Climate-Contingent Finance

TL;DR

This paper proposes climate-contingent finance mechanisms that align incentives for proactive climate adaptation by linking payments to climate outcomes, reducing risks for both investors and adaptors, and creating economic value beyond traditional insurance.

Contribution

It introduces a novel financial framework that coordinates capital based on climate risk, allowing proactive adaptation with risk-sharing and targeted returns, applicable to various shared risks.

Findings

Climate-contingent finance aligns incentives for adaptation.

Investors can earn higher returns during extreme climate scenarios.

Mechanisms reduce over- and under-preparation risks.

Abstract

Climate adaptation could yield significant benefits. However, the uncertainty of which future climate scenarios will occur decreases the feasibility of proactively adapting. 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. Because the return on investment is a function of the level of climate change, it is optimal for the adapting entity to finance adaptation with repayment as 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, parties 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. This coordinates capital through time and place according to parties' risk reduction capabilities and financial profiles, while also providing a diversifying investment return. Climate-contingent finance can be generalized to any situation where 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 return to ameliorate the downside.