Climate change, risk finance, and innovative financial instruments

February 21, 2023

Risk is “the potential for consequences where the outcome is uncertain and something of value is at stake” (Intergovernmental Panel on Climate Change). It has distinguishable elements including a hazard, exposure, vulnerability, response options, values, magnitude, likelihood, and temporal characteristics, and is further shaped by socioeconomic, cultural, and environmental factors. Whether they are faced by an individual, community, company, or national level, risks are multifold, complex, and interconnected.

In general, risks fall into categories such as market risks, liquidity risks, credit risks, operational risks, production risks, legal and regulatory risks, environmental risks, and many others. In the age of climate change, climate risk has emerged as a crucial additional category of risks that affects all sectors and areas of the economy, for example through extreme weather events, shifting weather patterns, and long-term processes including sea level rise and ecosystem degradation.

Climate change and risk finance

To manage climate-related or climate-compounded risks, entities have a range of options, for example risk prevention (reducing exposure), risk reduction (reducing vulnerability), risk analytics leading to risk-informed planning, and risk transfer, which is usually done through indemnity-based or parametric insurance mechanisms.

Risk finance is an integral part of risk management and vital to addressing the multitude of risks connected to climate change. At its core, risk finance is about finding ways to compensate for the potential of losses or damages in the most effective and least costly way possible. Depending on the risk, the entity, and available mechanisms and frameworks, risk finance can take many different forms and vary significantly in volume.

Cost of risk (COR) is a quantitative measure of the total direct and indirect expenditures dedicated to mitigating the risk exposures confronting an organization in pursuit of its objectives. However, it is important to note that risk finance cannot cover the entirety of risks faced by different entities. As the recent Sixth Assessment Report published by the Intergovernmental Panel on Climate Change (IPCC) outlines: “Risks can be reduced or managed by risk finance (insurance and other means), but some residual risk remains, particularly for high impact unavoided and unavoidable risk, which is retained implicitly or explicitly.”

Innovative financial instruments

Financial instruments and vehicles such as bonds, concessional loans, contingent credit lines, donor assistance, domestic credit, catastrophe deferred drawdown options, weather derivatives, or equity funds can play a key role for risk finance. They have the potential to attract and accelerate investment from other countries, multilateral institutions, or the private sector, and capitalize on a mindset shift towards more sustainable, green, climate-friendly, and responsible investment.

The IPCC’s Sixth Assessment Report has highlighted the potential for “innovative policy instruments like […] climate bonds” to supplement traditional financial instruments and scale up investment into climate-smart and resilient development projects. Social impact bonds, green bonds, and sustainability bonds are three major categories of “thematic” bonds that facilitate impact investment earmarked for a specific kind of usage. These bonds are issued to (re-)finance projects that have a positive social impact, a positive environmental impact, or a combination of both. In addition, sustainability-linked bonds are related instruments with a wider scope, funding not specific projects but general operations of an entity that are linked to sustainability targets and conditions.

Some categories of projects funded by green and climate bonds include clean and renewable energy and transport; enhanced energy and resource efficiency in key economic sectors; green buildings and cities; climate-smart transport systems; sustainable and climate-friendly food systems; nature-based solutions and ecosystem conservation; water management; waste and pollution control; or digital and frontier technologies with benefits for climate and environment.

Other related financial instruments include resilience bonds, catastrophe bonds (“CAT bonds”), CAT swaps, blue bonds, forest resilience bonds, climate-conditional grants, carbon credits, or ecosystem-linked insurance schemes, for example restoration insurance or reef insurance offering premium discounts or other benefits for ecosystem conservation and nature-based risk management.

Furthermore, public debt for developing countries has increased in the wake of the COVID-19 pandemic and more intense and frequent climate-induced losses and damages. To alleviate this strain on public finances, bilateral or tripartite debt-for-climate swaps have been proposed as a potential solution that could allow countries such as Sri Lanka to receive debt relief in exchange for commitments to undertake climate-related investments. The IPCC report also outlines initiatives such as “comprehensive debt relief by public creditors, green recovery bonds, […] and new SDG-aligned debt instruments” to address unsustainable debt burdens and free up investment in climate adaptation and a green economic recovery.

Risk finance and innovative financial instruments provide the potential for countries and economies to mobilize private sector investment and manage climate-related risks through blended finance, public-private partnerships, and enhanced access to climate finance. Through this, countries such as Sri Lanka can adapt to a changing climate and become more resilient, mainstream risk management, and secure funding for nature-based solutions, green and blue economies, and sustainable, climate-smart development.

This blog post was originally published as a guest column in Daily Financial Times on September 5th, 2022, and is available here.

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About the Author
Dennis Mombauer

Dennis has close to a decade of experience working in research, and management and administration in the private sector as well as two years in coordination in the development sector. His research focuses on ecosystem-based adaptation, sustainable development, climate migration, and other topics related to climate change. He has published articles about these topics in numerous places, for example Earth Island Journal, Mongabay, The Environmental Blog, Daily FT, and Colombo Telegraph. He holds degrees in Education, English Studies, and Philosophy from the University of Cologne, Germany, and has additional qualifications in GIS mapping, video editing, translation, and publishing. ‍