Climate Risk Bonds: How to Finance Climate Disaster Response and Adaptation

On a recent visit to California where drought has reached historic proportions, President Barack Obama announced a new initiative he intends to submit to Congress: a climate resilience fund. The fund, he said, would help communities address the increasingly costly consequences of climate change, including forest fires, drought, and floods.

While such a fund is needed, it shouldn't be the American taxpayers' job to pay for it. A far better approach would be an idea that has been around for decades: Make the polluter pay. Making polluters pay makes sense because it makes markets more efficient by placing the incentive to reduce pollution where it belongs -- on those responsible for it.

The two primary market-based approaches to climate change pursued thus far include carbon taxes and "cap and trade." Neither approach has gained much traction in Congress. But a third approach is one that can bypass Congress altogether and help state and local governments raise badly needed funds for climate disaster response and expensive adaptation measures -- climate risk bonds.

Bonding requirements for risky industries are nothing new. The federal government and most states require one form or another to help them cover their costs in the event of oil spills, industrial accidents, or abandoned infrastructure. It is time to extend this concept to the unambiguous risks associated with climate change. Here is how it would work.

Before issuing new permits to authorize extraction of oil, gas, or coal, state and local governments would require companies to post a climate risk bond to help offset economic damages expected from climate change disasters and help fund adaptation measures such as moving infrastructure out of floodplains. The bond would be calculated as the social cost of carbon- a per ton estimate of what the economic damages from new carbon emissions are likely to be, recently estimated by the Obama Administration to be roughly $40 per ton of carbon -- multiplied by the number of tons of carbon that are expected to be released over the lifetime of a project.

Take a typical well in North Dakota's Bakken field: With roughly 250,000 metric tons of carbon released over its lifetime, and at a social cost set at $40 per ton, this well would translate into a climate risk bond of $10,000,000.

What would happen to that $10,000,000? The citizens of North Dakota could choose as the costs of climate change hit home. For example, North Dakota does not now have a statewide plan to prepare for the health effects of climate change, and so a payout from this fund could be used to develop and implement such a plan. Or perhaps North Dakotans would use it to reimburse farmers whose crops are lost to extreme heat waves, droughts, and floods.

Rules of attributing extreme weather events to climate change (thereby triggering the payout) would have to be worked out, but progress is already being made on this concept in other regulatory settings. A means for equitable sharing of this form of finance would also need to be designed to aid states and counties who face steep climate change costs but who are not responsible for extraction. Ideally, the concept could be extended internationally.

Bonds would be held in trust and invested, as is the case with other forms of surety bonds and financial assurance instruments. And if climate disasters don't manifest or governments choose not to invest in adaptation, the funds would return to the oil, gas or coal company after operations cease.

This climate risk bond approach has all the right incentives. Instead of receiving subsidies to extract more coal, oil and gas, climate risk bonds would force fossil fuel companies to internalize the costs their operations place on the economy as a whole. Because risk bonds are returned once operations cease, the incentive to prolong production from marginal wells or mines would disappear. Since risk bonds would be based on emissions from combustion and extraction, companies would be incentivized to minimize methane leakage, a common problem in fossil fuel extraction, focus on energy sources with the lowest carbon content, and minimize the energy footprint of their operations.

The president's proposed climate resilience fund is a good idea. Climate risk bonds provide an equitable way to pay for it, bypass a dysfunctional Congress and empower local decision-makers to plan for the inevitable consequences of climate change.