The Winter is coming: Can renewables break dependence on Russian gas?

One thing is clear – Europe needs to cover gas demand with alternative sources. The EU energy security is compromised if there is no diversification to cover Russian gas imports.

One thing is clear – Europe needs to cover gas demand with alternative sources. The EU energy security is compromised if there is no diversification to cover Russian gas imports. EU gas imports account for over 1,500 TWh and need to be switched into an alternative source.

Energy security concerns are sparking lively debates not only in the politicians’ offices, boardrooms, and conferences. This topic has made its way to family dinner tables, parties, and pubs. There are wild stories to be heard with opinions being polarised and swaying in both directions. Although it may seem that we are facing the impossible task of shifting from fossil fuels to renewable energy sources, public polls actually show a high degree of consent (9 out of 10 Europeans agree) regarding the EU’s energy policy priorities to ensure secure, clean, and affordable energy for all Europeans, according to a new Eurobarometer survey published by the European Commission.
 
The main questions are evolving around the feasibility of energy transition and the corresponding timeline. It is not a matter of if, but how and when. Our Energy, Power & Mining team looked closer into this issue.
 
As of March 2022, 85% of the EU gas demand was imported. Thereof 34% came from Russia and only 17% from Norway. The dependency on Russian gas has grown significantly within the EU, some countries being fully dependent on the single source, as the diagram below indicates.

Source: GlobalData, Eurostat

Over 30% of the imported Russian gas is being used for power and heat generation, and an additional 25% is used by the residential sector followed by industrial production with 21%. It is hardly a surprise that Russia’s ability to weaponise energy only accelerated pressure on consumer prices, global supply chains and the labour market.

The road towards alternative energy sources

One thing is clear – Europe needs to cover gas demand with alternative sources. The EU energy security is compromised if there is no diversification to cover Russian gas imports. EU gas imports account for over 1,500 TWh and need to be switched into an alternative source.
 
The International Energy Agency (IEA) has elaborated a 10-point plan for Europe. The plan is divided into 4 major action fields as follows:

Gas oriented actions

  • No new gas supply contracts with Russia (15 bcm contracts to expire by the end of 2022, and 40 bcm by the end of the decade.)
  • Replace Russian gas with gas from alternative sources (30 bcm from other countries)
  • Minimum gas storage obligations to enhance market resilience (higher injection will add to gas demand and push up the prices.)

Energy efficiency oriented  actions

  • Speed up the replacement of gas boilers with heat pumps (reduces gas use for heating by an additional 2 bcm in a year)
  • Accelerate energy efficiency improvements in buildings and industry (reduces gas consumption for heat by an additional 2 bcm a year)
  • Encourage a temporary thermostat adjustment by consumers (reduce gas consumption by 10 bcm a year(!))

Renewables oriented actions

  • Accelerate the deployment of wind and solar projects (could bring the gas use by 6 bcm)
  • Maximise generation from existing low-emission sources such as bioenergy and nuclear (can bring 70 TWh reducing 13 bcm of gas use in electricity)

Market oriented actions

  • Enact short-terms measures to shelter vulnerable electricity consumers from high prices
  • Step up efforts to diversify and decarbonise sources of power system flexibility

Research shows that the successful implementation of the plan can eliminate the demand for Russian gas by 2030. The renewable share of Energy has been growing steadily since 2004 currently reaching 23%. Hydrogen is perceived as a support to the gas sector. Renewable Energy Directives (RED) are assessing the possibility of installing blending obligations for increasing the sustainability of the European gas system from currently 1% to 20%, but not without major grid and infrastructure adjustments.

Apart from reducing the dependency on Russian gas, which now seems possible, there are various other aspects of the energy transition to consider as well. But for the moment, keep calm and follow the plan. So far so good.

What about the risks?

We read and hear surprisingly little about the uncertainties, unknowns, and associated project risks of such undertaking. Known unknowns are what drive many scientific experiments, business intelligence and data analytics and refer to information whose existence is someone aware of but does not possess. They can also represent potential risks. They can also represent potential risks. Far worse are the unknown unknowns, pieces of unidentified information, or “things  we do not know that we don’t know”.

The plan addresses several items, which carry inherent limitations in their nature and can, therefore, be considered severe project risks. For example, selling and installing 30 million heat pumps in the shortest term possible is a challenge even without limited manufacturing capacity globally, supply chain pressure and logistical difficulties.
 
Accelerating renewable energy generation capacity (EU requires over 900 TWh additional capacity by 2030) seems extremely unlikely for the reasons mentioned above and impossible without the addition of new manufacturing facilities, ideally closer to home, and not overseas. This means that technical and technological sacrifices will need to be made to accomplish the colossal task in a very short period. Furthermore, new personnel must be hired and trained to a very high standard demanded by the ever-increasing complexity of the renewable generation machinery (especially wind turbines). The recent crises caused by post-COVID shortages of staff in European road transport and air travel industries demonstrate just how difficult is to mobilise and ensure the supply of qualified labour to meet the demands of the green energy business.
 
Also, the grid, gas transport and storage infrastructure will require more than a major overhaul to adopt hydrogen blending due to the physical and chemical properties of hydrogen (highly corrosive, existing networks were not built with that in mind).
 
Lastly, it would be interesting to read the estimates of the capital expenditure required to upgrade the entire EU’s transmission and distribution grid systems to accommodate the change of topology coming from the replacement of a small number of centrally dispatched generation assets (located near the largest industrial electricity users) by a large number of distributed renewable sources located across the entire continent and in the neighbouring seas.
 
Until then, Europe will have to keep its coal-fired plants going (for example, Germany has already initiated a legal proceeding to abolish the prohibition of operating thermal coal plants beyond 2022-23).
 
Besides, 2030 is still 7.5 years away, yet the winter will be upon us in just a few months.

Related Insights

Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04

Terrorism and Political Violence Insurance

For many insurance buyers in Europe Terrorism and Political Violence Insurance remains a niche coverage, although it is often required by financing banks or investors.

A terrorist attack, strike, riot, civil commotion and other types of politically motivated unrest can directly and indirectly affect businesses and human lives. Modern day terrorism is multifaceted and constantly evolving in its nature. An insurance policy cannot save lives, but it can provide for financial remedy to business owners to help them restore damaged property and recover quickly, to minimize financial losses resulting from business interruption or loss of rent or loss of attraction.

For many insurance buyers in Europe Terrorism and Political Violence Insurance remains a niche coverage, although it is often required by financing banks or investors. Despite major events such as 9/11 or Paris attacks, markets have not really seen a significant uplift in demand or price. The approach has changed only a few days after the invasion of Ukraine. Many businesses are looking to buy the coverage and are prepared to purchase it at higher costs. Active war in Ukraine has forced the market to shrink, but it remains largely intact.

Insured interests and perils

Critical infrastructure assets, such as energy and communication, are typically considered high risk. But also, other industrial objects and commercial real estate are often targets of terrorist attacks. Needless to say, that the nature of the risk itself has evolved over the past few decades. Due to high interconnectivity of modern economies, significant financial losses can occur even without a physical damage.

Whilst terrorist attacks, including active assailant or “active shooter” events, are becoming less frequent in certain regions, politically motivated violence or unrest and war is currently on the rise. Such events can cause enormous damage to property and interruption to businesses. Strikes, riots, civil commotions and malicious damage caused by individuals or groups often result in destruction of property and looting. Business owners may even become liable to third parties if they fail or neglect to implement safety and protective measures to safeguard life and property of others which is an exposure insurable under terrorism liability, a line of insurance not widely known.

The policies are written on “named perils” basis, which means that specifically named perils or events are insured. The coverage is granted to specifically scheduled and named property and gross profit. It is recommended to purchase policies on “new for old” basis. Underwriters will require a policy limit, which acts as a Combined Single Limit for property damage and business interruption.

The following coverages are available either separately or as a package:

Critical infrastructure assets, such as energy and communication, are typically considered high risk. But also, other industrial objects and commercial real estate are often targets of terrorist attacks. Needless to say, that the nature of the risk itself has evolved over the past few decades. Due to high interconnectivity of modern economies, significant financial losses can occur even without a physical damage.

There are specific exclusions of course. The aim is to draw clear lines with other, conventional property damage and business interruption coverages and avoid overlaps. Herewith, few key exclusions:

Loss or damage arising from:

  • Nuclear, Chemical, Biological or Radiation contamination or release
  • Seizure, legal or illegal occupation of property, Confiscation, Nationalization, Requisition
  • Electronic attacks – Cyber Terrorism
  • War between any two or more of the following countries: China, France, the Russian Federation, the United Kingdom and the United States of America (“World War Exclusion”)
  • Direct or indirect threat or hoax.

Standard Coverage does not cover:

  • Land or Land Values
  • Power, transmission or feeder lines not on the Insured’s premises
  • Any building, structure, or property vacant or unoccupied or inoperative for more than thirty days
  • Aircraft or any other aerial device, or watercraft
  • Any land conveyance. including vehicles, locomotives or rolling stock, unless declared and solely located at the property insured herein at the time of its damage
  • Animals, plants and living things of all types
  • Property in transit

Extensions of coverage

In addition to the above-mentioned coverages, there are a number of coverage extensions available, such as:

  • Terrorism liability: covers financial costs incurred by an insured following claim made against them for the damages suffered by third parties or employees who are injured in a terrorist attack at an insured location;
  • Non-physical damage business interruption: unique solution, which addresses the resultant financial burden of terrorism attacks occurring within the surrounding areas of an insured property which do not result in actual physical damage at an insured location;
  • Active assailant / malicious attack: coverage developed to address violent attacks which do not meet the coverage trigger requirements under traditional Terrorism polices, i.e. political, religious or ideological motivation. Initially created to respond to the shooting events which occur within the United States but interest in the coverage has seen an increase in other parts of the world including Europe.

For risk analysis and policy check please contact GrECo Specialty

Risk analysis is very important to understand all possible scenarios in order to create a tailor-made solution. The aim is to minimize the impact of a loss event. We can help you to analyze what might happen after a terrorist attack, political unrest or war. Typically, Terrorism and Political Violence risks are excluded from Property & Construction policies although SRCC (Strike, Riots and Civil Commotion) coverage may be offered by insurers with a sub-limit. But those covers are often subject to a special right of contract termination by the insurer at any time.

We recommend conducting a policy check in order to identify and avoid coverage gaps.

Related Insights

Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04

Are you ready for free electricity?

Europe is massively investing in Renewable energy production. Detractors of these technologies have a lot of compelling arguments and one of the most relevant is the energy availability: What if there is an instant surge in demand? What if everyone in England starts their kettle at half-time during the Euro’s final and there is no wind and no sun energy available?

Adjustment of energy production and consumption

This problem is not a small one. Failure in system capacity caused the 2019 blackout in England. A lightning event at a major production site and successive failure to maintain the grid frequency between 49.5Hz to 48.8Hz, as the system needed more than 2,100MW replacement capacity and only 1,000MW was available, caused a partial shutdown of the grid. More than 1 Million users lost electricity for 45 minutes. Indirect damage lasted over two days as train were still suffering from delays 48 hours later. Part of the incident was blamed on the Electricity System Response.

This event paved the way to a complete reshuffling of the energy production properties and technical requirements and new energy production tenders in the UK. One of the most important improvement required was that the speed of response must be faster than 0,5s from electricity request to input in the grid. Obviously, with no control over wind and sun, how can renewable energy producers face such challenges?

The role of energy storage

The solution resides in energy storage technologies. The most common are the battery storage facilities but there are many different options already in use that can be divided in three groups: electrical, electrochemical and mechanical.

Source: DNV GL AS (Safety, operation and performance of grid connected energy storage systems, October 2017, DNV GL AS)

Each of these types of storage represents new challenges, new technologies, unknown risks and a very steep learning curve – for the insurance sector. Clearly, pumped hydro and room temperature battery represents intrinsically distinct risks requiring unique risk management strategies. Massive capital will be deployed in these technologies in the coming years, as the Green Deal will accelerate renewable energy production development and accentuate their main problem of energy availability.

The new Super Power paradigm

In order to tackle this problem, the grid’s reserves must be equal to 3 days of consumption. With that in mind, we can already foresee an incredible energy paradigm shift materializing: Super Power. This revolution in our energy capacity will translate into more energy production than can be used and consequently, free energy at moments when energy storage is at full capacity and that there is more energy produced than consumed, as shown in the image below.

Source: RethinkX

This could lead heavy electricity consumers to maximize their energy needs according to these periods and develop new real time production processes that will allow to lower their operation costs. Cryptocurrency mining could feed exclusively on the excess energy production.

The paradigm change will materialize as “maximizing rather than minimizing energy use, because it is not harmful to utilize electricity generated from sunshine and wind but rather it is harmful to let it go to waste” . Maximizing energy use could also lead to new economical business model such as converting Seawater into drinking water.

This new paradigm, Super Power, will change the energy consumption scenery drastically and lead to upheavals that we cannot even foresee. As insurance brokers, we must investigate the horizon to better understand our client’s vision and help them find new and innovation solutions. We can therefore adequately support your company growth in the energy production and storage sectors even more when implementing new technologies.

Related Insights

Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04

Offshore Wind Insurance

Companies investing in the offshore wind sector need a risk partner with the knowledge and experience to deliver tailored risk advisory and insurance solutions. In addition, having an insurance partner capable and experienced in managing finance parties’ expectations and working with all interested parties in the setting of realistic and reasonable insurance requirements within the debt facility agreements is crucial – a skill set which GrECo have market leading expertise in. Choosing the right insurance advisory and placement partner will have a significant and long-term impact on the legal, procurement and insurance strategy, with the target of reducing costs and maximizing insurance and risk management solutions.

Supporting the entire lifecycle

We have the knowledge, experience and commitment to provide clients with in-depth, specialist offshore wind expertise. We work with offshore wind projects to offer contractual risk allocation, project and financial risk management analysis and create insurance strategies that enable our clients to protect cash flow and secure scarce capital across the entire offshore wind lifecycle (Bidding, Consent, Development, Procurement, Construction, Operation and Decommissioning.)

Innovative solutions backed by long-term experience

GrECo is independent, privately-owned company; as such our success and reputation depend on strong partnership with each client. GrECo is able to deliver an innovative, holistic approach to offshore wind project risk and insurance in the local and international insurance markets, underpinned by committed service excellence, a thorough understanding of the offshore wind project’s challenges and complete cost transparency for the solutions proposed.

GrECo together with partners have a proven track record of meeting client’s risk management and insurance requirements, offering deep sector knowledge and service excellence throughout the lifecycle of major renewable energy projects to project developers, operators and investors.

Related Insights

Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04

Michał Olszewski

Director – Energy & Mining Specialty at GrECo Poland

T +48 22 39 33 358

#FutureEnergy: Market Update Q2 2021

This is a series of articles related to the news and development of the global energy sector with focus on Europe, Russia & CIS. The Group Practice Energy, Power & Mining comprises of dedicated group of risk and insurance professionals providing risk and insurance related advice to the companies active in broader energy sector.

Foreword

In this edition of our quarterly update we decided to reflect on the changes to the insurance market for conventional power and renewable energy during the past several months.

A lot is being written, said and analysed on this matter. We tried to provide insights from the broader financial services industry, which will shape the insurance market in the future while the energy sector is undergoing significant reforms.

According to the BP Statistical Review, energy consumption in Europe (including Russia) fell by 1.1% in 2019, between 2008 and 2018 energy consumption in Europe contracted by 0.7%. Energy consumption in developed markets such as a North America and Europe has been steadily declining in contrast to growth in the emerging markets. The decline in energy consumption is set to continue in 2020 as the Covid-19 outbreak coupled with the economic downturn across Europe will weaken energy demand, and in the medium and long run, demographic changes in Europe, in particular a rise in the share of its ageing population, will continue to cause a decline in Europe’s global share of energy demand. On the other hand, as fossil fuels will be phased out from the fuel mix of the European Union, United States and other developed economies, the demand for electricity will keep growing, making investments in the power generation, transmission and distribution systems grow at an ever faster pace.

Several countries in the region have pledged to invest in developing their renewable energy sectors and have set internal greenhouse gas emission targets supplementing those set in the 2016 Paris Agreement.

The energy sector has reduced CO2 emission by 63% since 1990s, according to the report published by Energy Research Partnership. In an article which appeared on Business Insurance on March 16, 2021, Swiss Re pledged to exit all exposures from thermal coal in OECD countries by 2030 and the rest of the world by 2040. The move goes together with the investment policy to achieve net-zero emission by 2050. The reinsurer is one of the founding members of the United Nations Convened Zero Asset Owner Alliance, which includes global carriers like AXA, SCOR, QBE, Generali, Munich Re etc., who are likely to follow suit. The Alliance is representing USD 5,6 trillion assets under management and shows unified action to align portfolios addressing Article 2.1c of the Paris Agreement.

Assuming all projects proceed as planned, the current pipeline of projects will deliver 170.6GW of generating capacity in Europe in 2020-2024. Installed capacity is expected to peak in 2023, with 47GW projected to be installed as new capacity.

Europe – Power Generation, Construction Project Pipeline, Top 10 Countries by Value and Stage (US$ million)

Source: Global Data

Europe – Power Generation, Construction Project Pipeline by Type, Value and Stage (US$ million)

Source Global Data

Focus on Wind Projects

There are several important factors contributing to the sharp rise of rates and deterioration of coverages offered by international re/insurance markets from 2019.

  • Projects are getting larger and more complex. This increases severity of risks significantly.
  • Natural catastrophes occur more frequently and are more severe in nature. This is the reason for concern for the insurers and is rated as top 5 risks according to the Allianz Risk Barometer.
  • Defective products, design and quality control losses are on the rise.
  • Supply chain complexity, just-in-time production and interdependencies are more likely to cause project delays.
  • Political tensions, sanctions, compliance and political violence has become one of the top concerns for project risk managers.

All of them are the result of operation of market forces. At this point it is important to keep in mind that the overall performance of an individual insurer, or the market, is the combination of the result on underwriting activity and investment activity. Continuing underperformance results in either re-underwriting of the existing portfolio or complete withdrawal from writing certain classes or business (or less often, winding down of the whole company). It is also important to understand that the insurance market, unlike many other financial markets (such as public equity and fixed income markets) is not transparent and objective market information is not available usually other than at very high granularity information made available by national regulators and industry trade associations.

Market Performance and General Underwriting Considerations – Hard Phase of the Insurance Cycle

The rating of Engineering and Construction classes of business for Onshore Wind would depend on the following factors:

The Profitability of the entire Insurance Industry

2020 was a year of continuing deterioration of underwriting result and net result. For example, in the Lloyd’s market which provides substantial reinsurance capacity to insurers worldwide, the underwriting loss was GBP 2.67 billion, down from GBP 538 million of loss in 2019. As the investment return also contracted significantly, the market ended 2020 with a total loss of GBP 887 million, down from a profit of GBP 2.53 billion in 2019. As in practical terms it means the erosion of capital across the market, the result is the pressure for immediate action by their shareholders or the Society of Lloyd’s (or any other regulator). The Lloyd’s combined ratio (measure of underwriting profitability) was 110%, however, excluding losses from Covid-19 it was down to 97%, still a very poor result for the entire market. It is estimated that the total amount of underwriting losses suffered by re/insurance markets worldwide were in excess of USD 100 billion across 2020.

Withdrawal of Underwriters from writing certain Classes of Business

Since 2019 this affected Marine Cargo, Engineering and Construction as well as Renewable Energy. It was driven either by Lloyd’s which has the power to accept or reject individual syndicates’ business plans, or the insurers’ own management as a result of changes in their risk appetite. There have also been withdrawals of capacity from major MGAs writing Renewables business such as Pioneer, which unfortunately had to be placed into run-off. Having said that, there have been some new insurers launched across 2020 and 2021, taking advantage from improved rating environment and not burdened with previous years’ losses. Several existing markets have also successfully raised new capital to support their business in the hardening market.

Reinsurance Considerations

The market consensus is that the 1/1 2021 treaty renewals for Power and Renewables sector were higher than a year earlier. Also, the restructuring of treaty provisions, in many cases insurers are no longer protected by their obligatory treaties with respect to active loss attrition on their books. This will affect both direct insurers and facultative reinsurers alike.

Portfolio Rebalancing

For the companies that chose to continue providing coverage this took the form of:

  • Increasing rates – from 10-30% year-on-year on loss-free accounts to 90-100% or more for troubled insureds. Similar adjustment took place across 2019 with 25-50% typical rate increases or even upwards of 100% for complicated or distressed accounts.
  • Deterioration in the length and breadth of coverages provided, increased deductibles and decreased sublimits for certain perils.
  • Decreasing line sizes at renewal, sometimes significantly, or
  • Not offering renewal terms for distressed accounts. For example, according to one reputable London market, their retention rate of Renewables accounts was around 40% in 2020.

Accounts Performance

With the trough of the pricing cycle for Onshore Wind in the Summer months of 2018, 2020 was yet another year which brought about deteriorating claims and reserves development experience for the Renewable Energy insurances. For example, the adverse development of losses incurred in 2018 moved the loss ratio for that period for an initial estimate of 66% to 80% as of 2020, which made the 2018 year of account unprofitable. This of course needs to be reflected in rating adjustments for insurances sold in future years.
Notable causes of rating increases for Onshore Wind projects typically include:

  • Natural Catastrophe losses – even though no spectacular losses occurred throughout 2020, smaller scale catastrophes give rise to increasing loss activity.
  • Ageing of the fleet – increasing number of attritional losses and the need to replace ageing assets with modern technology, which is affected by costs, materials and labor inflation.
  • Constant upscaling and upgrading process of generators, which make them significantly larger and more expensive, also in terms of replacement and re-erection costs. Also, the boundary between the upscaled and the prototypical becomes ever more blurred as a result of the process.
  • Adequacy of “old” deductibles is being questioned by insurers, as it the view of many they no longer reflect the specifics of new technologies and substantially larger and more powerful units.
  • Concerns about the performance of the Engineering and Construction book – it has been noted that the contractors may be taking on too much workload (due to fast-increasing demand) which causes them to rush some projects to the point where there is a perceived increase risk of losses in the construction phase. In fact, data from some markets show that for 2020, contractor error losses amounted to about 36% of the quantum of all wind losses. As a result, the construction phase attracts the highest rating increases in the wind farm life cycle. The same applies to the increase in deductibles required by insurance markets. Unfortunately, the increasing demand pressure on major contractors makes them unwilling to give concessions to their clients as their order book is filling up quickly as old conventional assets are being phased out, making their bargaining position ever stronger.
  • The Covid-19 pandemic affected some routine claims handling (such as inspection dismantling, re-erection), risk engineering, as well as manufacturing processes. This affects both loss settlement times and – more importantly – the quantum of Business Income (BI/ALOP/MLOP/DSU/MDSU) losses.

Diminishing Returns on Investing Activity

For many years, deficiencies in the performance of the underwriting function would normally be corrected by returns on the investing activity. It used to be normal that in certain classes of business combined ratio of 110% was accepted for prolonged period (meaning that on every USD100 of premium there were losses and costs of USD110 incurred). With negative interest rates environment prevailing for a prolonged time and increased asset price volatility this is no longer the case and the insurers are pushed towards technical (underwriting) profitability.

Related Insights

Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04

Ain’t no sunshine

We are debunking four myths about parametric insurance for renewable energy

Parametric insurance has been around since 1990s although the reinsurance industry has been using the parametric structures with catastrophe bonds for more than 30 years. Back then it was considered a novel product, but it may now be reaching new levels of popularity with the renewable energy investors and producers due to rapid advancement of technology and increasing quality of data around the world. For example, insurance companies can now build better indices to approximate the yearly average energy production of a windfarm and the insured can protect his revenues using index based parametric insurance.

One of the key motivators for the companies to purchase such insurance is its efficiency. The wordings have only a few pages, the indemnity amounts are clearly defined and the Insureds avoid lengthy claims investigations, coverage disputes and payment delays.
Flexibility is also another important factor that contributes to the adoption of the product. All the parameters can be tailor made to perfectly suit the risk management objectives and the Insured is also free to use the payouts the way he likes, unlike traditional insurance. Basically, an index is triggered, payout is made – no questions asked.

Another key criteria is the reduction of volatility, hence, the predictability of future revenues, transparency and objectivity of underlying parameters by applying parametric insurance as a protection against weather underperformance.

Despite its efficiency and speed the use of the product has been limited, at best. We decided to investigate the intrinsic details of the coverage and debunk common myths associated with index-based insurance solutions for renewable energy sector.

Myth #1 – parametric insurance is not suited for SME and mid-corporate buyers

Although initially designed to transfer high and catastrophic risks on a country level especially in regions like Caribbean, advances in data science, sensor technology and artificial intelligence have allowed for the creation of a broader assortment of informational indexes. This opened the door to new applications for parametric insurance that go well beyond the traditional natural catastrophe uses. The payout schemes have evolved from the eye of a tornado going through a specific geographical circle through a modular payout based on the speed of wind at a precise location, ensuring incremental payouts according to the exact nature of the catastrophic event.

It is a common misconception that parametric insurance can replace the traditional indemnity-based insurance coverage. It is a complementary coverage and should be purchased together with the traditional property damage and business interruption policies.

Renewable energy industry is heavily dependent on the availability of the financing. Therefore, index-based insurance, also known as sun or wind resource volatility insurance, provides additional protection to the investors while it stabilizes the revenue streams and increases the risk rating of the project.

Project managers face a project risk transfer gap, which occurs between the contractual warranties and available insurance coverage. Whilst the traditional insurance contracts facilitate the transfer caused by man-made (machinery breakdown, fire etc.) and natural perils, parametric insurance is designed to transfer the weather underperformance risk where traditional policies apply exclusions or simply do not respond to specific adverse events such as insufficient or excess resource availability. According to GCube, the weather risk gap of insurance is estimated to reach over 56 billion USD.

Myth #2 – parametric insurance is complicated

Let’s start at the beginning. The Oxford Dictionary defines the adjective parametric as “relating to or expressed in terms of a parameter or parameters”. When applied to insurance, that means coverage is triggered by a parameter – i.e. a metric or an index – that is easy to determine. An insurable trigger needs to be fortuitous and insurers need to be able to model it. Parameter or index used for the basis of a parametric insurance solution must be objective (i.e. independently verifiable), transparent, and consistent. This is important for investors, as it eliminates the information asymmetry and the moral hazard.

Basis Risk
While parametric insurance has all the advantages of the cost-effective risk mitigation and transfer tool for renewable energy projects, it does have its shortcomings. This phenomenon is often referred to as Basis Risk. It is commonly considered as a “near-miss factor” or the event where the trigger index does not perfectly correlate with the underlying risk exposure, resulting in a situation where a policyholder suffers a loss but does not receive payment. For example, measured wind speed might fall within the insurable range, but the insured did not suffer loss of revenue below the pre-determined index, hence no payout.

Structured Index
When we speak about the sun or wind resource volatility index, we usually refer to the double-trigger policies, which require that a pre-determined parameter threshold is reached and the insured has sustained the actual financial loss, e.g. loss of revenue due to lack of wind.

The index is usually structured as a function of wind speed or solar irradiation level, and plant efficiency factor. The insured can choose the desired protection by defining the Strike, acting as a deductible, and the Exit point. The annual estimated energy production between the Strike and Exit represents the Total Sum Insured. The premium is consequent upon the wind speed historical volatility and the Strike and Exit scenario chosen by the client.

In case production energy production falls below a certain level, e.g. 98% (Strike), the payout is activated until the Exit scenario, e.g. 80%. The magnitude of the payout is determined by the actual loss of generation income for the plant. Hence, the index fluctuates, whereas the actual revenues remain almost constant. The volatility is reduced, and the project delivers revenue streams in accordance with the financing model.

Myth #3 – parametric insurance is expensive

Contrary to the common belief, parametric insurance is very cost-effective provided that correct index has been structured for the specific renewable energy type.

According to Modern Energy Management, the majority of renewable energy projects face significant cost overruns, which are mainly due to the failure to properly identify and transfer project risks. This creates often a huge gap in risk transfer, whereas the investors and lenders end up assuming greater project risk than they should. One of the main reasons is that the project contracts and insurance is often developed in isolation.

Parametric insurance reduces volatility of the projected income, thus enabling a steady, predictable stream of revenues that appeal to lenders and investors alike. Quite often it helps to reduce cost of capital by pushing the interest rates down and increasing the debt/equity ratio.

Investors must juggle with all the characteristics of the project to maximize the revenues generated from their investment. Vaisala has calculated that 33% of the total energy production uncertainty for a windfarm project comes from both the historical and the future wind resource variability. This is exactly what the index based parametric insurance is designed to mitigate.

For example, many solar farms secure their financing at P95 level, hence, leaving a 5% chance of not achieving the planned annual energy production. However, after reviewing over 200,000 solar farm projects, WindAnalytics has found out that the P99 radiance probability of a catastrophically bad year is not 1% as mathematically calculated but rather 6.3%. The consequence is that a project financed for 7 years with a loan size based on 1xP99 metric results has a 37% chance of defaulting in a given year.

Parametric insurance can appear costly when compared to the traditional indemnity-based insurance. The premium may range between 0,5% and 5% of the purchased limit, whereas the conventional policy will have a premium rate much lower than the index-based solution. Such comparison is not entirely correct. Property Damage and Business Interruption policies cover loss of or damage to insured property and the business interruption resulting therefrom. They require a physical loss or damage in order for the coverage to be triggered and have extensive list of warranties, subjectivities and exclusions incorporated in their wordings. Index-based policies, however, do not require a physical loss to reimburse the insured for the economic cost of the adverse event.

The index based parametric insurance can be structured in many different ways. The scenario, which involves a low Strike and high Exit, will result in minimum premium level. On the opposite, if the client choses a very high strike and a low exit, the expected premium will be a lot higher. The Insured will have received larger payouts. The product should be structured to match key project objectives, from securing the lenders and improving the credit rating of the project to reducing the volatility of future revenues to a minimum level.

Myth #4 – regulators do not approve parametric insurance as insurance

Insurers offering parametric insurance have to overcome the regulatory challenges. Those who are already offering such products usually use double trigger policies, which require the proof of loss by the insured even though both types of policies function similarly to derivatives. The main difference is the insurable interest, which derivatives lack. In certain countries, where the regulatory framework does not explicitly address the use of parametric, it is important that the indemnity payment does not exceed the actual sustained loss and that the insured can prove existence of the same.

One of the main issues regarding risk management in renewable energy projects is the confusion on how to best manage weather-related volume risks. In order to provide answers to this, insurance broker should be involved as early as the planning stage of the project, i.e. before the contract is drafted, negotiated and signed. Early involvement ensures the closing of the risk transfer gap and securing the best terms and conditions for the project`s finance. Parametric insurance can be tailored to match project of any size and budget.

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Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04