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Sink Or Swim: The Importance Of Adaptation Projects Rises With Climate Risks

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Sink Or Swim: The Importance Of Adaptation Projects Rises With Climate Risks

Since S&P Global Ratings' most recent review on the matter in December 2018 (see "Plugging The Climate Adaptation Gap With High Resilience Benefit Investments," published Dec. 7, 2018, on RatingsDirect), the need for climate change adaptation projects hasn't abated. Indeed, more people are noticing. We believe the recent surge in damage from extreme climate events has significantly increased the attention of public authorities on the need for investment in this area. According to the reinsurer Swiss Re, 2017-2018 insured losses from natural catastrophes, including climate related events, were $219 billion, the highest 24-month figure on record. In total, economic losses from natural catastrophes totaled $497 billion, with a further $40 billion during the first half of 2019. This implies uninsured losses from natural catastrophes of approximately $280 billion in 2017 and 2018 alone.

During 2018, only about 6% ($34 billion) of all climate change investments globally ($546 billion) focused on adaptation projects, with about 94% looking at mitigation, according to the Climate Policy Initiative. However, the imbalance is beginning to shift--in 2017, only 4% of climate funds focused on adaptation projects. Overall, the United Nations Environment Program (UNEP) forecasts adaptation costs in developing countries alone at $140 billion-$300 billion by 2030, and $280 billion-$500 billion by 2050. That is 4x-9x above the total amount of international finance available today--just to meet 2030 costs.

Over the past three years, the world has seen a flurry of extreme weather, most recently the Australia and California wildfires, and Cyclone Bulbul in India and Bangladesh. These events highlight that many countries are vulnerable to these events. Climate change is likely to make matters worse, irrespective of whether we manage to keep global warming to 2 degrees Celsius above preindustrial levels. Attention to climate change adaptation is therefore increasing, especially on how to finance it, given the need to raise enough public and private investment to fortify exposed countries and communities against the potentially devastating effects of physical climate risk.

The Global Commission on Adaptation forecasts that without adaptation, climate change could reduce growth in global agricultural yields by as much as 30% by 2050, as well as pushing more than 100 million people below the poverty line in developing countries by 2030. The GCA, co-managed by World Resources Institute and the Global Center on Adaptation, seeks to "accelerate adaptation by elevating the political visibility of adaptation and focusing on concrete solutions."

Still, governments aren't spending nearly as much money as one might expect. Part of it is political--it can be hard to justify the cost for something that might not happen. Part of it can be that governments are stretched financially as is. So one way to bridge the gap is with private investors. This makes the "resilience benefit" an important tool in raising funds.

Investment in adaptation can offer cost-effective protection against extreme weather damage, what we refer to as a resilience benefit. In particular, a strong resilience benefit and an attractive risk-return profile should attract private investors, bringing much needed money to the area. Introducing financial instruments that demonstrate a strong link between investment returns and resilience benefits could further help uptake in private sector adaptation investments.

 

Adaptation Gap

It is very difficult to accurately estimate global adaptation needs. Any reliable estimate needs to account for exposure growth and the impact of climate change on extreme weather. Nevertheless, there have been several attempts to estimate adaptation investment needs, with the UNEP estimate being the most referenced. For its 2016 Adaptation Gap Report, UNEP combined national and sectorial studies to come up with an estimate for developing countries of $140 billion-$300 billion by 2030, and $280 billion-$500 billion by 2050. In other words, financing for adaptation in 2030 would need to increase by 4x-9x (based on 2018 adaptation financing expenditure of $34 billion) above current international adaptation spending today. While UNEP didn't update the adaptation financing requirements in the 2018 Adaptation Gap Report, it stated that, overall, various studies of the global cost of adaptation indicate higher financial needs. We expect that a significant amount of this will need to go to the most vulnerable countries--that is, the least developed economies (see chart 1 for the geographical distribution of climate finance investments). As part of this, in 2018, the World Bank announced its intention to increase its direct adaptation financing plans from 2021-2025 to $50 billion, or $10 billion per year, more than double its annual level of funding from 2015-2018.

The adaptation gap is not just an issue for developing countries. Although developed countries are more resilient to extreme weather events, many of them will need significant adaptation investments to be prepared for the potential impact of climate change. One important aspect is adapting to rising sea levels, one of the biggest threats from climate change. The impact is relatively more certain compared with other threats, and it therefore should be easier to see the need for adaptation investments.

Chart 1

image

The Resilience Benefits

Adaptation in many cases is cost-effective. However, not every dollar spent on adaptation is equal. Specifically, the benefit-cost ratio of investing in early warning systems (for example, advance warning of a major storm event approaching) is nearly 10x, according to the GCA (see chart 2), so every dollar spent on early warning systems results in net benefits of nearly $10. Conversely, although providing a much bigger absolute benefit, the ratio from making new infrastructure more resilient is nearly 5x, according to the GCA. In total, the GCA estimates that total investments in adaptation of $1.8 trillion could lead to net benefits of $7.1 trillion by 2030, a four-fold return.

Chart 2

image

Assuming the cost-benefit analysis was performed on a probabilistic basis, projects such as these infrastructure-resilience ones, whose resilience benefit could exceed their cost by more than 4x, would achieve the highest level on the resilience scale of our "Green Evaluation Analytical Approach," published April 26, 2017.

Extreme weather events might disrupt economic activity, which also affects people's livelihoods. Businesses may be forced to close until damage is cleared or in case of a disruption to water and electricity services. Extreme weather events might cause higher operating costs. For example, businesses could use generators to supply electricity if there is a power failure or incur higher travel costs if there are transport disruptions. The economic disruption could extend beyond the affected region through global supply chains. For example, the floods in Thailand in 2011 had a global impact on computer and car production because the production of key parts was concentrated in the flooded area and many motor manufacturers operate a "just-in-time" approach to their supply chain. As a result, more than 50% of insured losses (which totaled over $15 billion) stemmed from business interruption claims. What's more, extreme weather events could weigh on public finances if spending is increased to help affected communities, and if they dampen economic activity.

Social benefits arise from reducing the risk of major disruption to the livelihoods of the people living in the affected area. Furthermore, ecological benefits might arise as adaptation projects help the natural environment.

Chart 3

image

Improved resilience could yield considerable secondary financial benefits. These investments may promote economic development in an area now adequately protected against extreme weather events. For example, the restoration of mangrove forests in coastal areas have two benefits. First, they protect coastal areas against storm surges. Second, they support local fisheries, as evidenced with Bangladesh's government initiated planting of mangrove forests. Furthermore, insurance costs could also drop in the protected area, reflecting reduced natural catastrophe risk and bringing another financial benefit.

Quantifying The Benefit

Quantifying the resilience benefits is progressing, as demonstrated by the estimates from the GCA. However, quantifying these benefits remains challenging, and estimates are often imprecise. Any analysis requires models to capture the variety of benefits across weather events of different magnitude and over a long projection period, for which detailed historical damage and exposure data are required. In addition, these models need to account for long-term climate scenarios, incorporating projections of how climate might develop and how exposure to the resulting risks might change because of growth in assets and population. (For more information regarding the challenges of quantifying the benefits, see "Plugging The Climate Adaptation Gap With High Resilience Benefit Investments."

Demonstrating the value of the adaptation benefit should be important in getting buy-in from all stakeholders: sponsors, the public, and investors. In particular, demonstrating a strong resilience benefit is likely to attract more private investors. This is because climate-minded investors will also consider the environmental benefit of investment opportunities, in addition to risk-return features.

It is true that the return of those investments is not directly linked to the expected resilience benefit of the investment. However, in many cases, adaptation investments will indirectly help returns. For example, if a local authority issues a green bond for an adaptation project, the project should help the local economy and community be more resilient to natural catastrophes--meaning the local community should suffer a smaller financial shock than without the adaptation project when a natural catastrophe happens. Everything else equal, this could lead to better credit quality for the issuer and a better investment return on all bond issues by the local authority, including the green bond used to finance the adaptation project.

Another investment case could be linked to the "public good" nature of adaptation projects, which are largely infrastructure projects providing a service to society. They reduce damage to property and provide other associated social and health benefits. So in much the same way that infrastructure projects such as hospitals, schools, and government buildings are funded by the public sector using concessions and public-private partnerships, similar structures could be considered for adaptation. This could provide a long-term revenue flow that would attract both infrastructure and green investors alike.

Barriers To Adaptation

We believe many adaptation projects with high resilience benefits are not seeing the light of day. The need for these works in densely populated areas of the U.S. (for example, around New York and Boston), Bangladesh, Indonesia, and the Philippines are well known and solutions are actively being considered, although implementing will take time due to the complexity of the projects and the size of investment required. However, there are many other lesser-known small areas that can be protected in a cost-effective way.

Given the high needs and benefits for adaptation, the obvious question is why the level of investment is so low. We believe the main factors behind this are the large sums involved and difficulties in demonstrating the value of adaptation to stakeholders, particularly in what timeframe. This makes it difficult to convince decision-makers to prioritize these projects relative to other development needs. Or it may be difficult to allocate significant amounts of financing to projects whose benefits might emerge only during an extreme weather event many years in the future.

Another important barrier for adaptation investments, in contrast to mitigation projects, is the difficulty of monetizing the benefits in the form of clear cash flow streams. Most of the benefits are to make society and business more resilient to unfavorable weather events, that is, to avoid costs. It is hard to estimate the specific benefit to every individual family or business in the area that would allow the project to explicitly charge to them for the benefits. As a result, public resources or development banks finance most adaptation projects. However, in times of strained public finances, these projects are unlikely to be high priority, especially when the expected benefit may not become evident in the near term.

Adaptation Projects Face Other Roadblocks

The large scale of adaptation projects requires significant amounts of finance and a complex approval process, which drains resources and leads to delays. They often require difficult decisions and trade-offs among different benefits and costs affecting various groups and communities, which typically leads to legal disputes and challenges. For example, an adaptation project might protect one area from flooding at the expense of increasing flood risk downstream.

Another important obstacle is social acceptance. Adaptation projects might change the daily lives of local communities. For example, a new seawall might restrict sea views and access to the beach, or may affect the natural environment. These inconveniences could make it difficult for local communities to support such projects if they are seen as disrupting daily life or lowering an area's attractiveness. As a consequence, the project could depress property prices or tourist activities, and the benefit of the increased resilience might not be sufficiently appreciated or understood to compensate for that.

Sometimes it might be difficult to undertake adaptation projects because of the lack of scientific certainty of the precise impact of climate change on extreme weather events, which complicates decisions about infrastructure design. The challenges for effective adaptation design, together with the potential negative financial or social impacts to some communities, could increase the risk of legal action, another possible factor deterring adaptation. On the other hand, authorities might face legal action if they don't build the necessary adaptation infrastructure, and communities suffer significant damage and disruption from climate change. However, they might also be under scrutiny if measures do not deliver the expected resilience benefits. Any legal or corrective actions could increase costs to sponsors and reduce the attractiveness to investors because of the reputational risk of being associated with failed adaptation infrastructure.

Finally, adaptation to climate change is a moving target because, by 2050, even countries that have taken action might have to enact additional measures if the 2 degree objective is to be met. One example of this is the Delta Programme in the Netherlands. This program focuses on flood defense, as well as freshwater supply continuity, in the low-lying, flood-prone Netherlands. As part of ongoing monitoring, a reevaluation exercise happens annually to assess the program's effectiveness in light of new information becoming available and amend it, as necessary.

The Need For Private Financing

We expect that due to the large size of the adaptation gap and constrained public finances, other sources would need to make considerable contributions to adaptation financing. Therefore, we see the need to attract private finance in this area, especially given the number of investors interested in opportunities in climate finance. We believe that the ability to demonstrate the resilience benefit of such projects through robust modeling will be an important catalyst. The Climate Policy Initiative estimates investment by the private sector in adaptation finance is at $500 million, which is very modest even allowing for disclosure and definitional challenges as to what constitutes adaptation financing. Furthermore, many countries where adaptation financing is most needed are subject to higher governance and transparency risks, which can further deter private sector investors.

Governments alone are unlikely to be able to provide sufficient financing to meet all future adaptation and mitigation needs. However, they continue to play the key role today and are likely to do so for the foreseeable future. Often, financing of major adaptation projects requires centralized, coordinated policy decision making. One recent example is the Environment and Climate Adaptation Levy, introduced by Fiji in 2017. Over $100 million has been raised via a 10% tax on prescribed services (e.g. hotel accommodation, tourist activities) and a 10% income tax on the rich. These proceeds have funded various infrastructure, cyclone rehabilitation, and agricultural development projects, in particular, to protect the country's natural environment, reduce its carbon footprint, and improve its ability to adapt to the impacts of climate change, including from rising sea levels and extreme storms.

One of the key challenges to facilitating private sector financing is that, often, upfront financing is required (either at the design or construction phase), but the payback only occurs much further down the road. Addressing these challenges is likely to require a partnership model, incorporating transferring risk to the capital markets (insurance, catastrophe bonds, or other derivative instruments), together with contingent financing from multilateral institutions and governments.

Related Research

  • Determining The Resilience Benefit Of Climate Adaptation Financing, Dec. 7, 2018
  • Plugging The Climate Adaptation Gap With High Resilience Benefit Investments, Dec. 7, 2018
  • Climate Finance & Sustainability: Key Research By S&P Global Ratings, 2018, Nov. 21, 2018

This report does not constitute a rating action.

Primary Credit Analyst:David J Masters, London (44) 20-7176-7047;
david.masters@spglobal.com
Secondary Contacts:Michael Wilkins, London (44) 20-7176-3528;
mike.wilkins@spglobal.com
Dennis P Sugrue, London (44) 20-7176-7056;
dennis.sugrue@spglobal.com
Olivier J Karusisi, Paris (33) 1-4420-7530;
olivier.karusisi@spglobal.com

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