The challenges of deploying complex financial products in the face of climate change

The challenges of deploying complex financial products in the face of climate change

By Laura Canevari

As countries respond to the COVID-19 pandemic, important lessons for climate action have started to emerge. In a recent article in Bloomberg Green, Kate Mackenzie reflects on the challenges of deploying complex financial products designed to attract investors and helping actors share the risks generated by large-scale disruptions.

Such is the case of pandemic bonds, a financial instrument inspired by catastrophe bonds and released by the World Bank in 2017 following the Ebola outbreak. These bonds are being triggered as a result of COVID-19; yet it seems that they are failing to provide the desired results in terms of rapidly mobilising resources to ensure an earlier, faster, better-planned and coordinated response.  In fact, it seems that the outbreak of the coronavirus pandemic failed to trigger pay-outs from these bonds in time to help countries avoid the worst outcomes. As noted by Tracy Alloway, former World Bank economist, “It has to be at least 12 weeks after the beginning of the outbreak before anything can be triggered […]. So that means it’s triggered much too late”. According to another Bloomberg source, due to their archaic structure, it has taken a total of 122 days since the start of the outbreak to unlock these bonds.

As noted by Tracy Alloway, the problem with the parametric risk financing mechanism is that “if it’s triggered earlier, the price of the insurance would be much higher because there is just so much uncertainty in the modelling”. This ultimately means delaying much needed early action in recipient countries and just as it is difficult to anticipate how an epidemic starts, it is also challenging to define when impacts triggered by climate change start being felt – especially in countries that lack adequate data on climate hazards.

Another problem presented by these bonds is that many resources that should be delivered as development money to the poorest countries ($115 million in total in the case of pandemic bonds) are being used to pay premiums, fees and interests to recipient investors; most (if not all) of which are in high-income countries. This means that the remaining resources have to be split between a large number of developing nations and will most likely be unable to satisfy their needs to respond to the outbreak.

Ultimately, mechanisms developed to share, mitigate and/or cope with certain risks (be it climate change or a pandemic) should not become a bottleneck; nor should they delay much needed early action. They need to be effective and speedy in delivering resources where these are most needed.

As countries continue to explore risk-sharing market mechanisms to deal with climate change, it will be important to closely examine whether these mechanisms truly deliver the results that they promise; and to consider what other investments are required in order to ensure that they can operate successfully. In the case of natural catastrophe bonds – which pay out in response to insurance claims from events such as hurricanes- it will be important to improve data collection and climate analytics in developing countries in order to reduce the levels of uncertainty of disaster risk models. Additionally, information systems that can assist a government’s ability to reach the most vulnerable during a crisis should also be strengthened. Moreover, building capacity at the local level for early intervention should be promoted alongside the deployment of any other risk management strategy. In the case of climate adaptation, we know that climate-proofing assets and infrastructure also means good business (e.g. it is estimated that for every dollar invested in climate-resilient infrastructure, six dollars are saved).  It is also unlikely that risk-sharing mechanisms will be able to cover losses from future (and more intense) climate events unless countries work on building their climate resilience, as these losses may become too unbearable.

Cover photo by NOAA on Unsplash.

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