Around the world, countries are increasing their focus on generating energy from renewable sources as part of their commitment for achieving the goals of the United Nations Climate Change Conference (commonly known as COP26) about climate change and to lower the rate of carbon emissions. Renewable energy becomes a hot topic for the enterprise and the number of renewable energy projects has been increased at an unprecedented rate in recent years.
Output generated by renewable energy, however, is highly volatile and is vulnerable to the weather variability especially when low wind to wind farm, drought to hydro plant and lack of sunlight to solar plant are the main perils leading to the decline in production. Not to mention natural disaster events, which have driven by natural catastrophe and climate change, are another potential peril to the infrastructure causing significant impacts on production to energy industry.
There are numerous examples of unfavorable weather conditions which brought negative impacts on the renewable energy market globally in the past decades. In February 2008, the wind power market in the US recorded a plummet by 82 per cent in energy production caused by lack of wind. Similarly, Scottish Power, an energy supplier in Europe, witnessed its profits tumble by around £40 million over six months due to less wind than had been anticipated during the first half of 2016. Shifting our vision to the other side of the globe, severe drought in India lasted from 2013 to 2016, resulting in a sustained drop of hydropower generation, materially hampering the Indian economy.1 According to the Central Electric Authority of India, due to this precipitation shortage, total hydropower generation during the 2015-2016 period was 6 per cent below the previous year, even as the operating hydropower capacity in 2015-2016 was 1,151 megawatts higher.
Compared to traditional insurance coverage, which is limited to the property damage and the actual cost incurred, while requiring the proof of physical damage or loss as a pre-condition to an indemnity payment, Parametric insurance provides coverage opportunities for the full life cycle of renewable energy projects, from financing or delayed start-up risk, for loss of production due to adverse weather risk, or even the loss from carbon credit trading volume which carbon credit is a precious and intangible asset for renewable energy industry.
While parametric solution has some advantages which are surpassing the conventional coverage, it also faces challenges from two main aspects.
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Parametric insurance covers the non-damage business interruption which conventional insurance does not. It covers the financial losses when the energy output is lower than expected. Such loss is not necessarily associated with any physical damage to the renewable energy asset itself.
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Payments are triggered by the value of an index such as the modelled renewable energy output. The value is based on data provided by an independent third-party source, the amount of the pay-out is calculated according to a pre-agreed threshold. Coverage options are straightforward and objective, which allow the claim to be settled immediately when the contract is triggered. It largely relief the client from the burden of proof.
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From investors point of review, parametric insurance effectively safeguards a minimum amount of revenue for the renewable energy investment regardless of climate variability, so lenders can assume a more confident estimate of their expected revenues. This means that lenders can offer more favorable debt service coverage ratios. Parametric insurance strengthens the project’s tolerance against weather variability, securing and stabilizing the project’s cash flow and revenue stream.
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In many countries, regulatory approval is required before a parametric insurance policy can be properly issued. In some cases, depending on a country’s regulatory and legal framework, parametric solutions are issued as a derivative rather than an insurance contract. The reason is that parametric solutions tend to include so-called basis risk, in which there is uncertainty on whether the payout will match the actual losses. This contradicts the fundamental indemnity basis of insurance as a contract that pays out according to incurred losses from an insured event. A further regulatory concern can be whether the insured has a legitimate insurable interest.
Nevertheless, to parametric insurance in renewable energy, legitimate insurable interests can be developed from third parties. For example, local government may wish to purchase parametric insurance to support its state-subsidized projects for climate risk mitigation. Since there is an increasing drive towards ESG objectives and the support of climate change mitigation from governments, it is anticipated that restrictions in parametric renewable energy insurance will be further reviewed to unleash the wide-ranging potential of this form of risk transfer. Regulator’s support will continue to be crucial to speed the adoption of parametric insurance, which in turn will help to close the protection gap.
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Sometimes it may be a challenge to obtain reliable and consistent data, considering the low density and unsatisfactory quality of weather recording instrumentation in some countries. Satellite-derived and computer-simulated weather measurements have been increasingly accepted and used to complement (or even replace) weather station data in parametric insurance program structuring and implementation.
WTW has developed a suite of proprietary weather risk analysis tools and parametric insurance solutions for renewable energy businesses reliant on wind energy, hydroelectric and solar energy. There is an interaction version about to launch in coming month for WTW clients’ advantage.
These tools and solutions are based on weather data from reliable providers that are accepted across the insurance market. For wind, hydroelectric and solar energy, separated modelled energy output are generated by inputting appropriate weather data into the model of energy generation accounting for specifications of each project. This modelled energy output is further calibrated, using locally measured data, actual historical output values or expected output values from a professional renewable energy assessment report, to reflect the performance of insured project.
The volatility of the past 41 years modelled output is then studied and incorporated by WTW’s pricing model to calculate financial consequences, which including the revenue of sales of electricity and carbon trading inventory, under various risk scenarios.
The tool also will provide a general concept of the premium range based on requested insurance structure with typically trigger point, pay-out formula and contract limit. What’s more, it also provides simulation results of distribution of financial loss of the insured project under different scenarios.
WTW strive to work closely with the world’s leading parametric (re)insurers in providing comprehensive protection for our clients, with the unique characteristics to bear the renewable energy certified emission reductions trading inventory in mind.
The costs to release CO2 into the atmosphere and the price of CO2 release is subject to fluctuations in the carbon trading market. In the EU, the carbon price has experienced a massive jump from EUR 30 per ton at the start of the year 2021 to EUR 60 per ton by August. Around the world the trading price is lower, but still substantial, at USD 7 per ton in the US and CNY 45 per ton in Shanghai, China. For each MWh generated from coal, 0.85 tons of CO2 is produced, whilst it is 0.59 tons for oil and 0.19 tons for gas-fired power plants2. Using coal, oil, or gas in lieu of renewable energy when there is low wind, low solar irradiation or low rainfall comes at some cost.
Under the Emissions Trading Scheme (ETS), there is a cost for each MWh of electricity generation from carbon-emitting energy profiles. In a portfolio that can produce renewable energy alongside traditional energy sources, each MWh of electricity generated from renewable energy can save up to 0.85 tons of CO2. As such, a “saved” quota of CO2 can be traded in the market as carbon credits. With the launch of ETS, two types of financial losses may be incurred as a result when renewable energy output is lower than expected. First, the direct loss based on per-unit price of one MWh of electricity and reduction of output. Second, the consequent loss of value from carbon credits volume. As associated with lower energy output, there is also income losses and possible penalty fees for not meeting total energy requirements. With WTW unique solution, both losses could be covered.
We cannot control the weather, but we can control how we handle the ways it affects the renewable energy market. Parametric insurance protects renewable energy investment return against weather risks which plays increasingly important roles with renewable energy development all over the world.
1 https://www.circleofblue.org/2016/world/indias-severe-drought-causing-havoc/
2 https://www.eeagrants.gov.pt/media/2776/conversion-guidelines.pdf
WTW is an insurance broker and gives its views on the meaning or interpretation of insurance policy wordings as brokers experienced in the insurance market. Insurers may take a different view on the meaning of policy wordings. Any interpretation or thoughts given are not legal advice, and they should not be interpreted or relied upon as such. Should a legal interpretation of an insurance contract be required, please seek your own advice from a suitably qualified lawyer in the relevant jurisdiction. While all reasonable skill and care has been taken in preparation of this document it should not be construed or relied upon as a substitute for specific advice on your insurance needs. No warranty or liability is accepted by WTW, their shareholders, directors, employees, other affiliated entities for any statement, error or omission.
For more information, please contact local entities of the WTW Group:
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