Bravo, science. Now, how are we going to finance it?
OPINION | By Andy Cox, Head of Energy Transition, Howden Group > A recent report published by Legal & General Investment Management concluded that science and engineering had largely done its bit: technologies required for a low carbon energy system exist. Now, the most pressing challenge is securing long term investment. To meet ambitious net zero commitments, we need solutions delivered at scale. For this, financing remains difficult to unlock.
Even in situations where traditional bank lending is available, there is often a funding gap and an overreliance on blended finance models to mobilise private capital.
Throughout my career at a “Big 4” advisory, I spent much of my time working on difficult energy deals. Often M&A, arranging financing or simple commercial viability. This meant countless hours in the boardroom debating the opportunities and risks involved. Market risks, political risks, supply chain risks, physical climate risks… the list goes on.
In the private capital markets, such myriad challenges are boiled down to a single metric. Just one number provides a critical benchmark to assess investors’ preference – the cost of capital.
Those boardroom conversations focussed on risk management, mitigation, allocation and often pricing. Seldom was insurance – the old fashioned form of risk transfer – part of any strategic conversation about reducing the cost of capital.
To understand the role insurance can play, it is helpful to know something of its past, and the role it has played at key moments in history.
The modern insurance industry can be traced back to 17th century London. Shipping insurance was traded in coffee houses, the most famous being Edward Lloyd’s down by the River Thames. Following the Great Fire of 1666, a merchant named Nicholas Barbon founded the first joint stock company to provide fire insurance to London property owners. It proved popular, and was widely imitated.
By the time the industrial revolution was afoot, Lloyd’s coffee shop had morphed into an insurance society, taking up much grander premises at the Royal Exchange. It now offered a wide range of cheap and stable fire insurance products. This enabled mercantile and manufacturing businesses to plough investment into the technologies du jour with confidence. This, in turn, facilitated aggressive industrial expansion.
Fast forward to the mid-twentieth century. Insurance played a critical role in space exploration, with Lloyd’s insurers underwriting the first space satellite insurance in 1965.
The energy transition is another big moment in history that the insurance market will be required to support. But this time, it will need to go beyond its traditional usage and perceived boundaries.
Strategic use of the insurance markets can help investors and financiers share the risk and in turn, lower the cost of capital.
Whilst not a panacea, insurance has a unique ability to isolate and transfer specific risks to an A-rated counterparty. It can dramatically improve the covenant strength of obligors and put financial limitations on the warranty obligations of sellers. It will step in to plug revenue shortfalls due to increasing weather volatility. It can even provide a mechanism to delay equity contribution payments to significantly increase project IRRs (Internal Rate of Return).In short, strategic use of insurance can entirely remove many of the financial risks associated with scaling emerging technologies.
Already, major underwriters in the UK and USA are gearing up to make significant investment in the energy transition. For example, last year saw the launch of the world’s first insurance product for the Voluntary Carbon Market (VCM). It is designed to give buyers and sellers of high-quality, verified carbon credits greater certainty. This should contribute to growing the VCM to $50bn by 2030.
On the client-facing end, my belief is that with brokers prepared to shape innovative solutions that the insurance industry can stand behind, risks will be transferred, cost of capital will be lowered and capital will flow more readily to deserving projects.
There are significant pools of capital ready to be deployed that will supercharge the transition to low carbon energy. Channelling funds into the right projects is vital.
While the industry has an enormous balance sheet capable of shouldering much of the risk weighing on the transition, it has a clear need to increase its own capacity.
Analysts estimate that the amount of capital required to be deployed into infrastructure projects to reach net zero by 2050 is anywhere between $120 and $150 trillion. Estimates today of the capacity available in the insurance market fall woefully short. This is an issue that’s quietly building around the market and one that the financial services industry will need to lean in to over the coming years. Simply put: if projects can’t be insured, they don’t happen. Without insurance, there is no energy transition!
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Howden is a leading global insurance group providing insurance broking, reinsurance broking and underwriting services and solutions to clients ranging from individuals to the largest multinational companies.
Founded in 1994, the group operates in 50 countries across Europe, Africa, Asia, the Middle East, Latin America, the USA, Australia and New Zealand, employing 15,000 people and handling $35bn of premium on behalf of clients.