How will Water and Agriculture Fare in the Net Zero Transition?
All companies are exposed in some way to transition and physical climate change risks and opportunities. What is less understood and emerging as a key realisation in the global financial community, is that these risks fall differently on different sectors, and introduce different types of exposures. In this article we focus on agriculture and utility water supply as two industries exposed to both physical and transition risks.
Physical and transition risks are linked but timeframes for impacts differ
The physical risks of climate change are not hard to describe. As the earth becomes hotter, and weather becomes less predictable, those sectors which rely on weather and climate certainty will be affected. Rising sea levels cause flooding, for example, which in turn creates pressure on cities and infrastructure, utility and transport asset resilience. Increased storms and unpredictable weather events damage social, commercial and residential infrastructure, which raises costs for owners and insurers. These changes differ by sector. For some sectors, the impacts are already being felt; for others, the impacts may not manifest for decades.
Transition impacts, by contrast, are caused by policy and market interventions to achieve net-zero targets. For companies, transition risks include the risks (and opportunities) of adverse policy and economic changes, and consequent technological advances, to meet a certain temperature change by a certain date. Government policies to achieve net zero by 2050 or 2070, for example, lead to industry policies that contain economic signals (through carbon taxes, for example), which in turn might impact negatively on the cashflows of carbon intensive industry or incentivise investment in less carbon intensive competition. For some industries, these risks are already occurring through withdrawals of support from financial markets, and through Government incentivisation of new ‘green’ technologies.
Sectors most impacted now
Understanding which sectors will be most impacted relies upon an understanding of the sectors most exposed to transition risk, the sectors most exposed to physical risk, and the timing of both.
Clearly, sectors which are highest in scope 1 and 2 emissions, for example energy and transport, are most impacted by the transition. These sectors will be most directly targeted both by Government policies to achieve net zero, and by the financial ecosystem seeking to reduce its scope 3 exposure. We anticipate the peak timeframes for transition risk impacts in these sectors to be between 2025 and 2040, depending on the carbon intensity of the sector, and the urgency and pressure on the national Governments to achieve their net zero target. It is for this reason that energy and transport sectors are now quickly moving to understand the range of diversification options open to them, both within existing markets (e.g., how can we make power differently) and in an overall sense (e.g., what else could we do if we don’t make power?). Coal fired power stations are closing and are forecast to exit the system by 2050; demand for coal is forecast to decline over time; and combustion vehicles will be replaced by electric vehicles (the UK banning new combustion vehicles sales by 2035).
Physical risks impact differently, and in a way, are inverse to transition risk. The harder the policy target (net zero by 2050 for example), the lesser the physical risk as climate outcomes are mitigated and global temperature impacts reduced. The more relaxed or long-dated the target (no net zero targets and an acceptance of 4-degree outcomes, for example), the less impactful the short-term transition risks are for carbon intensive industries. The backstop of course is that all sectors are impacted by physical risk unless temperature is kept to sustainable levels. The UN global crop economic models, for example, project up to a 29% cereal price increase in 2050 due to climate change, which will raise food prices globally and place up to 183 million additional people at risk of hunger compared to a no climate change scenario. Those same reports note that increased CO2 will lower nutritional quality of food, and that the distribution of pests and diseases will change, affecting production negatively in many regions. Given increasing extreme events and interconnectedness, the risk of future food system disruptions grows beyond 1.5 degrees.
Next wave of impacted sectors
The IPCC’s sixth climate assessment reported that global temperatures could hit 1.5 degrees Celsius above pre-industrial levels by 2030, meaning that sectors impacted by physical risk need to start planning now. Those most impacted in this next wave will be the water and agricultural sectors.
For the agricultural sector, the risk of physical change will occur in an environment of transitional risks and opportunities, which need to be considered through a competitive lens. From a policy perspective, the next ten years will provide an opportunity for Australia to position itself as a food bowl as more marginal areas are impacted by the emerging physical risk. Declines in crop yields and suitability is projected under higher temperatures, especially in tropical and semi-tropical regions. Heat stress will reduce fruit set and speed up development of annual vegetables, resulting in yield losses, impaired product quality, and increasing food loss and waste. How Australia deals with these risks relative to its competitors will be a critical issue. We expect Government policy to be net positive between now and 2030. On the physical risk side, there are significant issues to be overcome for the sector. Without integrated food system measures in farm management, supply chains and demand, inefficient agricultural operations and companies will face challenges in the transition to a low carbon economy.
For the water sector, three significant changes are coming, which will span both transition and physical risk ecosystems, and present new risks and opportunities for Boards of water companies who are accountable for the business continuity and customer service risks.
Firstly, 2025 onwards will see increased competition for water. This will span industrial use (to create hydrogen, for example) as the fossil fuel industry diversifies to deal with its own pressures, agricultural use (for the reasons outlined above, as crops change and rainfall variability increases the demand for flexible, certain supply), and for populations. According to the Australian National Hydrogen Strategy, the electrolysis process for hydrogen requires 9 litres of water for every 1 kilogram of hydrogen produced. When this is factored into recent ARENA forecasts that Australia will produce more than 3 million tonnes of renewable hydrogen annually by 2040, water companies will need to ready themselves to supply an additional 27 billion litres of water over and above current consumption levels. This is without taking account of population and climate change.
Secondly, water utilities will need to address the shifts in rainfall patterns relative to dam locations and existing water infrastructure. As the UN notes, “climate change is bringing multiple different changes in different regions – which will all increase with further warming. These include changes to wetness and dryness, to winds, snow and ice, coastal areas and oceans. It is intensifying the water cycle; this brings more intense rainfall and associated flooding, as well as more intense drought in many regions. It is also affecting rainfall patterns. In high latitudes, precipitation is likely to increase, while it is projected to decrease over large parts of the subtropics. Changes to monsoon precipitation are expected, which will vary by region. Coastal areas will see continued sea level rise throughout the 21st century, contributing to more frequent and severe coastal flooding in low-lying areas and coastal erosion. Extreme sea level events that previously occurred once in 100 years could happen every year by the end of this century.”
Thirdly, increased physical risk of flooding and sea level rises will alter the framework for asset risk. Pumping stations, for example, may need to be re-positioned, and water pipelines will need to factor in the prospect of flooding and excess rainfall. Recent global reports make clear that while climate change related asset resilience is on the radar for around half of utilities which supply more than 500,000 customers, these risks are rarely considered by smaller municipal utilities which remain highly exposed.
Planning for the future
Effectively planning for operations post 2030, and making least regret decisions today, means clearly identifying both transitional and physical climate-related risks and opportunities over the short, medium and longer-term, and understanding their impacts on business, strategy and financial planning. This is critical for Boards and management of companies both exposed to, and doing business with, supply chains which are facing transitional and physical risks. In both water and agricultural company boardrooms, there is a need for earnest, honest conversations about the value of water, with a clear understanding that neither the policy nor physical environment are static.
Scenario planning is essential. Climate-related risks are inherently more complex and long-term than most traditional business risks, and therefore understanding the physical, economic, commercial, and regulatory implications of future climate impacts on business and supply chain activities is essential. This means testing and challenging a range of future scenarios to determine what plausible future operating environments will look like, mapping the impacts of these scenarios on revenues, costs and financial ratios, and developing a clear and consensus driven approach to short, medium- and longer-term transition strategies.
Is your company planning for the future?