Expert Commentary: Meridiam on risks and opportunities

Climate change and carbon-related issues are vital to factor in when considering infrastructure investment, both in terms of risk and opportunity. Climate change and carbon are increasingly discussed in the investor community with various approaches to this subject.

From a risk perspective, it is essential to engage in carbon-related issues. It is key to include an analysis of climate and energy risks as well as opportunities during the investment phases of projects. As an integrated part of the investment process, a qualitative assessment of the energy, carbon, and climate-related risks which have potentially negative financial, operational, commercial, or reputational impacts on the project should be undertaken on the basis of a systematic analysis framework.

For instance, one of the first risks to consider is the likely effects on a portfolio’s performance engendered by increased fuel prices and/or stricter regulation relating to carbon pricing. A second concern would be the significant reputational risk that is associated with carbon-heavy projects, which would deter responsible and ethical investors from otherwise valuable projects. This can ultimately leave certain types of projects “stranded”.

From a risk perspective, preparing for climate change and extreme weather events to which projects may be exposed is also crucial. In addition to the deterioration that can be caused to such assets, factors such as the continuing usability of the infrastructure, increases to operational or maintenance costs or increase of insurance premia are factors that need to be considered.

Before making the decision to invest in a project, a detailed carbon, energy and climate change risk analysis should therefore be carried out. This risk analysis should take into account matters such as how a project’s energy supply will be managed throughout its life, how that project is exposed to energy pricing volatility, and how a project will react to climate change and extreme weather events. A rail project, for instance, in low-lying fields near to an area prone to flooding will obviously have to take into account the threat over the next decades of rising sea levels. A road in the Gulf of Mexico will have to forecast likely effects on the road of climate change-related increases in the frequency and severity of heavy storms that will damage the project’s infrastructure.

The analysis should examine a given project’s plan to transition to a low-carbon economy. This will not just affect projects which might be expected to be the most ‘carbon-exposed’ in the layman’s imagination, such as roads, but every project. The analysis of the transition to a low-carbon economy should try to forecast the impact of increased costs driven by weightier requirements in the context of tightening carbon regulation, and also the impact of policy changes induced by carbon markets and changes in carbon taxes. It should also forecast the impact of greenhouse gas emissions from a given project. By doing these analyses and synthesizing them into one coherent one, it is possible that an investor can make a helpful risk assessment of a project that will go some way towards whether to invest in it and if a ‘Go’ decision is subsequently made, how these risks can be managed and mitigated over a project’s lifetime.

In addition to the approach mentioned above, a number of investor initiatives refer to carbon footprinting of portfolios. Given the importance of infrastructure projects (especially when considering the full scope of impacts and including indirect emissions) and the ability to estimate future carbon footprints with some accuracy as the objects are well defined, this dimension should be included when considering infrastructure investment. Meridiam reports on the carbon footprint of its projects to allow our investors to report on it to their own stakeholders should they wish to do so.

There are ways whereby an investor can work with stakeholders in a project – procuring authority, contractors, local community groups to name only a few – to plan how to approach carbon matters in a systematic and easy-to-understand way, such as some well-developed and sophisticated carbon calculation tools.

In the interest of transparency and completeness, Meridiam has taken the decision that in each of its carbon footprint calculation tools, both direct and indirect emissions will be taken into account.

Scope 1 emissions of greenhouse gases (GHG) are the most obvious; GHG emissions which are directly related to a project’s activity, such as combusted fuel used on a tunnel boring machine for instance. Scope 2 emissions are more indirect; GHG emissions from the generation of purchased electricity that is needed for a project’s activity (generators for contracted builders’ accommodation for example). Scope 3 emissions are yet more indirect, and are emissions that result from the production of materials purchased from other parties and used in the project’s activity, such as the steel used to make a rail track or such as employee business travel or waste disposal.

At Meridiam we take into account all three of these levels in the interest of transparency and corporate responsibility. This approach also makes more sense from a risk analysis point of view. On one social infrastructure project, for instance, we found that despite the construction phase’s carbon footprint being relatively low, the forecasted footprint for the operational phase was very high. This was because the facility was built 20km away from a train station, meaning that the vast majority of its users travelled to it by car; an indirect emission that added greatly to the footprint. This kind of emission can of course be mitigated by the introduction of car sharing incentive systems and suchlike.

Once the relevant data has been compiled for a project, the next step is that it must then be compared to a reference situation, which is defined as the situation that would occur without the project. ‘Net’ emissions of the project are then assessed to be the ‘gross’ emissions of the project minus the emissions that would take place in the reference situation. Obviously a greenfield social infrastructure project will not have a reference situation, but for brownfield road projects this is a useful and simple aid to help determine if a project is likely to have a positive or negative net impact on carbon emissions.

By adopting and utilising the approaches above – a carbon risk analysis and a carbon footprint impact assessment – a responsible investor can determine whether or not to invest in a project and, should the decision be made to do so, how best to deal with the challenge of addressing the issues presented. Meridiam believes that any long term investor should incorporate this into their investment strategy on a systematic basis in order that they are aware of carbon issues and so manage their portfolio investment decisions accordingly.

In turn, once an asset has been acquired, the asset management team must be required to report at regular intervals on the carbon-related matters of a given project to investors. This will therefore become of salient importance to those they report to (their own clients or investors) and sensible and sensitive carbon management may therefore become a benchmark within infrastructure investing. It is not only a prudent strategy that will reward those who take it on in terms of excellent reputational risk management and mitigation, but also one that will improve the lives of communities globally and will fit in very well with increasing demand for environmentally responsible infrastructure.

This article is sponsored by Meridiam. It originally appeared in Private Equity International's Responsible Investing Special supplement, published February 2016.