rbc.com/environment