Climate policy uncertainty and investment risk

Future world power supplies cannot be assured unless substantial investment takes place. The IEA World Energy Outlook 2006 (WEO-2006) estimates that power generation investments to meet projected demand between 2005 and 2030 must exceed USD 3.1 trillion under an alternative scenario which takes into account policies proposed to reduce CO₂ emissions. Yet a number of risks could cause the delay of necessary investment. One critical uncertainty is the future form and stringency of climate policy, which could affect investment behaviour in the power sector.

While the UN Intergovernmental Panel on Climate Change findings make clear that future climate policy will be needed to significantly reduce emissions, the timing of the precise policy measures that will implement those reductions remain unclear. The International Energy Agency (IEA) began in 2006 a multistage project to explore the various ways in which climate policy uncertainty influences the timing of energy investment decisions.

This book Climate Policy Uncertainty and Investment Risk is the initial stage in the project. It presents: (1) results of an IEA study quantifying the cost of uncertainty in the process of climate policy evolution, (2) results from interviews with investment departments of electric utilities, and (3) initial policy conclusions. The book provides illustrative results for the choice between coal and gas (with and without carbon capture) as well as nuclear power plants. The findings can be summarised in a few key messages for policy makers:

• Climate policy uncertainty poses a threat, but it can be reduced with predictable policies. In other words, climate policy risks may be brought down to modest levels compared with other risks if policy is set over a sufficiently long timescale into the future. Longer commitment periods – extending beyond the current five-year period – will lower the risks from climate policy and thus increase investment in climate-friendly technologies.
• Climate policy uncertainty, all other premises being equal, slows down the introduction of new technologies when compared with conventional ones, because it adds an additional risk to other large existing ones – the risk premiums for new technologies can be as high as 40% of the capital investment cost for a power plant.
• Companies will generally be confident in committing capital to projects, even in an uncertain environment, as long as they can establish a competitive advantage over other market players. When it comes to regulatory risk, this requires that policy makers establish clear rules, which should be applied consistently to all market players, irrespective of ownership structure. Then, companies will feel less uncertain and more confident in power investment.