Climate change poses an increasing risk to our critical infrastructure and requires significant investment for upgrades, mitigation, and adaptation. This has attracted significant attention from the Federal Government, including the most recent U.S. Infrastructure bill that includes US$550 billion in new federal investments in America's infrastructure over the next five years.
This bill will partly focus on climate change mitigation, resilience, equity and safety. The electric power grid is a critical infrastructure system that is considerably impacted by climate-induced extreme events. In 2014, the Intergovernmental Panel on Climate Change (IPCC) concluded that there will be more frequent hot temperature extremes over most land areas as global mean surface temperature increases [1]. According to National Geographic, "an explosion in the frequency and extent of wildfires worldwide is hindering recovery even in ecosystems that rely on natural blazes to survive [2]."
Power grids are expected to be highly stressed by these events, combined with an ever-increasing power demand, reduced operational capacity, and increased probability of system failures resulting in significant power outages[3].
The economic and financial losses caused by climate-related events such as wildfires, heatwaves, and hurricanes can reach several billion dollars, threatening the financial health and solvency of the utilities. In addition, they can significantly hinder the ability of utilities to recover, which can lead to dire consequences for shareholders, ratepayers, and policymakers [4].
Developing and implementing a tailored disaster risk financing strategy will increase the ability of impacted parties to respond more quickly and resiliently to disasters [5]. A recent report by the World Bank Group indicates that an integrated operational preparedness and financial preparedness—as two pillars of resilient critical infrastructure systems—is of crucial importance in managing the climate risk in power infrastructure [6].
However, little attention has been given to develop a financial protection strategy by utilities to address this challenge. As an example, the 2018 Camp Fire alone in Northern California — which was sparked by PG&E's electrical infrastructure—made PG&E to face a multibillion-dollar lawsuit [7]. A wide range of disaster risk financing mechanisms can facilitate a utility's ability to access capital to cover the risk of climate-related events.
These mechanisms are not necessarily mutually exclusive and should be bundled together to ensure the required coverage for various climate-related scenarios [4]. Our recent analysis [8] shows a wide gap in the literature and industry practices to provide innovative actuarial analysis and investigating the effectiveness of various disaster risk financing mechanisms in power grid infrastructure in the face of climate-related disasters. However, there are various disaster risk financing strategies that can be adopted by utilities, as follows.
- Funded self-insurance is an approach where a utility retains all or a fraction of the risk by setting aside adequately funded reserves to cover unexpected losses and restoration costs. For instance, a utility can create a climate reserve account that collects funding over time until it reaches a pre-determined account balance. This account should be designed to return to ratepayers the collected amount that exceeds the required climate reserve level. While this mechanism can reduce the post-disaster financial burden to utilities and ratepayers, it will take time to build such reserve, and it may face regulatory challenges in some jurisdictions [4]. More details on economic theory and optimal level of self-insurance against natural disasters can be found in [9].
- Commercial insurance is another mechanism that utilities have traditionally used to cover disaster risk. Under this mechanism, depending on the jurisdiction, the cost of insurance coverage can be distributed to ratepayers as climate premiums. However, the recent increase in the intensity and frequency of these events have made this mechanism significantly more expensive for some utilities because of their increased risk exposure due to climate change [4].
- Catastrophe bonds (also known as CAT bonds) are a class of disaster risk financing mechanisms that can be used for transferring the climate-related disaster risk from sponsors (utilities) to investors. The sponsors can form a Special Purpose Vehicle (SPV) financial entity to collect principal from investors and make premium payments in return. The premium spread depends on the expected loss for investors. If a triggering event with previously defined specifications in a defined timeframe occurs, the principal is given to the sponsor (utility in this case), so they can cover their loss; otherwise, the principal along with return on investment is returned to the investors [4]. More details on CAT bonds can be found in [10].
- Captives, as an alternative insurance mechanism, are a class of insurance firms established by one or a group of companies to insure the owners (the parent companies). One or a group of utilities can form a captive insurance entity that collects insurance premiums, issues climate policies, and pays out claims—like a traditional insurance company, but only to its utility parent companies. This mechanism is especially useful to cover uninsurable or difficult-to-insure risks due to increased exposure, such as post-2017 and 2018 wildfires in California. In addition, it can be beneficial to utilities in hard insurance markets to reduce the risk transfer costs [4]. More details on optimal risk financing through captives can be found in [11].
- Risk pooling is a disaster risk financing mechanism for sharing risk among a group of participants. The participants combine their financial resources to cover losses whenever a pool participant experiences a loss that is covered in the pool. This mechanism is beneficial when commercial insurance is impossible, difficult, or expensive to obtain, and there is an adequate number of participants that can form a stable risk-sharing pool [4]. For example, in wildfire-prone areas with increased exposure, such as California, where several utilities are servicing the area, risk pooling can play a crucial role in managing the financial risk of wildfires. More details on disaster risk financing through risk pooling can be found in [12].
- Recovery bonds are a class of post-disaster risk financing mechanisms (as opposed to pre-disaster financing mechanisms described earlier) that can be used for acquiring capital to pay for unexpected damages from disasters. Depending on their jurisdiction, utilities can issue recovery bonds through various mechanisms, so they can access a larger amount of capital to pay for reconstruction expenses and other liabilities. In return, the investors will receive a return on their investment based on coupon rates on the bonds. This mechanism has been used by utilities for financing hurricane damages [13] and has recently been legislated for covering the utilities' liabilities due to wildfire events in California [14].
In summary, climate risk is emerging as the Achilles' heel of the modern power grid which threatens not only the continuity of operations, but also the solvency of the electric utilities. The good news is that a variety of risk management strategies and market-based mechanisms are currently available to strengthen the financial resilience of utilities in the face of these events. However, there is no “silver bullet” to address this issue, and a holistic, multi-layer financial protection strategy needs to be developed by the utilities for an optimal solution that meets their resilience goals and takes into account the economic constraints, risk landscape, and physical characteristics of their infrastructure.
