Three financial tools that could change the climate finance world

Three financial tools that could change the climate finance world

By Caroline Fouvet

The OECD estimates that climate-induced market damages could rise to over 3% of global GDP by 2060. Innovative financial tools are necessary to address these risks and limit the cost of climate change impacts. But in order to tackle a problem as complex as climate change, new financial tools are needed. Here I present three of the most promising financial instruments that could change the world.

Contingency finance and insurance

Contingency finance is essentially emergency insurance that pays out quickly in times of crisis. It enables countries and individuals to react in the aftermath of a disaster and improves their responses to unforeseen shocks. Establishing contingency funds is a way to disburse funding at a faster pace in a post-disaster situation than only relying on the mobilisation of humanitarian assistance. The African Risk Capacity (ARC) for example is an index-based sovereign risk insurance pool and early-response mechanism of the African Union that combines the concepts of insurance and contingency planning. Governments receive pay-outs from the ARC Insurance Company Ltd. to implement pre-approved contingency plans targeting extreme weather events and natural disasters. At the micro level, microcredits can also provide recovery loans after small income shocks to poor households.

Private finance

Public authorities can boost the investment in climate adaptation project by providing incentives to private investors. The recent emergence of resilient bonds, as part of the Re.bound finance programme launched by Goldman Sachs, RMS and Swiss Re, is an illustrative example. Based on the catastrophe bond model – high-risk debt instruments that secure cash flows to insurers covering financial losses triggered by climate-induced disasters – resilient bonds also provide resilience benefits for disaster-prone cities. Investments in local climate resilient infrastructures could be priced as they reduce the risk of a climate-related disaster. This reduction in vulnerability would be then captured in a lower premium paid to investors, called a resilience rebate, that could then be used by cities to fund additional projects that further advance community resilience.

Climate bonds

Climate bonds can also increase the amount of money available to climate-proof infrastructure and resilient cities. They are the largest subcategory of the emerging green bond market, which could reach US$ 120bn in issuance this year. These debt securities are issued by corporations, state-owned companies and multilateral development banks and are traditionally purchased by large institutional investors like pension funds. Mexico City airportfor instance issued climate bonds in 2016, for a total value of US$ 2 billion. Issuing climate bonds for adaptation purposes has great potential for growth as it represented just 5% of total green bond issuance in 2016.

Successful climate adaptation will require a wide range of financial instruments to be mobilised. To do so, governments will have to incentivise private sector investors, and raise awareness of the opportunities arising from climate-resilient investments.

Cover photo by Adrian Cable (CC BY-SA 2.0)

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