VIEW: On the importance of adaptation financing

Exacerbated by climate change, the frequency and severity of extreme weather events are increasing. As such, the need for adaptation projects – those that strengthen the resilience of buildings, critical infrastructure and communities against these climate-related risks – has garnered increasing attention.

Adaptation projects often generate returns at a multiple of their cost, but the sheer size of the adaptation financing gap, the enormity and complexity of such projects, and constrained public finances are all hindering development. While increased engagement from the private sector would ultimately lessen the financial burden on public sector entities, private investors face their own set of risks and difficulties in assessing the long-term returns associated with investing in adaptation projects.

But if the benefits of such investments can be quantified in financial terms, as well as environmental, we believe that a strategic collaboration between public and private sector financing could become the most likely path to success. For the insurance sector as a whole, adaptation projects provide opportunities across both sides of the balance sheet. Investment in adaptation can offer a certain level of cost-effective protection against physical damage caused by extreme weather – something we define as a ‘resilience benefit’. Indeed, investment in improving early warning systems against natural disasters can generate returns of almost 10 times their cost. The consequent economic disruption from severe weather events can often extend beyond the affected region through global supply chains.

The 2011 floods in Thailand, for example, impacted global technology and car production because the manufacture of key parts was concentrated in the flooded area. Consequently, over 50% of insured losses, totalling over £12bn, stemmed from business interruption claims. Areas that invest in adequately protecting themselves against extreme weather events may also see considerable secondary financial benefits as improved resilience may promote economic development. Between 2017 and 2019, weather-related insurance pay-outs were the equivalent of £222bn globally – the highest 24-month figure on record. Reduced natural catastrophe risk, therefore, could support decreased insurance costs, bringing yet further indirect financial benefit.

The adaptation finance gap Yet despite a general acknowledgement of the urgent need for climate adaptation projects among public authorities, including in countries such as Bangladesh, Indonesia, the Philippines, and densely populated areas of the US, such as Boston and New York, implementation is slow. While authorities may be under scrutiny if they fail to develop the adaptation infrastructure necessary to protect communities from climate-related damage and disruption, the challenge of effective adaptation design that delivers the expected benefits, compounded by potential negative social impacts to communities, may deter authorities from pursuing adaptation projects.

The often slow implementation is, at least partially, due to the high costs involved – and in times of strained public finance, these projects are unlikely to be high priority. In fact, to meet resilience needs, current adaptation financing needs to increase substantially. In 2018, about 6% – or £27bn – of total global climate change investments focused on adaptation projects. The United Nations Environment Programme, however, estimates that this investment will need to increase by 4x-9x by 2030 to meet resilience needs, highlighting a significant gap in adaptation finance which public entities cannot achieve alone.

Against this backdrop, we believe that there is a need to attract private finance support in this area – especially given the interest in climate finance opportunities among the investor community. Private investment in climate change adaptation, however, is currently around a modest £404m, with significant room for growth. In order to engage the private sector and bridge the current climate adaptation financing gap, it is vital that the resilience benefit of such investments is quantified in financial terms. Despite the difficulties in doing so, private investors must be able to justify the allocation of capital to projects whose benefits may only emerge many years in the future.

One way to calculate the resilience benefit of an adaptation project could be to estimate the reduction in expected damages that the infrastructure funded by the green bond is designed to achieve over the targeted period. If the cost benefits are clearly outlined in this way, private investors could be more inclined to engage and seek opportunities, such as transfer of risk to the capital markets in the form of insurance, catastrophe bonds, or other derivative instruments, as well as the support of contingent financing from multilateral institutions and governments. Meanwhile, constrained public finance would receive the boost needed to achieve widespread resilience against the ever-increasing effects of climate change.

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