Here are promising strategies for addressing climate adaptation with green bonds
This article is the first in a three-story series culled from the MMC Climate Resilience 2018 Handbook (PDF) and originally published on Brink.
To date, "green bonds" have been seen as the primary vehicle for environmental or social impact in the fixed-income market. Green bond issuance has grown significantly since the market was initiated in 2007, with offerings by the European Investment Bank and the World Bank.
In 2017, total labeled green bond issuances — those explicitly marketed by issuers as green and many receiving third-party verification of their "greenness" — amounted to $221 billion in debt outstanding. An additional $674 billion has been identified as "climate-aligned" by the Climate Bonds Initiative (PDF), bringing the total market for such debt to nearly $900 billion.
The vast majority of projects financed by green bonds have been focused on achieving climate change mitigation goals via low-carbon energy installations or public-transport initiatives to reduce greenhouse gas emissions. But a less frequently considered (if arguably just as critical) element of the climate change investing equation is the need for climate adaptation — initiatives that anticipate, plan for and adapt to the changing climate and its impacts. Examples include altering coastal infrastructure for anticipated sea level rise or implementing green roofs and permeable pavements to reduce heat island effects in cities.
The growing need for adaptation
Even if global warming is limited to 2 degrees Celsius by the end of this century, some significant level of change to historical weather patterns and sea levels is expected over this time frame.
Indeed, leading research — and recent events in California and the Caribbean/U.S. Gulf Coast — indicates that these impacts already are materializing. Although such impacts are notoriously difficult to quantify, the United Nations Environment Programme pegs the annual requirement for investments in climate adaptation at $56 billion to $76 billion per annum in 2015, increasing to anywhere from $140 billion to $300 billion per annum in 2030 (PDF). This equates roughly to an aggregate requirement of between $1.5 trillion to $3 trillion over the 15-year time period.
To date, actual and future committed public finance for climate adaptation has fallen woefully short of the estimated need.
Although data is limited, it appears as though private finance is not being mobilized adequately to fill the remaining gap. Evidence of such limited commitment to adaptation can be found in the green bond universe where only 3 percent to 5 percent of issuances have been tied to an adaptation-related project, all in the water sector. This despite the fact that the Green Bond Principles (PDF) acknowledge the application of bond proceeds to support "climate change adaptation (including information support systems, such as climate observation and early‑warning systems)" and that the Climate Bonds Initiative includes in its taxonomy an adaptation section (albeit unfinished).
How to close the financing gap
The reasons for the adaptation-financing deficit are manifold, and solutions will not come easily. But there are some promising subsegments in the global bond market for investors looking to diversify their sustainable investment portfolios with climate change adaptation solutions:
- Catastrophe bonds: Insurance-linked securities (ILS), in particular publicly traded catastrophe bonds, represent a compelling opportunity for investors to support financial resilience in the face of the multiplying physical impacts of climate change. While most ILS issuers today are commercial insurers, a growing number of such transactions are originating from public-sector insurers, nonfinancial corporations and public entities, many of which have at their core a social mission. The ILS market today is small — 30 times smaller than the climate-aligned bond market at just $30 billion in debt outstanding — but the capacity of the global capital markets to assume more weather and catastrophe risk is immense. This capacity could be put to use plugging the widening catastrophe insurance gap, although a broader array of corporate and public-sector issuers first will need to recognize the merits of ILS in helping them manage contingent weather/catastrophe liabilities.
- Environmental impact bonds: Social impact bonds are not all structured as bonds per se and so defy simple aggregation, but by most estimates they represent a very small investable market (less than $1 billion in total issuance outstanding). These bonds follow a "pay for success" model whereby investors receive a higher rate of return if a certain predetermined social objective is met. Recently, the DC Water and Sewer Authority issued what is believed to be the first environmental impact bond globally, the proceeds of which will be used to support green infrastructure improvements (such as permeable pavement). If stormwater runoff reduces by a certain amount in the years post-issuance, then investors will receive a one-time additional payout (PDF) when the bond reaches maturity.
- Resilience bonds: While resilience bonds are still just a concept, the elegance of the solution has distinct appeal, and several pilot programs are rumored to be in the works. In short, a resilience bond would act as a catastrophe bond for a municipality but with a built-in contingent premium discount for the issuer based on the completion of an infrastructure improvement, which would make the covered location(s) less susceptible to damage from the covered peril(s). Using premium discounts to incentivize long-term decision-making for individual policyholders is a time-worn concept in the personal insurance industry, although it has yet to be applied effectively in the catastrophe bond market.
While the above investment categories are all currently small (or as yet nonexistent), the building blocks for global investing in climate change adaptation are in place.
Scaling these opportunity sets will be essential, as the need to move more dollars rapidly into climate finance to support adaptation is clear. This need will increase as global temperatures continue to rise.