46 Pages Posted: 18 Feb 2021 Last revised: 23 Sep 2022
Date Written: January 1, 2021
Climate adaptation (reducing vulnerability to future climate change) could yield significant benefits. However, the uncertainty of which future climate scenarios will occur decreases the feasibility of proactively adapting. Fortunately, climate adaptation projects could be underwritten by benefits paid for in the climate scenarios that each adaptation project is designed to address because other entities would like to hedge the financial risk of those scenarios.
For instance, many infrastructure projects can be built to withstand extreme climate change through upfront spending. The climate adaptation expenditures generate more climate resilience benefit under more extreme climate. Because the return on investment of many adaptation actions is a function of the level of climate change, it is optimal for the adapting entity to finance adaptation with repayment that is also a function of the climate. It is also optimal for entities with more financial downside under a more extreme climate to serve as an investing counterparty because they can obtain higher than market rates of return when they need it most.
In this way, communities, cities, and states proactively adapting would reduce the risk they over-prepare, while their investors would reduce the risk they under-prepare. This is superior to typical insurance because, by investing in climate-contingent mechanisms, investors are not merely financially hedging but also outright preventing physical damage, and therefore creating economic value. Both sides of the positive-sum relationship — physical and financial hedgers — are made better off. This coordinates capital through time and place according to parties’ risk reduction capabilities and financial profiles, while also providing a diversifying investment return to investors.
Governments, asset owners, and companies reduce uncertainty in components of the economy (e.g., commodities prices, credit risks, and interest rates) through trillions of dollars of derivatives positions and insurance contracts – this Article proposes a solution to provide a similar capability in the climate context. Municipalities raise trillions of dollars of debt for infrastructure – this Article proposes to provide that type of investment flow for financing climate-aware real asset projects.
Climate-contingent finance is a fresh approach to addressing catastrophic risk, building a bridge between long-term funding needs and financial risk management. It can be generalized to any situation where multiple entities share exposure to a risk where they lack direct control over whether it occurs (e.g., climate change, or a natural pandemic), and one type of entity can take proactive actions to benefit from addressing the effects of the risk if it occurs (e.g., through innovating on crops that would do well under extreme climate change or vaccination technology that could address particular viruses) with funding from another type of entity that seeks a targeted financial return to ameliorate the downside if the risk unfolds. This approach can finance previously under-funded efforts to address risks to humanity’s long-term flourishing, including extreme climate change, large asteroids hitting the earth, and supervolcanic eruptions.
Keywords: Climate change, Climate adaptation, Climate economics, Climate finance, Climate derivatives, Climate investing, Sustainable finance, Impact investing, ESG investing, Infrastructure finance, Climate policy, Climate law, Machine Learning, AI, Simulation Modeling
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