This chapter highlights examples that encourage the use of innovative financing instruments at various scales to enable the integrated CCA and DRR policies that were suggested in 4.1. This contributes to tackling the increasing funding gap between the amounts of CCA and DRR finance and current needs for implementation of integrated CCA and DRR policies. As a result, disparities between CCA and DRR funding are currently on the forefront of challenges for institutional strengthening.
4.2.1 Sovereign Climate Insurance Funds with application of Index-Based Insurance and Distributed Ledger Technology
Sovereign Climate Insurance Funds (pools) with application of IBI and DLT that cover climate-related risks and provides financial protection/support to the regions and small farmers.
Climate change imposes unavoidable loss and damage (LnD) for both, local communities, economic sectors and national economies. Climate finance and risk transfer mechanisms can help bolster immediate action after disaster, speed up recovery and support access to critical services and rebuild critical infrastructure for people, communities and economies.
Making economic and financial systems resilient to climate change requires implementation of the 3D Nexus: de-risking, digitalisation and decentralisation.
In order to arrange a quick, safe and efficient process of data collection, evaluation and decision-making it is crucial to build up DLT-based (Distributed Ledger Technology) insurance mechanisms on the national levels – Sovereign insurance Fund (SIF). Such a mechanism will allow integration of the CCA and DDR areas, where data about the outstanding climate-related risks could be transferred into the de-risking strategic documents at the national level. A low penetration rate in the case of insurance against climate related risks suggests implementation of the DLT would offer protection even to small producers and decentralised storage of related data – digitalisation and decentralisation of the insurance mechanism. In addition, only 1% of climate-related losses in 2017 were protected with insurance services within the EU.
A SIF is a state-owned fund that invests in real and/or financial assets which is based on tax or national revenue. Sovereign Insurance (SI) is defined as a risk financing strategy for governments and may include reserve funds, insurance, catastrophe bonds (also known as CatBonds) or contingent debt. SI could be considered as a model of climate insurance under the umbrella of the UNFCCC. Premium-subsidies or international solidarity funds financed by carbon taxes or auction proceeds from globally linked emission trading schemes are considered as other alternatives in this workstream.
Existing yield-based approaches to the insurance of climate-related risks have a number of drawbacks including fraud detection and risk modelling. Index-based solutions (IBI) rely on the application of physical indicators that they use as a “trigger” for the compensation of losses. Compared to yield-based insurance, IBI has some positive features. Firstly, this approach is more objective due to the fact that indicators depend only on physical properties of the environment. In addition, compensation is limited to a fixed amount of money, based on past events and associated losses from previous periods. This approach can significantly reduce time for calculation of the losses and the time between the actual event and compensation payment. Another important advantage of IBI is the improved trust between insurance companies/funds and their clients. At the same time, IBI could simplify field loss assessment, reduce bureaucracy, increase transparency, making it less costly for small customers such as farmers.
Sovereign Climate Insurance Funds (CIF) with application of IBI and DLT with representatives from central and regional authorities could provide protection against climate-related risks through state guarantees and public financial resources, and contributions from the local level. In addition, such CIFs allow access to resources of the financial market by implementing innovative financial instruments.
The CIF should be able to issue sustainability, environmental impact, catastrophe, water and/or pandemic bonds. Application of the Catswaps could establish an opportunity to transfer climate-related risks to the financial market via facilities of the European Financial Stability Facility or European Investment Bank (see recommendation 4.2.2)
Ministries of Finance, Ministries for Environmental Protection, UNFCCC, national authorities responsible for auctioning of the emission allowances, local/regional authorities. Climate-related risks could lead to escalation of the systemic risk for the entire financial system – response on the national and EU-level is needed. Such risks (like natural disasters or political risks) require systemic approach in protecting economic agents from them.
4.2.2 Risk Transfer and data collection via European Risk Transfer Mechanism
Distrbuted Ledger Technology-based platform with the aim of transferring risk from Sovereign Climate Insurance Funds to the financial market; collect, process and store climate-related data.
All economic sectors are negatively affected by climate change, particularly extreme weather events and natural disasters. In this respect, special attention should be paid to the agricultural sector, which has direct and indirect impacts on our daily life (for example, food security). The existing Common Agricultural Policy (CAP) –is unable to provide protection against climate-related risks. In addition, the effectiveness of subsidies for the agricultural sector within the CAP raises many questions. The main disadvantages of the existing CAP are: increased transaction costs and losses; opportunities for fraud; limited initiatives to optimise the use of inputs; most of the subsidies are received by a limited number of very large farms. As a result, there is a need to support national initiatives in providing protection against climate change (see recommendation 4.2.3) by establishing a risk transfer mechanism at the EU level – transferring risks to the financial market.
Possible losses resulting from climate change pose significant systemic risk not only to agricultural policy, but also to the entire economy, cities, households and businesses. The difference in the costs of capital could contribute to systemic risk for the entire European financial system if innovative financial debt instruments are applied. Since climate change could contribute to the systemic risk, it requires an adequate response at the EU-level to protect the entire European financial and economic system against climate-related risks.
In this respect, a special mechanism is needed in order to issue debt instruments (such as catastrophe bonds – catbond), derivatives (such as catswaps) and transfer climate-related risks from CIFs to the financial market and preventing possible financial turmoil in the European financial system (see recommendation 4.2.1).
Since financial market instruments have very high transaction costs for small investors and issuers of such instruments, it is very important to establish a DLT-based risk transfer mechanism on the EU-level (European Risk Transfer Mechanism, ERTM). Such a mechanism could deliver solutions for immediate transfer of the money from the financial market to provide compensation of the losses and damage via CIFs without any delay. Such a mechanism could also facilitate collection and evaluation of the information about damage and losses, improving management of climate-related risks on the EU-level.
EFSF or the European Investment Bank (EIB) could be considered as the managers of the DLT-based ERTM and issue catbonds or catswaps to transfer climate risks from Sovereign Insurance Funds to the financial market. EFSF already exists in the European Union – it was established in 2010 with the aim of providing financial assistance to those EU Member States with severe debt conditions. This body can issue debt instruments and swaps, which could serve as an effective instrument for transferring risks from Sovereign Insurance Funds to the financial market. Such an approach could equalise the costs of capital in case of issuing catbonds as the creditworthiness of the EU is much higher than for some Member States.
A DLT-platform at the EU-level for national and sub-national authorities or institutions in order to transfer climate-related risks to the financial market, and collect and process related data. Such data could contribute to the reduction of transaction costs and improve management of climate-related risks on the EU-level.
The following institutions and organisations at the EU-level should be involved in the project: Ministries of Finance, Ministries of Environmental Protection, European Financial Stability Facility, European Investment Bank.
4.2.3 EU Green Taxonomy and EU Green Bond Standard with CCA and DRR components
EU Taxonomy for green projects with combination of CCA and DDR indicators and metrics in order to improve effectiveness of climate finance.
On the financial market, there is no unified understanding of green assets – this leads to a rise in information asymmetry and high transaction costs. The lack of standards in this area limits green investment flow. At the same time, in the financial market there are different debt instruments, which can help to mobilise climate and environmental finance. Among those instruments, green and sustainable development bonds play the most important role.
The main advantage is that international financial institutions have developed their own standards to identify underlying assets and the use of proceeds. At the same time, there is now unified standard for classification of green assets – debt markets can deliver only a limited portion of the financial resources for sustainable development projects. In other words, the international financial community is still trying to deliver common rules on how to identify green or sustainable investments and avoid so-called “green washing” – creating clear rules to unlock green or sustainable financial flows.
A small number of influential initiatives, created by financial institutions, national authorities and international organisations are trying to foster implementation and utilisation of the green or sustainable financial instruments – facilitating creation of a taxonomy for such instruments and projects, supporting different legislative steps which are taken by the national authorities.
In 2018, the EU Commission adopted an Action Plan for establishing a Sustainable Financial System in the EU, not only to facilitate mobilisation of financial resources for climate-related projects, but also to improve resilience of the European finance system to non-financial risks. The EU Commission stated the following aims: reorientation of capital flows towards sustainable investments; enhancing management of environmental and social risks; fostering transparency of economic and financial activities.
In 2019, the incoming president of the European Commission announced a European Green Deal with the aim of establishing a circular economy, and providing financial support for related projects. In this respect, green financial instruments should play a critical role in mobilising financial resources. At the same time, the lack of a clear legal definition of “green” leads to phenomena such as “green washing” on the financial market. As a result, clear guidance for identification of green projects and assets is essential. In addition, there is a need to incorporate CCA and DRR aspects when identifying green and resilient projects.
Incorporation of CCA and DRR indicators and metrics into the EU Green Bond Standard and the EU Green Taxonomy for identification of green projects and green financial instruments.
European Commission and High Level Expert Group on Sustainable Finance.
4.2.4 Forecast-based financing to anticipate disasters and reduce human suffering and losses in a changing climate
We need to move forward towards impact-based forecasting, meaning to forecast what the weather will do rather than how the weather will be. The ability to take timely action in advance of peak impacts holds considerable promise in Europe, particularly for hazards such as floods and droughts. Therefore, DRR and CCA communities should apply forecast-based financing (FbF) to protect local population and infrastructure against climate risks.
Forecast-based financing is an example of targeted disaster risk financing, automatically applied in emergency situations which leave no time to develop substantial measures on the national or subnational level. It provides assistance for the most vulnerable, for example small farmers, in order to protect lives and livelihoods before a potential disaster. The objective is to allow actors to make the best use of forecast lead times and risk analysis (depending on the hazard), to avoid making hasty decisions (for example, by having an automatic trigger system), to enable plans to be made with sufficient consultation of stakeholders, and ultimately, to reduce the impacts of extreme weather events (IFRC 2020). The forecasts can have seasonal dimension (droughts) but also cover time scales of 3 to 15 days (floods), depending on the type of hazard. Funds are allocated automatically when a specific threshold is reached. This gives an opportunity to provide immediate financial support, in some cases only days after the onset of a disaster (GRC 2019).
Climate projections play an important role in the FbF planning process. During the setup of the forecast system, a profound risk analysis looks into historical weather events and disasters, and also into potential future changes that could influence a change in risk factors. Disaster events induced by hazards including heatwaves, droughts and floods, are expected to increase in frequency and severity as a result of climate change and other risk factors.
The ability to develop further and make use of advance warnings and scale up meaningful interventions offers an opportunity to reduce the risks of disaster events and adapt to a changing climate. Governmental and non-governmental actors at international, national and sub-national levels could provide support and guidance to populations at risk before the shock and negative impacts have materialised, reducing the overall burden of the disaster event. In addition, they can expand the response options made available to actors via advanced planning and consultative processes across different Government sectors, Disaster Managers and other key institutions with a role to act early before disaster happens. In doing so, institutions within the DRR and CCA fields could be strengthened, better coordinated, and more able to reduce risks to extreme weather events.
By strengthening the relationships between forecasting services and DRR and CCA institutions, it would be possible to co-develop meaningful impact-based Forecasting services, that integrate weather and climate information with understanding of risk across different timescales, including the consideration of future climate prediction is current Early Warning and Early Action strategies.
Forecast-based financing seeks to anticipate extreme weather events in order to implement actions prior to the event or before impacts are experienced. Therefore, the focus is more on mitigation, and of course also on improve preparedness and emergency response. FbF was developed in the humanitarian sector for use in low resource settings, to enable the automatic release of anticipatory humanitarian funds.
For forecast-based financing (FbF) to be successful, a multi-stakeholder approach is essential. This begins with a feasibility analysis that involves the National Hydro-Meteorological Service (NHMS), DRR and CCA agencies, the affected local communities themselves, humanitarian and development actors, and the scientific community, who will take active part in the FbF set up and advocacy process.
4.2.5 Self-financing and crisis financing mechanisms with application of Distributed Ledger Technologies (DLT)
Development of national self-financing and crisis financing mechanisms with application of DLT.
Taking into account existing NDCs, our current pathway of global warming is over 3 degrees Celsius by 2100. Hence, CCA and DRR are at the core of current efforts at international and national levels. Finance could play an important role in bringing together two climate change communities: CCA and DRR.
Provision of financial resources is a common requirement within both the Paris Agreement and Sendai Framework on Disaster Risk Reduction. Finance could contribute to improvements in climate risk management (see recommendation 4.1.1) – another common topic for CCA and DRR communities. In addition, both communities aim to promote economic, social and cultural investments in order to improve resilience to climate change.
Climate-related investments in critical infrastructure should also encompass co-benefits in economic and social dimensions. This requires improvements in existing methodologies of cost-benefit analysis in order to monetise intangible assets achieved because of the improved resilience. In addition, the integration of DRR and CCA could bring more favourable returns on investments – improving efficiency of the funding mechanisms.
We face a gap between our current investments and the need for DRR and CCA finance. According to data provided by UNEP, at the international level only 20 billion USD for adaptation needs are being mobilised on an annual basis. At the same time, our current needs in adaptation finance account for 140–300 billion USD. More importantly, there is a lack of DRR and CCA investments both at the international and EU-level. Effective combination of both DRR and CCA components, fiscal and market-based financial instruments is crucial on the way to improved risk management and overall resilience to climate-related extreme weather events and natural disasters.
Disaster financing comprises a variety of instruments designed to achieve different outcomes. A strategy based on a diverse set of complementary financial instruments and institutions is more capable of managing and responding to a variety of environmental and man-made risks. Insurance offers individual protection against the risk of damage caused by various natural hazards. However, it must be embedded in government action to regulate and complement the products. For example, comprehensive agricultural multi-risk management systems have to be supported by common market programmes.
Existing financial mechanisms in the area of CCA and DRR can be divided into five broad groups: savings or self-financing; debt financing; contingent and crisis financing; climate insurance; risk transfer (reinsurance).
Alongside self-financing or savings opportunities, there are other mechanisms of debt financing, climate insurance and risk transfer. Such mechanisms could contribute to the process of bridging the gap in DRR and CCA finance on different levels, improve management of climate-related risks and resilience of the financial system to non-financial threats.
National DLT-based platforms for accumulation of savings and climate-related crisis financing.
Ministries of Finance, Ministries of Environmental Protection, International Organisations.