Investing in the age of uncertainty
There is a lesson to be learned from the debate about the renewal of the French nuclear fleet. A nuclear reactor is among the most technically challenging and expensive assets in the world. At the same time, its useful economic life spans decades and can be prolonged over time. Looking forward, the current fleet could still be producing well into its fifth decade and even further down the line. Adding the decommissioning period, the life of a reactor from its inception to its final deconstruction could span nearly a century.
Yet, even with this perspective of enough cashflows to satisfy multiple generations of investors, it is proving difficult to find private sources of financing at a reasonable cost to undertake the construction of six new reactors. Part of the reasons for this are well known and are related to construction risk. Others are related to the structure of the European energy market that strictly curtails State aid mechanisms that have been available in other jurisdictions.
However, the elephant in the room, and probably the main difference with the late 20th century when the previous wave of nuclear construction took place, is that we have now entered the age of uncertainty. Traditionally investment decisions are made using the net present value of cash-flows, the internal rate of return and looking at the payback period of the investment. These criteria provide however little insight for long-term assets as they all rely on the underlying assumption that tomorrow will not drastically differ from yesterday. None of the models used for making investment decisions in long-term assets over the past 20 years foresaw a financial crisis, a global pandemic, a global inflation shock and an energy crisis triggered by a Russian invasion of Ukraine.
Looking forward, we are faced with the most radical of uncertainties, climate change and its consequences on our economy. These are two-fold. Physical risk will materialize through the destruction of assets in catastrophic events they were not designed to withstand — think once-in-millennium storms or floodings. It will also materialize less spectacularly with the incremental degradation of operating conditions — think increasing scarcity of water or chronic droughts leading to cracks in foundations. This is unfortunately only the first part of the problem.
The second relates to the measures we are collectively going to implement to tackle climate change. This is transition risk. And here things get tricky because no-one knows how our societies are going to evolve over the coming decades, let alone which climate change trajectory we are embarking on. We are collectively betting on a 1.5°C — 2°C trajectory but we rely on the unspoken assumption that emerging and developing countries will somehow manage to grow their economies without overly polluting. We also assume that developed countries will successfully and mostly painlessly transition towards carbon neutrality within 25 years or so.
These assumptions are ambitious and yet we still use them because we simply do not know how to value the alternatives. The magnitude of the changes in terms of market regulation, consuming behaviors and technology is such that we very humanely discard scenarios that are straying too far from the perpetuation of the current modus vivendi.
Which brings us back to the question of investing in long-term assets in this age of uncertainty. Financing such assets, be it through debt or equity, confronts the investors very directly to these questions and forces them to take a position on these uncertainties, without the proper tools to do so. The financial world relies heavily on deterministic models to appraise risks and still does not have a standard toolbox to value systemic risk and radical, unquantifiable uncertainty. And yet we need, today, to decide on these investments. We are not only talking about nuclear energy but about the hundreds of billions of euros of infrastructure investments that are required to achieve carbon neutrality: renewables, hydrogen, energy networks, railways, carbon capture and storage…
The financial industry is keenly aware of these issues and is scrambling to tackle them through series of initiatives throughout the world. The emergence and adoption of a standardized toolbox that would produce coherent results in a fashion similar to what the Capital Asset Pricing Model has been doing for decades remains however an elusive goal.
Does this lead to the conclusion that only the State is able to provide sufficient certainty to investors for long-term projects and that a form of public backing is going to be increasingly required for long-term projects? It is probably too early to tell and to what extent but it is clear at this stage that new ways of thinking are required if we are to build a more sustainable world for our children.
