Explainer

Financing Adaptation

Options are increasingly available to channel more funds to emerging markets but asset owners require scale.

Current global financial flows for adaptation, including from public and private finance sources, are insufficient for and constrain implementation of climate change adaptation options, especially in developing countries, according to the Intergovernmental Panel on Climate Change’s (IPCC’s) latest report. The losses and damages from climate change in developing countries are also not comprehensively addressed by current financial, governance and institutional arrangements.

While there are adaptation projects in emerging markets, they are not attracting attention or funds, because many countries are still building the basic infrastructure that aligns with the 1.5 degree warming target. “Adaptation has not been a tremendous focus for the public sector nor the development banks. The latter have been more focused on mitigation and transition than on adaptation.” says Nadia Nikolova, Lead Portfolio Manager for Development Finance at Allianz Global Investors.

In this explainer, we look at the state of play in adaptation finance and how public and private capital can be directed to the countries in most need.

What is adaptation?

The IPCC says adaptation plays a key role in reducing exposure and vulnerability to climate change. Adaptation, in response to the current effects of climate change, is reducing climate risks and vulnerability mostly via the adjustment of existing systems, natural and man-made. Many adaptation options exist and are used to help manage projected climate change impacts, but their implementation depends upon the capacity and effectiveness of governance and decision-making processes.

Growing public and political awareness of climate impacts and risks has resulted in at least 170 countries and many cities including adaptation in their climate policies and planning processes, says the IPCC report. Adaptation can generate multiple additional benefits such as improving agricultural productivity, innovation, health and well-being, food security, livelihood, and biodiversity conservation as well as reduction of risks and damages.

Adaptation options cited by the IPCC include water use efficiency and water resource management, efficient livestock systems, resilient power systems, and sustainable acquaculture and fisheries.

Effective adaptation options for water-borne and food-borne diseases, for example, include improving access to potable water, reducing exposure of water and sanitation systems to flooding and extreme weather events, and improved early warning systems

Nikolova says there are three aspects to adaptation – one looks at existing infrastructure elements and how they can be modified to become climate resilient, another is about building new infrastructure that takes into account climate risks, and the third is projects whose goals are purely climate adaptation.

What did the IPCC report say about the need for more finance for adaption to climate change?

The IPCC found that the overwhelming majority of globally tracked climate finance was targeted to mitigation while a small proportion was targeted to adaptation.

With adaptation finance needs now estimated to be higher than those presented in its Fifth Assessment Report, the IPCC says enhanced mobilisation of and access to financial resources are essential for implementation of adaptation and to reduce adaptation gaps. To accelerate adaptation, the IPCC says building capacity and removing some barriers to accessing finance is “fundamental”.

This can be done via public and private finance instruments such as inter alia grants, guarantee, equity, concessional debt, market debt, and internal budget allocation. Public finance is an important enabler of adaptation and public mechanisms and finance can leverage private sector finance for adaptation via public-private partnerships. This blended finance approach attracts commercial capital towards projects that contribute to sustainable development, while providing financial returns to investors.

“Sustained adaptation actions are strengthened by mainstreaming adaptation into institutional budget and policy planning cycles, statutory planning, monitoring and evaluation frameworks and into recovery efforts from disaster events. Instruments that incorporate adaptation such as policy and legal frameworks, behavioural incentives, and economic instruments that address market failures, such as climate risk disclosure, inclusive and deliberative processes strengthen adaptation actions by public and private actors,” says the report.

How is blended finance used?

Specialist investor network Convergence says blended finance transactions range considerably in size, from a minimum of US$110,000 to a maximum of US$8 billion. The median blended finance transaction has been US$64 million in total size (2010-2018).

Convergence says blended finance transactions should have three signature characteristics:

  • The transaction contributes towards achieving UN Sustainable Development Goals. However, not every participant needs to have that development objective. Private investors in a blended finance structure may simply be seeking a market-rate financial return.
  • Overall, the transaction expects to yield a positive financial return. Different investors in a blended finance structure will have different return expectations, ranging from concessional to market-rate.
  • The public and/or philanthropic parties are catalytic. The participation from these parties improves the risk/return profile of the transaction in order to attract participation from the private sector.

Concessional debt or equity has been the most common archetype, says Convergence, and can come in many shapes and sizes, including first-loss debt or equity, investment-stage grants, and debt or equity that bears risk at below-market financial returns to mobilise private sector investment. There has been an increase in the use of both concessional debt or equity and guarantees or risk insurance in recent years.

Sub-Saharan Africa has been the most frequently targeted region in blended finance transactions, with energy the most frequently targeted sector.

When looking at blended finance for adaptation initiatives, the first question is where does the revenue come from, who is paying for it, says Nikolova. “Usually, revenues are generated from concessions and are paid over time from a government and such models do exist. Another question is whether governments see adaptation projects as having the same importance as building basic infrastructure such as new hospitals and schools. The countries subject to the greatest impact from climate change are often the least prepared financially to manage these risks. Many emerging markets have high debt burdens. The public-private partnerships (PPPs) often used to finance infrastructure, for example, are another form of debt.”

What changes are needed to blended finance to get more money to emerging markets?

A paper from the UN convened Net-Zero Asset Owner Alliance (NZAOA) argues that much more private capital can flow to climate adaption and mitigation projects in emerging markets via blended finance solutions. Progress depends, however, on overcoming obstacles to sharing risks, returns and data among different types of investors.

Historically, these obstacles have reduced activity and appetite among asset managers. According to Convergence, asset managers accounted for only 11% of commercial participation in blended transactions from 2017-2019, with was down from 15% across 2014-2019.

The NZAOA says blended finance can offset investors’ concerns about risk, market access and transparency in emerging markets by increased provision of a first-loss tranche; expanding market access through the preferred creditor status of multilateral development banks (MDBs) and development finance institutions; and increased collaboration on data disclosure “to close the gap between perceived and actual risk”.

Blended finance comes with a “significant amount of complexity” so for adaptation projects to take off in emerging markets, investors need to see greater scale, which will make the complexity worth managing, says Nikolova. “Concessionary capital providers (who are providing the de-risking) want to see real, measurable impact from their investments. For governments, they want the least financially burdensome approach while private capital is seeking a good risk return profile.”

For large private investors like Allianz, who are able and willing to invest in blended finance structures, scale is key. “So aggregation of projects will play a significant role as it will create the scale the private sector is looking for. By combining projects, the need for concessional blended finance can potentially be reduced due to the creation of a granular, diversified portfolio of assets,” says Nikolova

“We have the techniques for adaptation finance, including aggregation, blended finance, PPP financing. There is also a willingness in the private sector to become involved. However, we do need to make sure adaptation projects come in wrapper that meets all stakeholders’ priorities.”

Private investors, particularly large institutional investors, have much greater financial resources than the public sector to invest in sustainable projects in emerging and frontier economies, according to the Investor Leadership Network (ILN). The Network, which comprises 14 global institutional investors with over US$9 trillion in assets under management and is supported by the Rockefeller Foundation, released a blueprint at COP26 that called for “a sea change” in how MDBs, governments, foundations, and other public institutions see private-sector involvement.

Among the blueprint’s proposals are:

  • A rolling pool of funds offering first- or second-loss guarantees so the private sector can cover currently hard-to-insure risks such as those relating to regulatory changes, taxation, and reputational risk;
  • A separate facility to help with foreign exchange risk;
  • A detailed shared database of projects that MDBs are screening so that private investors can express an interest early on;

A searchable virtual toolbox so investors can more easily find the risk-hedging instruments that MDBs and philanthropic organisations offer.

What recent initiatives are aimed at developing better blended finance solutions?

Private-public partnership platform FAST-Infra is working to standardise sustainable infrastructure as an asset class through a combination of a labelling framework, blended finance options and public-private partnerships. Its ‘Sustainable Infrastructure Label’ is designed to help institutional investors to identify assets that are genuinely sustainable and will drive investment into sustainable infrastructure in emerging markets. Financing of infrastructure projects is limited and lacks sufficient investment from the private sector, which is crucial to bridging the investment gap, argues the group, which includes HSBC, JP Morgan, BNP Paribas and Macquarie.

The recently launched Landscape Resilience Fund is a blended finance initiative for adaptation in communities most vulnerable to floods, droughts and other climate-related risks. An initiative of South Pole, World Wide Fund for Nature, Global Environment Facility and Chanel, it states that blended finance is “the most effective way to galvanise leaders to take on this huge task of global climate change adaptation” and to close the adaptation finance gap.

At COP26, the Asian Development Bank (ADB), along with the UK Government and the Nordic Development Fund, launched the Community Resilience Partnership Program (CRPP), which is focused on supporting local climate adaptation measures.

The CRPP will provide long-term sustainable support to scale up climate adaptation measures that address climate, poverty, and gender challenges. The programme is designed for implementation over a 10-year period from 2021 to 2031.

The CRPP will be operationalised through a ‘Financing Partnership Facility’ which will include a multi-donor trust fund to support research, capacity building of national institutions, innovative pilots, and project preparation through technical assistance and grants. The support will aim to kickstart large-scale investments that can be financed through an ADB developing member country’s national budget, with additional financing from ADB and other development partners. The trust fund will have a dedicated window to promote women-focused investments in climate adaptation.

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