Financing Adaptation to Climate Change with Climate Derivatives

Abstract

Natural hazard events in 2010 and 2011 such as the eruption of the volcano Eyjafjallajokull on Iceland, the heatwave in Russia, the extreme floods in northeastern Australia, and more recently the earthquake followed by a tsunami at Fukushima in Japan demonstrated the vulnerability of the networked global economy, where interruptions in supplies of important goods to industrial firms or to the food industry meant that gradually more and more sectors of the economy were affected. Further, interest in attributing the risk of damaging weather-related events to anthropogenic climate change is increasing. Hence, as climate change progresses over the coming decades, a widening range of sectors will experience both direct and indirect climate change related damages. The 2001 IPCC report stated that if greenhouse gas (GHG) concentrations were stabilised, sea level would nonetheless continue to rise for hundreds of years. However, according to the latest estimates from the International Energy Agency (IEA), in 2010 GHG emissions increased by a record amount, indicating that emissions are now close to being back on a business as usual path. Therefore, adaptation is inevitable and one has to build uncertainty into the planning process resulting from the effects of the emissions that have already occurred and will still occur in the coming decades. We propose to use climate derivatives to make climate investible in order to finance mitigation and adaptation to climate change. We give a detailed explanation of the mechanism used to provide higher yield than market to long-term investors, and describe as an example two structured products designed to finance adaptation via the real options approach and the context-first approach.