Climate change adaptation financing can benefit from partnership with ILS

Climate change adaptation projects and the need for them are rising up the agenda, as a recent surge in damages from severe weather and climate related catastrophe events concentrates the mind on the importance of investing in this area.

Public authorities are showing renewed and increasing interest in climate adaptation, while they are also more aware than ever of the need for investment to support the ultimate goal of a more resilient society.

However, while investments into climate change adaptation projects are flowing, they aren’t anywhere near sufficient to deliver the significant progress required to actually increase the resilience of the regions of the world facing the highest climate related risks.

While climate change adaptation, resilient infrastructure and other trends have become hot topics, the data shows that it isn’t where the bulk of the money is flowing to.

S&P Global Ratings explained that just 6% ($34 billion) of all climate change related investments globally (which in 2018 totalled $546 billion) were focused specifically on adaptation projects.

In fact, 94% of climate change related investments are focused on mitigation instead, S&P highlights using data from the Climate Policy Initiative.

While this is clearly imbalanced, a shift is beginning, according to S&P, who said that a year earlier in 2017 just 4% of the investment flowed into adaptation projects.

The rate of investment in climate change adaptation is expected to increase going forwards, but in order to deliver the progress that is required, as rapidly as it is needed, a partnership approach between different areas of finance will be required, with an opportunity for insurance-linked securities (ILS) and other forms of reinsurance-like risk transfer to the capital markets set to emerge.

While there is an increasingly urgent need for more climate change adaptation financing in developing countries, the need is also there for the more advanced economies of the world as well.

In developing countries, the United Nations currently estimates that up to $300 billion will be required to finance adaptation by 2030, rising to up to $500 million by 2050.

It’s significantly more capital than is being made available for climate change adaptation today and one of the reasons for that is the risks inherent in these investments.

The climate related exposure within investments in infrastructure projects for adaptation, for example, is significant and the key may be in finding partnership ways to carve out or manage those risks, with risk transfer to the capital markets a potential avenue.

Without adaptation it is estimated that growth in global agricultural yields could be reduced by as much as 30% by 2050 and over 100 million additional people around the developing world could be pushed below the poverty line by 2030.

As governments struggle to make the necessary investments available, harnessing private investment capital to fund adaptation is urgently required, providing an opportunity for hybrid financial tools to be developed that can deliver on funding as well as resilience linked risk transfer.

S&P explained that, “Introducing financial instruments that demonstrate a strong link between investment returns and resilience benefits could further help uptake in private sector adaptation investments.”

We’ve covered in detail before projects such as the one to develop a “resilience bond” which proposes a hybrid tool that would enable financing of resilient infrastructure risks, while also enabling transfer of the underlying peril exposures to investors through a catastrophe bond like structure.

The concept has been around for a number of years now, but has yet to be put into practice in any major projects. But the idea of enabling risk to be managed through transfer to the capital markets (akin to a cat bond or reinsurance), while being reduced through the development of the resilient infrastructure and investor coupons reflecting the reducing risk at the same time, is potentially a sound one.

To-date the structure has not got beyond the conceptual stage, but as the need for climate change adaptation financing and infrastructure projects keeps on increasing and the urgency in funding these rises, there is every chance further innovation helps to develop a structure that is both effective and palatable to capital market investors.

Overall, climate change adaptation projects are expected to reduce damages from climate linked catastrophes and severe weather events, therefore it is in the interest of the world’s largest investors to support such financing needs, to better insulate their own portfolios.

That’s not to mention the social, ecological and also economic benefits of climate adaptation investing, as well as the potential to reduce issues such as business interruption which often stem from a lack of resilience.

The secondary financial benefits could be huge, if private capital can be channelled into adaptation project investing.

To meet the financing need, projects may have to look beyond typical investment sources.

“We expect that due to the large size of the adaptation gap and constrained public finances, other sources would need to make considerable contributions to adaptation financing,” S&P explained.

Adding, “Therefore, we see the need to attract private finance in this area, especially given the number of investors interested in opportunities in climate finance.

“We believe that the ability to demonstrate the resilience benefit of such projects through robust modeling will be an important catalyst.”

If the resilience, or reduction in risk, can be clearly evidenced in data output from risk and financial models, it may be possible to find ways to dovetail the benefits of risk transfer and reduction into the financing structure, finally finding a way for the ILS structures that already facilitate climate risk transfer to work in harmony with adaptation financing.

“One of the key challenges to facilitating private sector financing is that, often, upfront financing is required (either at the design or construction phase), but the payback only occurs much further down the road,” S&P continued, before concluding that, “Addressing these challenges is likely to require a partnership model, incorporating transferring risk to the capital markets (insurance, catastrophe bonds, or other derivative instruments), together with contingent financing from multilateral institutions and governments.”