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Finance

How the Financial World Adapts to Climate Change

Knowing the ins and outs of upcoming trends in finance is indispensable for any aspiring consultant. You are likely to receive a question at your upcoming job interview, which assesses to what extent you are up-to-date with the latest business developments, and also requires you to reflect on that knowledge with regards to a major social-political issue.  A prime example for such a question is how finance is adapting to the issue of climate change, and might assist its mitigation.

Green Finance

Green finance is any structured financial activity that funds the development of green projects, minimises the environmental impact of ongoing ones, or both. The most common type of green finance are government-issued bonds, which first came about as structured AAA-rated bonds from the European Investment Bank. The value of green bonds traded in the market is projected to skyrocket from around EUR 670 billion in 2020 to EUR 2 trillion by 2023. While the top three issuers are the US, China and France, the growing role of the European Central Bank is notable. When it comes to private loans, green investments appear to be less significant, although reporting on this segment is less rigorous. The most common green loan structure is the ‘sustainability-linked loan’, which links the term of the loan with how the borrower scores on predetermined sustainability factors. As things currently stand, global finance has not really embraced sustainability-focused financial instruments, but there are a few promising developments worth having a look at.

Insurance

As the frequency of natural disasters increase, insurance companies are starting to include climate science and the projection of environmental hazards into actuarial assessments, thereby moving away from the traditional reliance on historical data. An interesting new set-up is parametric insurance, where payouts are based on the severity of the trigger event, not on the value of assets actually lost. For instance, the payout might increase with the wind speed recorded for a hurricane. Though the insured firm risks losing more than the payout, the advantage is speed and ease. It is far easier to quantify the severity of a storm than to calculate damages, so payouts can be processed more swiftly. This non-traditional type of insurance is especially applicable in the agricultural sector of developing countries where climate-related disasters take the greatest toll, but where the administrative systems needed to quickly and accurately assess damages do not exist. A success-story in this regard is the Caribbean Catastrophe Risk Insurance Facility (CCRIF), which has assisted St. Lucia to recover from multiple earthquakes since 2007, and assisted the Turks and Caicos Islands to recover from Hurricane Ike in 2008.

Resilience Bonds

Resilience bonds are hybrids of bonds and traditional insurance whose proceeds are invested in projects to reduce the impact of climate change. An institution can issue these bonds to raise money for a ‘resilience project’, such as building new seawalls, and investors are rewarded with coupon payments. If there is a trigger event, a proportion or even all of the principal value of the bonds is kept by the issuer to cover damages. The idea is that a company seeking to insure against climate risk and also reduce its exposure to climate risk could issue these bonds.  The European Bank for Reconstruction and Development (EBRD) launched the first ever dedicated resilience bond in 2019, which received a AAA rating, raised US$700 million, and was used to fund Tajikistan’s Qairokkum hydropower plant.

Final thoughts

Although green finance remains marginal today, there is huge untapped potential in these types of financial instruments. Asset managers are paying increased attention to Environmental, Social and Governance (ESG) criteria for a good reason. According to the study of Stephen Malinak and Greg Bala, an investment portfolio that picks the top 30% of companies based on their ESG momentum has been shown to consistently outperform an S&P 500 index within five years [pdf]. Keeping an eye on developments in green finance may turn out to be handy for any business consultant.

Bence Borbély is a Hungarian first-year History and Politics student at the University of Cambridge whose professional fields of interest are management consultancy, public policy-making, politics and international relations.

Image: Pexels

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