Climate Adaption Equities

Scott Burns and Dirk Forrister have written a fascinating, creative paper on new methods of financing adaptation to climate change. (Private Investment, Market Mechanisms and Climate Change Adaptation: Options for Closing the Adaptation Financing Gap). They note that the World Bank estimates that climate change will trigger $70 to $90 billion a year of adaption costs for the global economy over the next 40 years - investments in energy and water infrastructure, emergency relief, new agricultural systems, and health threat response. Already, Bangladesh and Pakistan have established funds dedicated to investments that prepare for or mitigate climate threats.

Much of the paper is devoted to new types of climate adaption financial instruments. The authors argue convincingly that traditional private capital markets don't earn quantifiable returns from broad-based adaptation investments such as a new irrigation system or immunization program. They also remind us that many of the countries most vulnerable to climate change already have very large investment and infrastructure shortfalls. These shortfalls and their relatively new capital markets make it difficult or impossible for public sector entities to finance billions more in adaptation investments. Meanwhile, the hard-hit governments of the developed world have balance sheet troubles of their own and clearly not a good source of adaptation capital.

With this in mind, Burns and Forrister explore a wide range of approaches, including climate adaption credit trading, climate adaption bonds, dedicated loan funds, and other approaches. One example they give is a Climate Adaption Bond, which would give a semi-annual coupon in the case of no significant weather event and return principal after ten to twenty years. The principal would be guaranteed by the World Bank, and an infrastructure similar to that surrounding the CDM would be created to administer the program.

This may be an excellent idea, but it got me thinking about the terms under which such bonds would be sold and how the market would price them. Because the bonds pay a pre-defined interest so long as there is no severe weather event (as defined in the bond), they represent sovereign obligations of the adapting country. In effect, they are national loans whose interest is automatically forgiven if there is severe weather and whose principal may ultimately be forgiven if the World Bank chooses to exercise its guarantee. To investors, they are a combination of betting on the probability of that nature will dodge the defined severe events and the consequent value of the interest stream.

I wonder if a similar objective could be met under better terms if these Climate Adaption Bonds instead became Climate Adaption Equities. These equities would pay a dividend that was a function of the economic output of the issuing country, being careful not to count disaster-related outlays as positive output growth. By a predetermined formula, a small fraction of growth above the GDP baseline would add to the baseline "dividend yield" of the equity. And yes, for the sticklers among us it would probably be more accurate to call these preferred rather than common adaption equity.

Adaption equities might have some incentive properties and administrative aspects that improve on those of adaption bonds. The effect of disasters is that the economic output declines and governments' ability to raise tax revenues to pay either stock or bondholders declines. With climate bonds, however, there is a simple cliff - the defined disaster events - that governs whether the host country pays interest or not. If weather slightly less bad than the trigger event occurs repeatedly, the country may suffer just as much, perhaps more. Conversely, if weather outcomes are fortunate but other problems hinder the ability to pay bond interest, the loans could further depress the country's finances and ability to grow.

Another possible advantage of adaption equities would be investors' enhanced stake in the success of the host country. Rather than have a fixed coupon in all times other than disasters, investor returns would move with the countries' own economic success. Unlike the fixed bond obligation, this linkage to internal economic growth should make the taxation needed to service the equity more politically acceptable, lowering investor risk. At least in theory, no external financial guarantee should be necessary.

Defining the baseline level of economic growth at which the first level of positive dividends are paid would undoubtedly be a challenge, but it is also an opportunity to calibrate the equity much the same way investment bankers calibrate the issuance of new equity before an IPO. If the trigger level of growth for a dividend yield is viewed by the market as too optimistic the market will pay little for the adaption shares; if it is too little the host country will be underpricing itself. Similarly, the definition and calculation of the trigger growth provides the host country with an opportunity to redefine its economic goals as something beyond conventional GDP, which is a valuable exercise in its own right.

The idea of adaptation financing is in neo natal care, and there are surely financial, legal, and political challenges to every financial instrument we can now imagine. Nevertheless, as we strive to reduce climate harm through reduced emissions it is certainly worthwhile thinking about how we will finance an increasingly stressed economic infrastructure around the world.

DR. PETER FOX-PENNER is a Principal and Chairman of The Brattle Group and
author of Smart Power: Climate Change, the Smart Grid and the Future of Electric Utilities. The views expressed in this article are strictly those of the author.