By Maya Dhanjal
There is a rising cost associated with economic damages related to climate change with 2019 being the most expensive year to-date and expected to only get worse. Governments who are mainly responsible for providing this funding are strapped in their ability to mobilise and manage emergency funds. Resilience bonds provide a unique opportunity to hybridise principles in debt securities and insurance policies and ultimately divert available funds into climate-resilient projects that will enhance adaptive capacity, particularly for long-lived infrastructure assets that have to face the test of time and a changing climate. Conceptualised in a RE.bound white paper back in 2015, the resilience bond has now been successfully put into practice .
Extreme weather events are becoming more frequent and severe thanks to climate change. In 2019 alone, the world stood witness to devastating bushfires in Australia, Venice’s worst flooding in 50 years, and Japan’s biggest storm in decades. In 2019, the United States of America, where data on cost incurred per natural disaster is most available, suffered 409 natural catastrophe events resulting in economic losses of $232 billion.
2010 to 2019 was the most expensive decade of global economic losses resulting from events caused by climate-related natural disasters, exceeding $2.98 trillion – $1.19 trillion higher than the preceding decade.
Given these numbers, the most pressing question is: Who bears the cost of such damages? Taxpayers? Businesses? The insurance industry? Historically, the cost of damages to the environment, such as pollution, have been treated as an “externality” in our economic models – continuously passed onto those who can least afford it, not to mention those who least contributed to it. As the frequency and associated costs of catastrophic climate-induced disasters increase over time, governments are finding themselves in a reactionary position, and strapped in their capacity to disburse emergency funds, let alone manage and coordinate them.
This is not exclusive to climate-related events – in response to the economic fallout from COVID-19, developed nations worldwide are expected to provide a financial stimulus which will only further tighten their hands and potentially purse strings from a fiscal policy perspective. So how will governments manage financing the exorbitant and rising costs of climate change? One solution is to transfer the risk to capital markets via a resilience bond.
What is a resilience bond?
Resilience bonds are a novel insurance product developed and authored in 2015 by re:focus partners in collaboration with other members of RE.bound. They were inspired from catastrophe (or “cat”) bonds which are a debt instrument designed to raise capital for insurance companies (who arguably are the best-equipped at handling risk of loss, translating hazard into damage and damage into cash) in the event of a natural disaster under a trigger event, such as an earthquake or tornado. In the case of resilience bonds, the capital raised would be specifically earmarked for projects that increase resilience to climate change, such as sea walls to combat sea-level rise or building shelters in cyclone- and typhoon-vulnerable areas.
If you got confused reading the first sentence of the above paragraph and asked: “wait – how can resilience bonds be an insurance product?”, you have come to the right place.
Let’s take a step back and quickly review bonds: bonds are a fixed income/debt instrument that an issuer (such as a government or large corporation) sells to raise capital for projects. These projects typically require large sums of liquid cash that the issuer does not have on-hand but needs, so they go to the capital markets to obtain it. When the issuer sells the bond to investors, they raise that liquid cash needed to cover a project. Issuers are now happy. Over the lifetime of the bond, issuers will provide interest (aka “coupon”) payments to the investor which incentivises investors to have parted with their liquid cash in the first place. More often than not, this means that once the bond has matured, investors not only receive back their principal investment but also the accrued interest over of the lifetime of the bond which results in a return on investment. Investors are now happy.
Now that we have covered how a bond works, we can apply the above principle to understand how a resilience bond raises capital for climate-resilient projects. However, what happens if a trigger event occurs over the lifetime of a resilience or cat bond? That would naturally disrupt the interest payments that an investor is due to receive until maturity, so how does pay-out work? This is where the insurance policy bit kicks in and why resilience and cat bonds, albeit have the word “bond” in the title, do not operate like traditional treasury or municipal bonds.
Similar to an insurance policy, once a trigger event such as a typhoon or flood occurs, the resilience bond will pay out cash to those who can cover the costs incurred from economic losses, which as previously mentioned are typically insurance companies who would be best equipped to manage and disburse proceeds from the resilience bond. Is it still worth the investment to investors if the bond will not pay out money to them after a trigger event? In one sense it would be twisted for an investor to look forward to a pay-out of funds after a catastrophic climate event. In another sense, investors who put money into climate-resilient projects that will likely withstand harsher conditions and still economically provide after a trigger event will be considered a smarter investment in the long run.
Re:focus authors best explain that just as a life insurance policy has reduced premiums for interventions that reduce overall risk (such as quitting smoking or exercising regularly), resilience bonds have reduced premiums for climate-resilient interventions that reduce economic losses from disasters over the term of an asset (such as seawalls or flood barriers). So, what is a marriage of sorts between a fixed income instrument and an insurance policy, resilience bonds respectively not only provide financing for projects that aim to increase resilience, they also provide a certain coverage against climate-induced disasters. However, as the re:focus authors warned, just as life insurance does not actually make you physically healthier, resilience bonds do not actually reduce physical risks, rather they reduce the financial consequences for asset owners.
How does a resilience bond raise money for climate-related disasters?
To understand how a resilience bond reduces the financial consequences for assets owners, it is imperative to review how a resilience bond is priced. Issuers use financial models to determine the price of resilience bonds on two levels: in the situation where a trigger event (which has a predetermined threshold, such as a 10-foot surge or $1 billion in economic losses) occurs with the resilience project, and in the situation where a trigger event occurs without the resilience project. Since a resilience project by nature will reduce the chances of a trigger event incurring damages, resilience bond investors are willing to accept a lower coupon payment after the project is completed (lower risk = lower coupon payments). This difference in coupon payments (with versus without a resilience project) therefore represents the financial value of a resilience project which is captured in the form of a resilience rebate. This resilience rebate will ultimately be used to finance risk reduction investments which includes covering economic losses from a trigger event and alleviating the burden from budget-constrained governments to cover these vast costs.
Not only do resilience bonds provide a reduced investment risk to investors once a project is complete, they also provide financing to governments for risk reduction investments that will reduce exposure and build resilience over the long-term.
Say there is no trigger event over the lifetime of the bond – investors recoup their principal investment as well as their regular coupon payments under the “bond” principle. Now, say there is a trigger event over the lifetime of the bond – policyholders of the bond will retain the full value to pay off the losses, leaving investors either a portion or none of the cash they initially invested under the “insurance policy” principle. This does not sound ideal for an investor to lose all of their investment; however, this article will conclude with why an investor in their right mind would engage with this capital markets product in the first place. For the meantime, it can broadly be said that investors of resilience bonds are typically institutional investors with large, diverse, and robust portfolios, and have a higher risk appetite for a higher return on their investment.
The world’s first resilience bond
The first resilience bond was issued in 2019 by the European Bank for Reconstruction and Development (EBRD): a five-year climate resilience bond rated AAA (by Moody’s/S&P/Fitch) at 1.625% which raised US$700 million. The first orderbook’s distribution statistics saw demand from 15 countries (58% from Europe, 28% from North America and 14% from Asia) from over 40 accounts (32% asset managers, 31% central banks/official institutions, 28% banks, 9% insurance and pension funds).
The bond was actually oversubscribed by $200 million which demonstrates strong investor appeal so much so that the demand exceeded the supply. As mentioned earlier that bond proceeds must be earmarked for specific resilience projects, EBRD has developed a €7 billion portfolio of adaptation-related projects under which funding can be made available, including climate-resilient infrastructure (such as the Qairokkum hydropower plant in Tajikistan), climate-resilient business and commercial operations, and climate-resilient agriculture and ecological systems (such as the Saiss water conservation project in Morocco).
The bond is also aligned with the four core principles of the Green Bond Principles including: use of proceeds, process for project evaluation and selection, management of proceeds, and reporting. By having these overarching principles, the climate bond market demonstrates and actively promotes integrity, transparency, disclosure, and reporting. It would be difficult to name one institutional investor or pension fund that does not have a demand for that kind of data. Not only does the EBRD bond adhere to the Green Bond Principles, but the projects earmarked for the “use of proceeds” are aligned with the Climate Resilience Principles (CRP) by the Climate Bonds Initiative (CBI). Fun fact: CBI convened an Adaptation and Resilience Expert Group of which our own Acclimatise CEO, John Firth, sits on. As EBRD was the first issuer to use the CRP to structure their climate resilience bond, EBRD gained the first-mover advantage which will hopefully motivate others to support climate resilience.
As amazing as this innovation is, one recurring and fair concern investors have on the climate bonds market is the monitoring, reporting and evaluation of the bond proceeds, and whether the bonds truly do demonstrate attractive, if not stronger, returns – which leads us to the future of climate bonds.
The future of climate bonds
Given this financial product has not been around long enough to amass robust data, it is hard to gauge the value of the resilience bonds market. However, on pace with other green products, the climate bonds market has an estimated value of $346 billion, while the cat bonds market has an estimated value of $30 billion. Therefore, the demand for resilience bonds is expected to grow rapidly.
There are likely an array of reasons why demand is rising. We are seeing an increased demand from institutional investors and fund managers with an appetite for stable or ESG-integrated investments. Institutional investors (who are the primary buyers of climate bonds) are pouring money into green investments for the following reasons:
Climate bonds offer an attractive interest rate.
An interesting phenomenon is happening in Europe at the moment – there is around €15 trillion of bonds trading at a negative interest rate. Think about that. A bond offering a -0.5% interest rate? It seems weird to have negative rates (meaning the investor has spent more money for a bond than its value), but that is the reality. In fact, earlier last week, the United Kingdom government for the first time in history sold a treasury bond that pays a negative yield. And negative-yielding bonds typically lose money for bondholders. Climate bonds, on the other hand, are not trading at a negative rate and with negative interest rates expected to stay down in the economy at the moment, bond markets are making resilience bonds more attractive to investors.
Climate-resilient projects are financially viable and will make money.
Although climate bonds are on par with other bonds (meaning they are not necessarily cheaper or more expensive), they are rated the same way as other bonds. When rating agencies such as Moody’s or S&P assign credit ratings to bonds, they are concerned with default risk or missing interest payments because their rating is based on cash flow generation – not environmental or climate factors. To assess cash flow generation, rating agencies look at the financial health of the issuer. Issuers will receive a credit rating, and given that many issuers are governments (for example EBRD’s AAA-rated climate resilience bond was backed-up and guaranteed by the European Bank), rating agencies will assign AAA status which is the highest rating due to the little chance of default.
Investors have an increasing moral appetite to invest in ESG-related products
Ceteris paribus, the opportunity
cost of investing into a climate bond is relatively the same when compared to
investing into another debt security. However, climate bonds are emerging as a
preferred investment because of the moral aspect – investors want to see their
money put towards climate change and resilience. What with markets crashing
from COVID-19, many are realising that money needs to be spent more mindfully
to ensure we prevent massive pay-outs that could have been avoided down the
line. This realisation is evident with the rise of many industry-led
initiatives that champion climate integration into financial systems and
services, such as signatories to the UNEP FI Principles for Responsible
Banking, Taskforce on Climate-related Financial Disclosures pilots, Net-Zero
Asset Owner Alliance, Global Reporting Initiative, Network for Greening the
Financial System, Principles for Responsible Investing, and more. In fact,
pension funds who have a fiduciary duty to consider climate-related risks are
growing their appetite for these kinds of products such as Canada Pension Plan
Investment Board (CPPIB) with $420.4 billion AUM who issued their inaugural
green bond back in 2018. And more recently than that, a BlackRock study this
week found that in the first quarter of COVID-19’s market drop, 94% of
sustainable indexes outperformed traditional ones. The data is starting to
catch up to investor ears and they are listening.In conclusion, resilience
bonds are an innovative capital markets product that possess the ability to finance
climate change adaptation by providing liquid cash for risk reduction
investments, as well as actively build resilience while providing a return on
investment to investors. They are inspired from cat bonds and work similarly to
insurance products rather than traditional bond products, yet resilience bonds
(unlike cat bonds) have earmarked proceeds for resilience projects, which can
be aligned with the Climate Resilience Principles. Having these industry-wide
initiatives such as CRP and even the Green Bond Principles ensure transparency
and provide more data to investors who are increasing their appetite for
ESG-related products. The first climate resilience bond was issued by EBRD and
its oversubscription is another clear indication of the strong demand (particularly
across Europe and Asia from governments and institutional investors) for these
green products. This demand, alongside the financial strength and growth of the
broader climate market in general (such as green bonds or ESG investing) and
their outperformance of other products, indicate the potential of climate
resilience bonds as an effective tool to build resilience. Although climate
bonds have yet to establish themselves as a systemic response and solution to
the changing climate of both our world and global economies, they represent progress
towards a future that is aligned with the Paris Agreement and a resilient
future with adaptive capacity to deal with the extreme effects from climate