The effects of climate change on hydropower are an increasing concern for investors. Earth Security argues the solution may be to bring natural capital on to the balance sheet.
Whilst hydropower has a vital role to play in energy transition, its dependence on cloud forests makes it vulnerable to deforestation and climate change
Investors are getting increasingly concerned after recent events such as the droughts in China and Brazil that brought hydropower plants to a standstill
What should investors’ do? The solution going forwards will be bringing natural capital onto balance sheets
A new report recently released by nature-based assets solutions specialist Earth Security revealed that some $246 billion of hydroelectricity depends on water from tropical cloud forests, which are threatened both by deforestation and climate change.
Alejandro Litovsky, Earth Security’s founder and CEO, tells Impact Investor: “Working with King’s College [London}, we have been trying to get our minds around how physical climate change will affect the cloud forests. In the short term the most important negative factor is deforestation, but over the longer term climate change will also have significant effects.”
Of course physical climate change and deforestation go hand in hand in having a negative impact. Deforestation means you can’t contain the water in drought conditions which would otherwise be possible. It also affects the quality of the water.
The report, Cloud Forest Assets: Financing a Valuable Nature-based Solution, finds that of the 979 hydropower dams currently operating in the 25 cloud forest countries, more than half depend on water from cloud forests, representing billions of dollars of electricity production that “take nature’s ecosystem services for granted”.
Of the 1,084 dams that are at various stages of planning to support the energy transition across these cloud forest countries, 684 – almost two-thirds – are set to rely on cloud forest water in the future, too. Most of these forests remain unprotected and, the report argues, should be treated by countries as part of their strategic green infrastructure.
Hydropower an increasing concern amongst investors
Hydropower is considered to play a vital role in energy transition and it’s a particular priority for many development finance institutions and impact investors.
Earlier this month, the Emerging Africa Infrastructure fund, partnered with the African Development Bank (AfDB) and other lenders including and the German international development agency (DEG) to invest €25 million in Ivoire Hydro Energy (IHE), which will build a 44MW hydro electricity generation plant on the Bandama River in Côte d’Ivoire.
But many hydropower investors are increasingly concerned after recent experiences such as the power emergency in Sao Paulo following a severe drought. In Brazil, hydropower generates 64% of the power used. This report has added significance in that context.
Jags Walia, head of global listed infrastructure at Kempen Van Landschot says: “One sector which stands out that we are worried about is the hydropower sector. We have seen significant effects in Brazil and China on hydropower plant operations challenged from the droughts experienced in recent years.” He is worried that some of these plants will effectively become stranded assets.
Minesh Mashru, global head of infrastructure investing at Cambridge Associates, is cautious about overestimating the effects of physical climate change arguing “most of the investments in infrastructure are going either into renewables, telecoms or traditional energy and we see limited physical climate risk in these areas”. But he does worry that there might be some concerns around hydropower construction “for example droughts, and broader ESG concerns on development”, particularly in developing markets.
Given this, it is important to consider what mitigating actions investors might take. Litovsky argues here are two types of solution which are very important. “Firstly, for the investors in hydropower and dam operators it is important that they review the dependency of these assets on the broader green infrastructure and pinpoint which elements of the cloud forests need to be maintained, and almost sealed off.”
Secondly, he believes “investors need to more broadly understand the value of the water that is coming from the cloud forest, as well as the value of the carbon they are storing. If we can create payment systems, then we may be able to harness the value of nature. It is important to have a payment for ecosystem services. Efforts so far really haven’t worked as they have been too small”.
Litovsky thinks we need to build a bridge between two worlds. Academia has been undertaking studies for decades as to what the effects of deforestation and climate change are on the world’s rainforests, but investors have yet to become proper stakeholders in creating a practical payment system.
He argues: “Payment for ecosystem services really has to be undertaken at a national scale. It’s important for national governments to create the fees and taxes as necessary that create a steady income from the cloud forests.”
In his proposed solution, there are three things to do as an investor. Firstly, “it is important for investors to use the strong relationships they have with local governments to influence policy”.
Secondly, they must “participate in creating a payment system – for ecosystems for example making payments to local farmers that incentivise them to behave in a way which will impact the ability of the businesses they are investing in to survive. This really is a balance sheet calculation”.
Finally, sometimes it’s literally best for investors to simply buy the land themselves take direct control of what should really be considered part of the infrastructure they are investing in.
Will the TNFD change perceptions?
Could new regulations help this sea change? A new regulatory framework is coming in for banks and private investors as a result of the Taskforce for Nature-related Financial Disclosures (TNFD). This will make it a requirement for institutions to disclose their nature related risks. The organisation states: “The market-led, science-based TNFD framework will enable companies and financial institutions to integrate nature into decision making.”
Litovsky concludes: “In the future investors will become intelligent about that risk exposure to nature as they face these gradual regulatory challenges. For an infrastructure investor it is important to recognise that they have a very specific dependence on a geo-located ecosystem. Nature must be embedded in the operation of their asset.”
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