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How to prevent the credit crunch taking a nasty bite out of plant assets

The current financial turbulence is hitting the power generation industry. Tom Roche of US firm FM Global explains how the value of risk management and loss prevention has never been higher.

Tom Roche, FM Global, USA

The sound of alarm bells across the globe is reaching deafening levels as the supply of both credit and power takes a hammering. In the 21st century, the voracious appetite of the consumer is in danger of outstripping the source of its food chain as upwardly mobile developing countries aspire to reach the standards of the world’s leading nations, which, in turn, continue to aim ever higher.

The power generation industry is literally the engine room for this unstoppable process, and the demands on it are immense in an industry, such as power that is at the mercy of uncontrollable factors such as adverse weather, the job of maintaining seamless operation is plagued by risk.

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Most events that can have a dramatic impact on plant production can be predicted. Increasingly unusual weather conditions can have a catastrophic effect on coal production, as experienced recently in the key producing nations China and Australia, where mines were hit by severe snow storms and flooding, respectively.

Even more foreseeable is the exhaustion of equipment. It is well documented that many gas, coal and nuclear plants are running well beyond their originally designed lifespan and are due to come off-line in the next decade.

Property insurer FM Global has plant fire-testing expertise dating back more than a century
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For the power generation industry to stay one step ahead of these obstacles, insurance alone is not enough: with the effects of both the credit and supply crunch converging on the financial and practical aspects of the power generation industry, the value of risk management and loss prevention has probably never been higher.

The key to staying one step ahead

Prevention rather than cure has always been the most profitable and efficient approach to running a business, and this is what has formed the ethos of risk management firm FM Global since the company was established in 1835.

The practice of loss prevention and control was virtually unheard of at the time, but thanks to the vision of FM Global founder Zachariah Allen, a prominent textile mill owner who saw the advantages to his business of minimizing the chance of fire loss, the concept evolved into the multi-billion dollar business it is today. Now one of the world’s leading property insurers, the company operates in nearly 100 countries and employs over 4500 professionals to protect the interests of more than one in three of the FORTUNE 1000 companies.

The challenge facing Europe

The landscape of power generation in Europe is changing more rapidly than ever, but as renewable energy technologies mature and carbon neutral generating systems are increasingly implemented, the risks affecting production are changing.

To continue paving the way towards a sustainable energy future, there is a very real need to protect and progress the advances made to date by the European system of the integration of both renewable and other distributed sources. Challenging times indeed, but the success of this progress cannot be guaranteed without a parallel support strategy of insurance-backed risk management.

Following warnings from James Hansen, one of the world’s leading climate scientists and head of the NASA Goddard Institute for Space Studies, that the European Union’s (EU’s) current emissions reductions target à‚— the strictest in the world à‚— is not strict enough, the gauntlet of improving energy efficiency lies firmly on Europe’s political agendas.

On the table for those countries participating in the European Emissions Trading Scheme (ETS), the EU’s flagship market-based mechanism for a progressive reduction of carbon emissions, are financial rewards and the avoidance of fines, which in turn deliver additional revenues to low-carbon forms of power generation, such as wind energy and solar power.

However, if risks and losses in other areas are not curtailed and contained, it will be a case of taking two steps forward, one step back. With the price of carbon permits having risen by 4 per cent for 2008 as investors took the view that this year’s tighter emissions rules will mean permit shortages in the future, resources to deal with this challenge clearly need to be increased.

Industry figures from April 2008 indicated that, among the big countries, France and Germany came in well below their permitted levels of carbon dioxide emissions while the UK, Italy and Spain overshot their targets.

Facing down risk

Research among executives from the world’s leading companies has demonstrated that, in a global arena, disruption to the supply chain comes second only to competition as a threat to a company’s well-being. Indeed, managing a business that provides such a fundamental necessity as power is not for the faint-hearted. On a daily basis, the risks facing the industry are manifold and the resulting losses can be crippling.

Hoping to eradicate risk in any business is unrealistic à‚— crystal balls do not exist and hindsight is a wonderful thing à‚— but a bespoke risk management strategy can bring a company as close to this aim as is humanly possible. For Europe, the need to address the issue of ageing power plants should be top of the agenda.

Replacement of key generation equipment is not only a major investment, it can also waste very valuable time. The sector has exceptionally long lead times on the manufacturing of replacement equipment, sometimes running into years.

However, for many, the horizon of many power generators is just one to two years ahead, which is simply not enough to maintain seamless operation. By taking a long-term view on cost savings, with an ideal timeframe of three to five years, it is possible to circumvent the effects of an ageing plant that exacerbate the risks of supply failure. This is the timescale that FM Global suggests generators should adhere to.

FM Global’s commitment to property loss prevention is designed to help power generators fully understand and address property risks at locations around the globe and to select coverage that best fits their overall risk management needs. These services complement the risk management process and provide the tools needed to make informed, intelligent, risk management decisions.

The unique research and testing capabilities of FM Global ensure consistent and up-to-date loss prevention engineering standards. Regular on-site assessments, combined with its risk analysis expertise, provide an accurate assessment of potential loss and its impact. FM Global’s loss prevention and control expertise provides dependable, scientifically based solutions that go beyond insurance to impact the cost-of-risk equation. We help clients select the best options, execute them and manage change.

A clear assessment of underlying risk will help determine whether to accept or transfer risk. When transferring risk, FM Global is the ideal carrier because of its financial strength, willingness to pay claims and ability to provide a capacity commitment with proven reliability.

Minimizing loss damage

Power generation is a unique sector with regard to loss. The effects of interruption are instantaneous because energy cannot be stored, meaning that smaller generators, especially, cannot afford to lose one unit. Buying replacement supply for customers on the wholesale market is a worst case scenario because of the heavy costs involved and is a crisis position to be avoided by any means possible.

The lasting effects on a company’s health from the chain of loss can be hard to recover from. Share prices can plummet, staff levels may fall and reputation à‚— the most fragile and vital aspect of any business à‚— can be damaged beyond repair.

FM Global mocks up equipment in its research facility to create engineering solutions to address risks
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By using exposure driven engineering to focus on the hazards specific to power generation, FM Global is able to mock up key generating equipment in its research facility to create engineering solutions to address risks specific to this industry. Unique data on coal conveyor belts, transformers and cable tunnel, for example, highlight the likelihood of future losses and allows a viable prevention strategy to be designed and implemented.

While mitigation involves an additional overhead, the costs from loss events are far greater. Moreover, the costs of a risk management programme that places an emphasis on prevention and control can be offset in the form of lower insurance premiums, creating visible savings.

Case Study à‚— Tenaska

Within the electric energy industry, Tenaska is an unusually complex company that demands a highly developed support system to maintain optimum levels of operation à‚— precisely what FM Global can offer.

Tenaska is a privately held company that develops, owns and operates electricity generation plants in North America. The company also markets natural gas and electric power, provides energy management services and is involved in asset acquisition, fuel supply, and gas transportation and electric transmission systems.

Each power plant is a stand-alone facility and is owned and financed individually on a non-recourse basis, with 100 per cent of its output purchased by a single customer. This means that the only source of funds to meet its financial obligations is the power generated and the revenue produced at that facility. The interruption of production, therefore, is keenly felt. Preventing this is a major concern.

FM Global has been the primary property and business interruption carrier for Tenaska’s domestic assets since 2001, and the fact that FM Global has consistently met Tenaska’s complicated requirements is a testament to its flexibility and commitment to responding to its clients’ needs.

This supportive relationship helps Tenaska immensely when issues arise, such as changes in gas turbine technology, that might affect its risk profile. Because the client servicing team understands and is able to evaluate the information, the company is confident that it can work through tough issues.

For Tenaska, with its diversity of geographic locations, FM Global’s success in increasing its sub-limits for natural disasters such as hurricanes has been a big plus, and reflects its ability to assess risk, mitigate loss and apply surplus growth in recent years to the benefit of its mutual owners. And the bar is always being raised. By setting and achieving goals to deliver Tenaska’s policy progressively earlier, the company knows exactly what coverage it has in effect at all locations when coverage commences, which is of inestimable value. It would be a challenge to find any other property carrier delivering this kind of service.

The time is now

As the emerging markets’ scramble for a greater share of the world’s raw materials continues to fuel the supply crunch, and prices are forced ever upwards, a long-term strategy for surviving the turbulent times to come should be the primary concern of the power generation industry.

Production disruption in some of the world’s major producing nations results in a painful ripple effect on dependent customers, and the nature of the industry means there is no time in the future when these risks will not exist.

The supply crunch is predicted to continue through to 2012 and beyond, and with every interruption translating into an immediate impact on share prices, the necessity to establish an underlying structure of support cannot be ignored. In other words, if you plan for the worst, there is a good chance that it will not happen.