Rise of the Adaptation Bonds

This article was initially published by ImpactAlpha, a subscription-based, multi-channel digital media platform providing investing news for a sustainable edge.

Bonds that protect their issuers from climate shocks are making headlines.

This November, California residents will vote on a first-of-its kind climate bond that would raise US$10bn to harden the Golden State against floods, droughts, wildfires, extreme heat, and other hazards.

In Colombia, the International Finance Corporation is rolling out a US$50mn biodiversity bond that will pay for climate-smart agriculture and mangrove restoration, both critical to the country’s climate resilience. Cities in the US and Europe, banks in Latin America, and entire countries have also issued bonds to finance their adaptation needs.

The flurry of issuance underlines the potential of debt instruments to provide financing for the tough, unsexy work of strengthening communities, businesses, and public infrastructure as a rapidly heating planet brings more intense and frequent storms, floods, heatwaves, and fires.

From 2000 to 2019, global extreme weather damages averaged more than US$16mn per hour, according to the World Bank. Physical damage from climate-related disasters is expected to cost the world up to US$3trn a year by mid-century. Yet climate adaptation funding has long taken a back seat to mitigation.

Bonds are “a proven, demonstrated asset class with high demand from fixed income investors,” Ujala Qadir, director of strategy and programs at the Climate Bonds Initiative (CBI), told Climate Proofers earlier this year.

That positions them to scale quickly to meet surging demand. “We don’t need to puzzle over new and innovative instruments, though those are helpful, too,” she said. “We have something to start with that already kind of works.”

For years now, labeled debt instruments have been all the rage among sustainable investors. The CBI, a nonprofit that promotes the use of debt capital markets to support climate goals, says US$4.7trn of bonds labeled ‘green,’ ‘social,’ ‘sustainability,’ or ‘sustainability-linked’ have been issued since the market’s inception.

However, most have been focused on dealing with curbing emissions. Until recently, few of these bonds have financed efforts to deal with the physical impacts of climate change.

An analysis of green bonds by the Global Center on Adaptation and CBI found that as of September 2020, just 16% of green bonds included financing for adaptation and resilience activities, mostly from government-backed entities.

That’s starting to change. In recent years, a number of bonds with explicit adaptation goals have been sold — and the pace of issuance is quickening.

Bonds for climate adaptation and resilience “will be an important way for sovereigns and corporates alike to raise capital to respond to climate impacts,” says Sabrina Nagel, who leads adaptation and resilience for the UN High-Level Climate Champions and works as a senior advisor at the Atlantic Council.

For example, the Dutch government issued green bonds in 2019 and 2023 with some proceeds earmarked for the Delta Programme, the Netherlands’ multi-billion euro network of flood defenses. The 2023 bond was reopened earlier this year, raising an additional €2 billion on top of the nearly €5 billion achieved last October.

Institutional investors piled in. Roughly a quarter of the investors were pension funds and insurance companies; another quarter were asset management firms. Dutch pension fund APG has sunk €600 million ($650 million) into the bond. Hedge funds and private banks also took a slice.

The bond attracted broad-based interest beyond the low-lying Netherlands: Around one-fifth of investors were from the UK, 25% from other European countries, and 24% from non-European jurisdictions.

The Dutch aligned the use of proceeds with the adaptation goals of the EU’s new Taxonomy Environmental Delegated Act on climate change adaptation and sustainable use and protection of water, an addendum to the bloc’s blueprint for climate-friendly investment.

The Asian Infrastructure Investment Bank (AIIB) went even further last May, issuing an explicit climate adaptation bond, the bank’s first. The bond raised AUD$500mn (US$338mn) for projects where at least 20% of the financing will be devoted to climate adaptation.

One such project is the Punjab Municipal Services Improvement Project in India, which is enhancing water infrastructure for millions of people. The deal was more than twice oversubscribed, with the AIIB saying the adaptation theme persuaded many investors to pile in.

Adaptation bonds aren’t the sole preserve of sovereigns or development banks. Last December, asset manager Symbiotic Investments arranged a green bond for the Ecuadorian microfinance lender Banco Solidario. The issuance will boost Banco Solidario’s lending to small farmers for sustainable agriculture, climate smart farm inputs, restoration of natural landscapes, and soil erosion alleviation.

The bond will “help improve the productivity of small farmers in Ecuador and the quality of production, thus improving their credit risk profile,” said Symbiotics’ Sebastián Sombra.

As the Symbiotics example demonstrates, adaptation bonds offer a double benefit for investors. Not only do they provide direct returns through coupon payments, the climate-proofing activities financed may also reduce risk and improve the performance of other, related businesses.

“In the long run, we’ll be able to demonstrate what is already becoming evident: increased resilience leads to improved economic performance,” says Nagel.

This thinking influenced Swedish insurer Folksam’s SEK 2.5bn (US$230mn) investment in an adaptation bond issued by the City of Stockholm earlier this year. Folksam had a clear interest in supporting the bond, it said, since upgrades to the city’s water infrastructure financed by it could reduce the risk of policyholders filing expensive claims against flood-related damage.

Last August, storm Hans swept through Scandinavia, causing widespread flooding and US$1bn in claims for Sweden’s largest insurers. Folksam itself received claims from over 1,500 customers in the immediate aftermath. The bond investment may help shield the company from soaring payouts in the wake of future storms.

A similar thought process may motivate investors in two bonds issued by the San Francisco Public Utilities Commission in late July, which together raised around US$1bn to strengthen the resilience of its wastewater and stormwater systems.

About $430mn of the issuance will be sold on a taxable basis, which could attract international investors looking to build adaptation-oriented portfolios.

Issuers’ self-interest may drive increased adaptation bond issuance in the years to come. S&P Global estimates that up to 4.5% of world GDP could be exposed to climate-related losses by 2050 without adaptation. That’s a lot of economic output worth protecting by investing in adaptation today.

The development of clear standards and guidance on how to put together adaptation bonds could also help boost the use of such bonds. The Climate Bond Initiative is working on a Climate Bonds Resilience Taxonomy, to be published by year end, that will arm the market with common definitions and concepts for adaptation and resilience finance. The taxonomy will offer guidance on what investments and activities align with seven resilience themes, covering agri-food systems, health, infrastructure, cities, communities, industry and commerce, and nature and biodiversity.

“There’s really very little out there in terms of very granular level information that can guide issuers and investors [on adaptation],” said Qadir. “Issuers want to raise more finance from capital markets to fund their climate priorities, and they want to use thematic bonds. But they often struggle to identify what pipeline of projects could actually go into this bond,” she said.

Investors, meanwhile, need a large, liquid and credible market so that they can readily buy and sell the bonds, she said. “What the taxonomy is really trying to do is expand the universe of assets that are eligible to be included in these bonds.”

Thanks for reading!

Louie Woodall
Editor