Raising resources using climate-resilient bonds
The lack of any concrete advances on finance pledges in the recently concluded climate change negotiations in Marrakech amplifies the need for innovation in financing mitigation and adaptation activities, as well as to insure against loss and damage caused by climate change. If Paris was about committing to prevent the rise of temperature beyond 2 degrees Celsius, Marrakech aimed to move the needle on loss and damage. Parties approved a five-year work plan on loss and damage, which, starting 2017, will see countries formally address topics such as the slow-onset impacts of climate change, non-economic losses and migration. However, developing countries are fast realizing that financial support for loss and damage (which is not governed by a legally binding framework) from developed countries is likely to be very small.
Research by the Council on Energy, Environment, and Water (CEEW), in collaboration with the Indian Institute of Management, Ahmedabad, and the Indian Institute of Technology, Gandhinagar, estimates that direct costs of extreme events spurred by climate change in India are $5-6 billion per annum. The associated economic costs and non-economic impacts are several orders of magnitude higher. As India gears up to attract trillions of dollars of investment as part of its development agenda it requires mechanisms to protect these against climate risks.
Extreme events and changing precipitation seem to be the new norm in the India we inhabit. In the last 14 years alone, we have witnessed 131 instances of major flooding, several instances of heat and cold waves as well as major drought. All of these have far-reaching financial impacts. When combined with India’s mammoth renewable-energy targets, and the annually rising adaptation spending, the financial needs are gargantuan. The world, and India in particular, is at a critical juncture in climate history—where mitigation, adaptation, and loss and damage all need to be addressed urgently, and this cannot be done by public money alone. International debt markets, estimated to be around $95 trillion, are the largest pool of capital in the world. Climate-resilient bonds are an innovative way for countries around the world to use public money to drive private investment from these debt markets into the underserved climate-adaptation market, while spreading the impact of loss and damage from climate risk thinly between investors.
Spending on adaptation actions across five sectors—agriculture, forestry, fisheries, water and ecosystems—is estimated at $206 billion by 2030. Adaptation actions across infrastructure (energy, transport, roads, buildings, bridges) and health are likely to be significantly higher. For every $1 trillion of new infrastructure investments, adaptation costs are likely to range from $30-100 billion. For existing infrastructure, adaptation costs could be from 15-20%. Therefore, the adaptation gap for India by 2030 could be around $1 trillion.
A climate-resilient bond could take several forms, most common being a green bond. A green bond channels debt capital for projects with environmental benefits, predominantly for mitigation activities like renewable-energy deployment, which decreases future climate risk.
Another possible form of a climate-resilient bond is a publicly issued bond used to insure against the outcome for a specific climate risk. For example, the government of West Bengal could issue a tax-free—yielding market return—bond for a five-year duration. In case of major flooding due to a rise in precipitation in West Bengal during the duration of the bond issue, the investment is forfeited by the investor and has to be used by the state to cover the loss and damage caused by the flooding. This sharing of liability between investors, and the pooling of resources to hedge against the impacts of climate disasters, opens up a new set of financiers for loss and damage that has historically been tackled by public funds alone. Such a debt instrument would leverage the high government credit rating to attract investors, with the market interest rates compensating for the climate risk being passed on to the investor.
Another efficient form of climate-resilient bonds is when the funds raised to protect against climate risks are used for adaptation activities. This form of climate-resilient bonds combines two important aspects, one of borrowing from the debt market for climate projects, and the other of sharing the climate risk between multiple individual investors.
Such a bond would require public money to pay market or higher rates of return on the investment, which would be used for adaptation projects such as flood barriers that reduce the loss from climate disasters. In case of a climate disaster, the bond investors forfeit their capital up to the limited liability of their investment. In the absence of a disaster, the climate-resilient bond would work like any ordinary debt instrument with the capital and interest paid out in accord with the terms of the bond issue.
As the likelihood of climate disasters goes up, the need to mobilize additional finance to both address the losses from the disaster, as well as adapt to the likelihood of growing climate impact is imminent. For instance, on a high-emission pathway, the incidence of extreme drought affecting crop land could increase by about 50% in South Asia. In order to transition away from such a high-emission pathway, as well as adapt to existing and future climate impacts, governments would have to test and promote several permutations of existing and additional financial instruments.
While developing countries need to continue seeking clarity on the pathways of financial support under the UN Framework Convention on Climate Change (UNFCCC) regime, they cannot wait for it. Climate risk is real, and it is growing. We all must share the burden, and act now.
Kanika Chawla and Hem Himanshu Dholakia are, respectively, senior programme lead and senior research associate at Council on Energy, Environment and Water (CEEW).