02 Governance, Structure & People APPROACH TO RISK

CEFC ANNUAL REPORT / 2014–15

APPROACH TO RISK

The CEFC operates under a sound risk management framework designed to identify and effectively manage critical risks. At the Corporate level, risk is managed by a focus on the six pillars of risk management activities:

  1. Governance

  2. Strategy

  3. Risk Profiling and Reviews

  4. Compliance

  5. Controls

  6. Assurance

The largest aspect of risk for a financing entity with the CEFC’s operating profile is investment risk. The CEFC manages other corporate risks (e.g. workplace health and safety) through identifying, assessing and controlling activities. These activities are reported and reviewed at Board meetings, by the Board’s Audit and Risk Committee, and by the Executive Risk Committee. Management of risk is performed by the Executive itself, and by well‑inducted and trained employees who understand that risk management and compliance is everyone’s responsibility and part and parcel of working at the CEFC.

Environmental, social and governance risk

The Board believes that effective management of financial and reputational risks, including matters related to environmental, social and governance (ESG) issues will, over the long term, support its objectives and mission. More information about the Corporation’s environmental and social impact is available in Section 1 (Performance Report) and Appendix B of this Annual Report.

DEALING WITH INVESTMENT RISK

Risk is related to return and is integral to how the CEFC assesses, considers, approves and manages investment opportunities. As a responsible investor, the CEFC is ever conscious that return does not come without risk, and the levels of investment return should be commensurate with assumed risk. 

A strategy that is too risk-averse would not allow the CEFC to fulfil its mandate and public policy purpose. On the other hand, an approach which is too tolerant of investment risk could lead to unacceptable levels of capital losses. The CEFC recognises this reality and the CEFC Board has established an enterprise‑wide Risk Management Framework that integrates with the CEFC Investment Policies and embeds the active management and mitigation of risks into all areas of investment. 

Figure 36: Illustration of the CEFC enterprise risk management framework

Types of risk in CEFC investments

Credit Risk

The CEFC is exposed to credit risk, that is counterparty risk associated with extending finance to other parties. This is the macro risk that any business may fail or default on its payment obligations. At the portfolio level, diversification and concentration guidelines are in place. Guidelines are also applied to single asset, entity and industry level exposures.

During the 2014–15 year, there was a change in the Investment Mandate which basically has the effect of imposing a portfolio ceiling on credit risk measured with reference to the risk levels present in the portfolio as at 5 March 2015.

Market risk

The CEFC is also exposed (indirectly) to market risks. These risks are associated with a general fall in prices of energy and in particular, a fall in realised (as compared to expected) prices for both ‘green’ and ‘black’ electricity. Such price changes may adversely impact a borrower’s ability to make repayments in accordance with a loan facility. The CEFC includes regulatory risk that impacts on prices within this set of risks.

Technology risk

The CEFC is, in addition, exposed (indirectly) to technology risks. Technology risk is defined as the risk of losses arising as a result of a technology not operating as effectively as predicted which may arise from design, engineering and/or implementation issues. Renewable energy, energy efficiency and low emissions technologies all present varying degrees of technological risk depending on the nature of the technology under consideration, the nature of the technology’s application in the subject investments, the technology’s stage of development along the innovation chain, and the nature and pace of innovation in competing technologies. Each individual project will carry its own risks for implementation underperformance (for example, delays in construction or installation).

Technology risk includes regulatory risk associated with the use of the particular technology. Assessment, analysis and mitigation for technology risk is a key component of the CEFC’s investment risk analysis process.

Concentration risk

The CEFC has concentration risk. The sector-specific purpose of the CEFC limits the scope for diversification as a risk mitigant.

At the portfolio level, diversification and concentration guidelines are applied to technology types along with geographic, regulatory, single asset and industry level exposures.

Policy risk

The CEFC is also exposed to policy risk at both state and federal level, but particularly at federal level. Many of the existing policy settings at the intersection of the energy and environment portfolios were placed under review or proposed to be abolished as part of government policy. Many of the CEFC’s investments depend on a ‘green price’ for financial viability and the RET review impacted on demand for CEFC finance. As the CEFC’s focus is on investing in clean energy technology, these developments require close monitoring and careful evaluation in respect of the CEFC’s existing and potential exposures.

In considering investments in this period, the Board and Management have been cognisant of these regulatory policy risks and have sought to mitigate these wherever possible while performing the statutory function.

Treating investment risk

A high-level summary of how the CEFC deals with investment risk is as follows:

  • The CEFC has a well-developed process for gating and screening investments to ensure that there are multiple ‘checkpoints’ for risk before a given investment proposal makes it to the Board for approval

  • This is underpinned by a thorough process of due diligence

  • The CEFC only escalates investment proposals through the process that are credible and investment ready

  • The CEFC applies the industry standard means of risk identification, risk analysis, risk evaluation and risk treatment to produce a risk assessment on any given investment which is tested at various stages throughout the approvals process

  • Where shortcomings are identified, or the nature of the risks involved are unfamiliar, the progression of the investment may be paused while extra due diligence or market specific research is undertaken

  • Where appropriate, the CEFC seeks the presence of reasonable subordination or a sufficient equity buffer as a protection of the CEFC investment against underperformance

  • If the CEFC lends to projects selling power at ’merchant rates’, it does so where the loan is expected to be comfortably serviced from revenue, even where actual prices received fall below current forecast prices and overall merchant risk exposure is capped at portfolio level

  • The CEFC applies conditions to the investment that are appropriate to managing the proposed CEFC risk, for example, by applying special conditions that take effect for underperformance that result in extraordinary repayments of capital

  • The CEFC has a clear preference for other debt participants in any transaction and usually seeks other private sector capital to share risk

  • For debt investments, the CEFC is typically secured against the borrowing entity, the project or the equipment it is lending towards

  • The CEFC spends considerable effort understanding the creditworthiness of borrowers, the technology, the business case of the proposal, the security on offer, and what will happen to the CEFC’s funds in the capital structure (see Figure 37) if the proposal ultimately fails

  • The CEFC diversifies its portfolio, seeking to avoid excessive concentration of risk in specific technologies, in exposure to single entities, in exposure to higher risk finance in the capital structure, in exposure to merchant risk, in exposure to individual commodity markets and geographical areas

  • The CEFC has instituted an extensive portfolio management function, systems and process

  • Inevitably, and despite the CEFC’s best efforts, a given proportion of loans will underperform, and for some of these, the CEFC will experience a loss on default. In a default, the CEFC structures investments to minimise loss and maximise the chance that it will get principal and interest returned

  • While no loans have defaulted to date, and the CEFC is not aware of any individual loan that is in actual default, the CEFC Board has adopted a prudent approach to provisioning for losses on the balance sheet.

Figure 37: Illustration of the order of application of losses in the capital structure

Conducting Due Diligence

Conducting thorough technical due diligence and integrating those findings and outcomes with financial modelling analysis is a key component of the overall investment analysis process.

Critical considerations for the CEFC’s technical due diligence include the historical data on the reliability of the technology, the assessed suitability of the technology for the purpose and location, the degree of customisation required, levels of testing undertaken, and the confidence levels expressed regarding the expected performance of the technology.

CEFC staff have diverse specialist technical knowledge and experience which is supplemented by external due diligence and working together with agencies like ARENA and the CSIRO, as well as knowledge sharing with other green banks on complex technical and engineering risk assessments.

Rigorous due diligence and financial modelling analysis of the business case, along with assessments of other key investment risks, including credit risk, are used to determine appropriate investment structures, financial covenants, and the required legal undertakings for an intended investment, all of which are designed to enhance and protect the CEFC’s position.

The CEFC’s loans are early in their life and the Corporation does not yet have a long history from which to ascertain the future performance of these investments.

Collective provision overlays may be appropriate in future periods and the CEFC will need to accumulate data in relation to trends and its experience, as well as monitoring for impairment indicators that may give rise to a need for provisioning of losses.

In the meantime, the Board has required all lending to take place at a sufficient margin to allow for recovery of normalised expected loss estimates in a commercial lending portfolio in the energy sector.