Dissecting the Banking Industry's Latest Move on Adaptation Financing

Is this the year the banking sector woke up to climate adaptation? A new UN-backed initiative certainly hopes so.

Last month, the Principles for Responsible Banking (PRB) – a coalition of 300+ banks that have pledged to align with the UN’s Sustainable Development Goals and Paris Climate Agreement – published guidance on Climate Adaptation Target Setting. Its purpose? To empower PRB signatories to invest in climate adaptation.

This means financing projects and activities that help businesses, communities, and households bounce back from climate physical risks, which are surging in frequency and severity. From wildfires rampaging across North America to floods in Pakistan, climate calamities are disrupting lives and livelihoods at an ever-increasing scale – and taking an economic toll, too. This is particularly true of developing countries, where the brunt of global heating is being felt. 

Financing Gap

Yet the current flow of capital toward adaptation is little more than a trickle. Total adaptation investment stands at US$63bn per year on average, according to a recent report, of which only around $1.5bn is attributable to the private sector. Contrast this to data compiled by the United Nations Environment Programme (UNEP), which found the adaptation finance needs of developing countries alone are between US$215 - 387bn per year. That’s one whopping gap between supply and demand.

Hence the PRB’s interest in adaptation finance target-setting. Using the guidance as a blueprint, banks can align their business models with local and international adaptation policies and capture ripe investment opportunities in the burgeoning market for climate resilience.

In no way is the guidance a simple appeal to banks’ better natures. Instead it explains why climate adaptation is an economic imperative, and something that has to be financed in the interests of risk management and asset protection.

It shouldn’t take banks too much convincing to see adaptation through this lens. After all, the financial havoc unleashed by climate change has been on lurid display this year. The Maui wildfires and extreme rains in India, China, and Japan decimated entire communities and brought down public infrastructure, the essential underpinnings of economic activity. Recent data out of S&P Global even found that without adaptation, up to 4.4% of the world’s GDP could be lost annually through climate-related impacts.

Paul Smith, climate adaptation consultant and physical risk lead at UNEP’s Finance Initiative and a key architect of the guidance, thinks companies already get this argument: “Most financial institutions will see this as a risk management issue, to ensure they know where their risks are, that their supply chains are diversified, and their portfolios as well.”

Opportunity Knocks

While the appeal to risk management may drive some banks to take adaptation seriously, it’s unlikely to mobilize the capital necessary to close the financing gap alone. That’s why another focus of the PRB’s target-setting guidance is on leveraging business opportunities in the climate adaptation economy. The hope is that by clarifying the link between adaptation measures and investment returns, banks will be incentivized to lend more. 

On paper, the opportunity is vast. The World Economic Forum estimates that the adaptation market could be worth US$2 trillion a year annually by 2026. Furthermore, all sectors and regions have adaptation needs, meaning there should be something for every type of lender to invest in. 

“Resilience can provide increased cash flows and hence bolster valuations in the future, disproving a lot of the myths that it’s all just downside and only risk management,” said Mahesh Roy, Investor Strategies Programme Director at the Institutional Investors Group on Climate Change (IIGCC), on a PRB webinar introducing the guidance. In fact, analysis out of the National Institute for Building Sciences Resilience, a US nonprofit, estimates that for US$1 invested in natural hazard mitigation avoids US$4-$11 dollars in future losses.

Groups like IIGCC and PRB are hard at work building the case for increased adaptation financing based on the potential upsides – and UNEP FI’s Smith points out there are plenty of quick wins banks could make if they start looking at adaptation through this “opportunity” lens. “There are things that cost very little – like early warning systems, changes in housing design, etc., that take very little effort and can have a pretty immediate return,” he says.

In addition, there’s a whole menagerie of profitable investments to be made that don’t have adaptation as their primary objective, but may generate co-benefits that will bolster adaptive capacity nonetheless. Think of advanced weather monitoring systems, water management infrastructure, and agritech. These and other activities should yield multiple benefits, of which improved climate resilience is just one. Hence why the guidance recommends banks explore the interlinkages between climate adaptation, climate mitigation, and nature when setting targets. Leveraging these connections will not only multiply the financial and environmental upsides of investments, they may also lower banks’ risk exposures more efficiently, too.

Data and Metric Hurdles

Making the case for expanding adaptation finance is one challenge. Ensuring banks have the necessary tools, resources, and data is another. Climate change writ-large is a systemic risk, but the frequency and intensity of specific climate physical impacts vary by geography and economic sector. This means banks need more data, better modeling, and improved climate scenarios to build a comprehensive picture of their particular exposures. Getting hold of all this is a work in progress.

“The data is still developing. For net zero, it’s about emissions, CO2e [carbon dioxide equivalent] is the metric that does most of the work, with decades of efforts on accounting and refining emissions information. Conversely, physical risk is multi-faceted and location specific. In addition, its augmentation by climate change is something that is still being worked out, as it’s very hard to extrapolate from historical models with the recent dramatic changes,” the IIGCC’s Roy says.

On the PRB webinar, Dipeeka Ramgolam, sustainability lead at Mauritius Commercial Bank, provided a practical example of banks’ data needs. “For us in Mauritius, we have a data challenge because we have started to track climate disasters, but overall on the island, trying to start with the physical risk assessment is quite challenging because we don’t have data downscaled to the size of Mauritius.” 

She also highlighted the “data and knowledge gap” among small and medium sized corporations, which are just starting to build an understanding of their physical risk exposures and the importance of adaptation. 

The dearth of useful impact metrics is another blocker. A bank’s ability to demonstrate how investments not only reduce risk but can have a positive impact on households, communities, and businesses is essential to justifying capital allocation to one adaptation project over another. This is already how multilateral development (MDBs) banks function, but is still a novel concept for private sector lenders. Aligning how MDBs and private banks assess opportunities could go a long way to streamlining public-private finance flows.

The IIGCC’s Roy agrees that this is key. “The financial industry needs to innovate with companies and governments to look at quantifying resilience benefits and finding ways to identify – and where relevant – commercialize adaptation and resilience opportunities,” he says.

Perfect is the Enemy of Good

There’s a whole ecosystem of vendors working on bridging data gaps and developing impact metrics. New coalitions of public and private entities have formed to address measuring impact too – including the Impact Disclosure Taskforce, which aims to promote impact reporting, analysis and financing in pursuit of the UN Sustainable Development Goals (SDGs). UNEP FI is also hustling to get more tools and resources in the hands of lenders. 

However, a key message out of the target-setting guidance is that banks need not wait for every last byte of data to get started on adaptation financing. 

“Lots can be done that doesn’t need granular analysis,” says Smith. “You just need to look at the [Intergovernmental Panel on Climate Change] AR6 report and see, for example, that there will be 20% less precipitation in a given region and therefore there’ll be a need to adjust irrigation. We don’t have to wait for perfect data.” 

There may be no such thing as “perfect data” when it comes to climate impacts anyway, given that forward-looking scenarios are inherently limited and rely on parameters and assumptions that are the product of expert judgment, rather than objective fact.

Now that the PRB guidance is live, UNEP FI and PRB are planning a pilot exercise with volunteer banks to work out the kinks and build industry support for adaptation target-setting. It’s also hoped that the pilot will generate the sort of noise that’ll attract central bank and policymaker interest. Smith acknowledges that regulators’ engagement would be helpful for creating the investment taxonomies, data resources, and disclosure requirements needed to embed climate resilience within bank business models.

“We need to challenge the central banks that regulate us and governments that make our policy framework to support this,” he says.