EXPLAINER

Ways to Pay for Climate-Related Loss and Damage

Estimated losses from extreme weather events, such as severe storms and flooding, run in the billions of dollars. Credit: ADB
Estimated losses from extreme weather events, such as severe storms and flooding, run in the billions of dollars. Credit: ADB

Various financial schemes have been developed to cover some of the risks of loss and damage associated with climate change impacts.

Introduction

Over the period from 1980 to 2015, the Munich Climate Insurance Initiative recorded approximately 16,600 extreme hazard events around the world, the bulk of them being meteorological (e.g., tropical storm, extratropical storm, convective storm, local storm), hydrological (e.g., flood) and climatological (e.g., extreme temperature, drought, forest fire) in nature. While most of these events (56%) were recorded in high and upper middle income countries, most fatalities (76%) were recorded in lower middle and low income countries. This set of events gave rise to a total estimated loss of approximately $3.2 billion, of which 74% was accounted for by high and upper middle income countries, and 26% in lower middle and low income countries. However, almost all insured losses were recorded in high and upper middle income countries, with almost none in lower middle and low income countries.

Source: Adapted from P. Hoeppe. 2016. Climate Risk Insurance for the Poor and Vulnerable: Principles for “InsuResilience.” Presentation at the Munich Climate Insurance Initiative Side Event, Boon Climate Talks, May 2016.

The risks of loss and damage associated with climate change impacts are of a numerous nature, and increasing. Various financial instruments have been developed to address some of the risks. None of the instruments can, however, address in a comprehensive manner all risks of loss and damage. Challenges remain in developing new types of instruments.  

Existing Financial Instruments

The Warsaw International Mechanism for Loss and Damage associated with Climate Change Impacts refers to five categories or groups of financial instruments for addressing the risk of loss and damage associated with climate change impacts. Table 1 describes each category and provides examples. Table 2 identifies some of the advantages and challenges for each group of instruments.

In this video, Shereen D’Souza, co-chair of the Executive Committee of the Warsaw International Mechanism for Loss and Damage, gives a brief overview of financial instruments for addressing climate-related loss and damage.

 

Table 1: Five Categories of Financial Instruments for Addressing Loss and Damage Associated with Climate Change Impacts

Category

Description

Examples of Instruments

  1. Risk transfer, risk pooling, index-based insurance schemes

Risk transfer instruments are used when risks cannot be prevented or reduced or when risks would be too large for companies or individuals to cover on their own. These allow risk holders to transfer some of their financial risks and/or losses to the insurer in exchange for an insurance premium.                             

A particular type of risk transfer instrument is an index-based scheme where payout is triggered by pre-determined conditions (such as a temperature or rainfall threshold), instead of being triggered by the occurrence of loss and damage.        

Risk pooling enables risk holders to gain efficiency by bundling risk. In schemes applied to affected areas or countries, the risk holders would have access to collective reserves, which can sometimes take the form of a fund contributed by countries and used according to need. 

  • Various financial instruments linked to risk reduction measures, such as insurance, credit, and savings.
  1. Catastrophe risk insurance

This protects against low-probability, high-cost events that can result in an extremely large number of claims being filed at the same time and at unpredictably high costs.

  • Catastrophe reserve funds   
  • Insurance-linked securities                 
  • Group insurance
  1. Contingency finance

This is aims to be a fast-burning finance opportunity by setting aside funds to finance activities in emergency situations. It can provide financial resources in the form of grants (e.g., relief fund) or loans (e.g., contingent credit) in the immediate aftermath of a natural disaster.

  • Contingency fund
  • Social protection schemes
  • Disaster relief fund
  • Restoration fund
  • Contingent credit
  • Microcredit, micro savings, micro grants
  1. Climate-themed bonds

These are debt securities used to finance projects related to addressing climate change. In most cases, the bonds are largely issued by corporations and multilateral development banks. Purchasers are mostly institutional investors.

  • Climate bonds
  • Standard and certification schemes
  1. Catastrophe bonds

Also known as “cat bonds,” these are high-yield debt instruments that are usually insurance-linked, in order to secure cash flow in case of a disaster. Cat bonds include a special condition stating that if the issuer suffers a loss from a particular pre-defined catastrophe, then the issuer’s obligation to pay interest and/or repay the principal is either deferred or completely forgiven.

  • Catastrophe bonds
  • Ex-post bonds

Source: Adapted from UNFCCC. 2016. Best Practices, Challenges and Lessons Learned from Existing Financial Instruments at All Levels that Address the Risk of Loss and Damage Associated with the Adverse Effects of Climate Change. Executive Committee of the Warsaw International Mechanism for Loss and Damage. Bonn.

Table 2: Advantages and Challenges of Different Financial Instruments for Addressing Loss and Damage Associated with Climate Change Impacts

Instrument

Advantages

Challenges

Risk transfer, risk pooling, index-based insurance schemes

  • Suitable for sudden and unpredictable events.
  • Helps to spread losses widely, across time and stakeholders.
  • Encourages rigorous risk assessment and management.
  • Index-based insurance reduces administrative costs, which could result in lower insurance premiums. It also enables more reliable and timely post-disaster relief, since loss assessments are not required.
  • Less applicable for slow-onset events.
  • Lack of access to data, information asymmetries (causing moral hazard and adverse selection), transaction costs, and enforcement challenges constrain development of new insurance markets.
  • Potentially high premium levels relative to willingness or ability of beneficiaries to pay when risks are changing.

Catastrophe risk insurance

  • Provides opportunity for enhanced finance, if leveraged through public-private partnerships, and pooled across wide areas.
  • Enables rapid payouts after catastrophes.
  • Requires high-quality catastrophe risk models
  • Often requires a high deductible.
  • Difficult to apply to slow-onset events.
  • May create moral hazard problem: holders may have reduced incentives to reduce risk.

Contingent credit

  • Fast-disbursing finance opportunity.
  • Limited availability for poorest countries as loans increase debt.

Disaster relief fund

  • Potential for improving efficiency of use and scale of financial resources is greater when linked with insurance.
  • Implementation often suffers from inadequate budgeting and funding in developing countries.

Social protection schemes

  • Can increase adaptive capacity, prevent and reduce risks, and enhance livelihoods.
  • Linking social protection schemes with insurance can improve efficiency and cost-effectiveness of both financial instruments and bears potential for innovative and effective approaches for loss and damage.
  • Can address both extreme and slow-onset events.
  • Often suffer from inadequate funding.
     

Micro credit

  • Suitable for relatively small shocks.
  • Linking with (micro) insurance could prevent overindebtedness due to extremes and bears potential for innovative and viable solutions.
  • Credit may increase vulnerability of households because of liabilities.
  • Long-term planning and investment is difficult for those struggling to meet basic survival needs.

Micro savings

  • Effective for relatively small income shocks and to be used for reconstruction or reacquisition of assets.
  • Links to sovereign insurance schemes can enable rapid, funded scale-up in case of disaster.
  • Challenging to implement for low-income households because of low saving potential.
  • Long-term planning and investment are difficult for the poor.

Climate-themed bonds

  • Efficient in raising finance for risk reduction and adaptation projects that produce revenue streams.
  • Provides security to the investor, ensuring that their investments are used for climate-related projects.
  • May have limited applicability for covering/addressing loss and damage as projects need to generate revenue.
  • Higher barrier for most vulnerable countries where interest rates would be high.

Catastrophe bonds

  • Disburse money quickly in the event of a catastrophe.
  • May contribute to raising funds for climate change adaptation and risk reduction.
  • Tend to focus on shorter timeframes, e.g., 3 years as opposed to long term.
  • Tend to come with stricter terms and conditions compared with traditional risk financing, such as insurance.
  • Have a higher fixed expense component.
  • Usually only available to institutional investors.

Source: Adapted from UNFCCC. 2016. Best Practices, Challenges and Lessons Learned from Existing Financial Instruments at All Levels that Address the Risk of Loss and Damage Associated with the Adverse Effects of Climate Change. Executive Committee of the Warsaw International Mechanism for Loss and Damage. Bonn.

Key Challenges

D’Souza talks about the challenges in implementing these financial instruments and the way forward.

 

First, no single financial instrument is capable of addressing the whole range and scale of risks. Hence, the applicability and use of financial instruments must be assessed against a set of advantages and disadvantages given the specific type of risk a community (local, national, or region) aims to address. In particular, existing financial instruments may not be capable of generating financial resources at a scale sufficient to meet growing requirements as levels of exposure and vulnerability increase with the magnitude of climate impacts.

Second, not all instruments are accessible to all vulnerable communities. A number of instruments require a certain level of liquidity or creditworthiness that some of the most vulnerable may not able to meet. For example, some developing countries may not be in a position or lack the capacity to issue catastrophe or climate-themed bonds as they may not be deemed creditworthy by institutional investors. Poor households may not have the capacity to access lines of credit, even for small or subsidized loans.

Finally, most financial instruments cannot fully address the risk of loss and damage associated with slow onset events, such as sea-level rise or desertification. New financing tools are needed to address risks of this nature.

The Way Forward

The number and range of financial instruments will continue to evolve as the impacts of climate change become increasingly significant.  Important next steps in strengthening the implementation of existing instruments and further developing new ones include: 

These should include capacity building, social protection schemes, disaster risk reduction programs, and climate change adaptation initiatives.

This may involve:

  • Embedding effective climate risk management toolkits in strategies for risk prevention, risk reduction, preparedness, response and recovery;
  • Linking financing for disaster risk management and adaptation in such a way that financial instruments and tools for managing the risks of loss and damage can be integrated into national adaptation plans and other relevant processes; and
  • Making sure insurance premiums reflect the underlying climate risks and be structured to promote loss prevention and loss reduction.

This may involve the use of risk assessment and analysis as a prerequisite for using financial instruments and tools in the loss and damage context. An enabling environment is further supported through ongoing capacity building and donor engagement. Such activities can help users enhance their capacity to formulate comprehensive risk management plans and integrate risk finance.

The private sector can play a key role in helping protect the most vulnerable populations, complemented by public policies. 

Conclusion

Multiple financial instruments could be used to address loss and damage associated with the impacts of climate change. Each instrument has its own advantages and disadvantages.  The effectiveness of such instruments depends on the institutional implementation capacity  and the socio-economic characteristics of those affected communities. On their own, financial instruments are unlikely to have significant impacts if not implemented within an overall strong and effective planning and institutional context aimed at managing the risk of loss and damage.

This article is part of a series of explainers developed based on discussions and contributions at the 2016 Forum of the Standing Committee on Finance of the United Nations Framework Convention on Climate Change, which focused on financial instruments that address the risks of loss and damage associated with the adverse effects of climate change. The forum was held at the Asian Development Bank in Manila on 5-6 September 2016.

Meet the Experts

  • Xianfu Lu
    Senior Climate Change Specialist, Asian Development Bank

    Xianfu Lu is ADB’s focal point for climate change adaptation. Prior to joining ADB, she worked at UNDP’s Global Environmental Facility Unit and at the Secretariat of the UN Framework Convention on Climate Change. Trained as an applied meteorologist, she spent the first 10 years of her career researching climate scenarios and their use in climate change impacts and vulnerability assessments in different parts of the world.

  • Rexel Abrigo
    Climate Change Officer, Asian Development Bank

    Rexel O. Abrigo supports key adaptation-related activities, including the implementation of ADB’s climate risk management framework. Prior to his current position, he was part of the team that mainstreamed climate change adaptation in the project development process for South Asia, and implemented several capacity building activities there. He has a Master of Science degree on Environmental Science and Management.

Resources

A. Durand, et al. 2016. Financing Options for Loss and Damage: A Review and Roadmap. Climate and Development Lab, Brown University International Centre for Climate Change and Development. Rhode Island, USA.

S. D’Souza. Current Spectrum and Structure of Financial Instruments to Address the Risks of Loss and Damage. Slideshow presentation at the UNFCCC Standing Committee on Finance Forum. Manila. 05 September 2016.

UNFCCC. 2016. Best Practices, Challenges and Lessons Learned from Existing Financial Instruments at All Levels that Address the Risk of Loss and Damage Associated with the Adverse Effects of Climate Change. Executive Committee of the Warsaw International Mechanism for Loss and Damage. Bonn.

Munich Climate Insurance Initiative

Related Links

Explainer: Understanding the Risks of Loss and Damage from Climate Change

Explainer: Understanding Different Approaches to Managing Climate Change Risks

Explainer: Developing New Financing Tools for the Climate Vulnerable

Explainer: Catastrophe Bonds Explained

Explainer: What Countries Are Doing to Protect against Climate-Related Loss and Damage

Explainer: Mobilizing Contingency Funds for Climate-Related Disasters

Explainer: Key Lessons for Addressing Unavoidable Impacts of Climate Change

 




   Last updated: February 2018



Disclaimer

The views expressed in these articles are those of the authors and do not necessarily reflect the views of the Asian Development Bank, its management, its Board of Directors, or its members.




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