Market arrangements:
These are instruments of government that influence the way in which industry actors behave in various markets. Examples include water trading and trade policy.
International discussion about climate finance for adaptation is dominated by a focus on the provision of financial aid by developed countries to developing countries to build their resilience against climate variability. However, it has become clear that adaptation investment must also become a priority for developed nations as severe weather events increase in severity and rapidity within their borders. Despite this reality, procuring or leveraging the necessary finance for such measures has not taken centre-stage in adaptation policy discussions. To date there has been no published estimate of the overall costs of adaptation in developed nations (Agrawala and Fankhauser 2007). Nonetheless, an indication of the required costs for adaptation in Australia can be ascertained from sector-specific calculations. For example, funding estimates for the adaptation components of the Water for the Future program – being only one policy initiative - exceed AU$11billion over 10 years (ABS 2012). Conversely, at least AU$63billion of capital assets in coastal settlements are vulnerable to inundation from sea-level rise (DCCEE 2009).
Accordingly, protecting assets – both fiscal and physical - from the risks of climate change is going to require significant capital outside of normal government channels and business as usual (BAU).
The importance of capital markets and private sector finance actors to this discussion becomes clear here. In 2011 the global bond and equity markets were valued at US$95 trillion and US$55 trillion respectively (Maslakovic 2011), which dwarfed Australia’s GDP (purchasing power parity) of less than US$1 trillion (CIA World Factbook 2012). Private sector finance actors are economic gatekeepers with access to money and the innate ability to move it around. For example, the Investor Group on Climate Change (IGCC) represents Australian institutional investors with approximately AU$900 billion of funds under management (IGCC 2012a). This includes industry superannuation funds, property investment trusts, retail and wholesale fund managers, and the research units of global investment banks (IGCC 2011). These entities also invest in several markets/assets for which adaptation investment will be required, namely: property (residential and commercial), transport infrastructure (roads, bridges, airports), social infrastructure (hospitals, prisons), utilities and network infrastructure, and agriculture (IGCC 2011). As such, institutional investors themselves have a clear interest in being involved in this discussion and any potential solutions.
Clearly, we need to be thinking about how best to incentivize and leverage private sector finance to facilitate the necessary capital for adaptation initiatives. Specifically:
(a) existing and future monetary assets, such as superannuation investments, need
to be protected for the long term; and (b) private sector finance/investment must be channelled into new and existing physical assets and infrastructure to increase climate resilience.
Unlocking the substantial potential for private investment will require overcoming certain institutional and regulatory barriers to investment. The first institutional barrier is simply awareness. Attention to climate change is not widespread amongst private finance sector actors in Australia or elsewhere. In 2008, a report of the United Nations Framework Convention on Climate Change (UNFCCC) noted that adaptation to climate change was not a significant consideration for private sector actors even though they are responsible for the bulk of investments in climate-sensitive sectors (UNFCCC 2008, p.34). More recently in 2012, Mercer found that climate-related policy risk alone could contribute 10% of risk to an investment portfolio yet “nowhere near 10% of the average risk manager’s budget or attention” is being dedicated to climate risk management for institutional investments (Mercer 2012, p.15).
Second, information asymmetry and perceptions of risk can create investment reticence. In the context of adaptation, robust cost-benefit analyses are hampered by information gaps regarding the precise local impacts of climate change and resulting costs, how impacts and costs might apply to specific assets, and a lack of definitional clarity around the term ‘adaptation’. Moreover, risk perceptions for climate-related investments are often high due to future uncertainties such as global and domestic climate policy frameworks and technology preferences (Brahmbhatt 2011).
Third, the long timeframes required for major infrastructure present challenges for business case evaluations of adaptation investment in physical assets. For example, the planning timeframe for refurbishing major infrastructure is 10 to 30 years, and major upgrades or replacements have an expected lifetime of 50 to 100 years (PIA 2004). As such, long-term risk/benefit analyses are required to project decades into the future. A concern for investors is that risks might arise after the completion of the project but during the life of the asset, which are very difficult to account for upfront.
Importantly, community benefits or ‘social returns’ of such investments, such as airports and utilities, are outside the timeframe and scope of private sector investment decisions (DCCEE 2011).
Finally, Mercer recently found that extant institutional barriers include a widespread deficit of ‘how to’ climate-related financing experience (Mercer 2012). Specifically, fund managers may not know where to allocate climate-related investments. This means that even robust climate-related investment opportunities will be overlooked if they do not fit neatly into an established asset-class classification or silo.
On this point, market-based innovations can assist fund managers to identify and allocate climate-themed investments. For example, the HSBC Climate Investment Indices re-classify industrial sectors into four climate-related themes: low carbon energy production, energy efficiency, climate finance, and water/waste/pollution control. In so doing, the Indices evaluate and funnel investment into “companies that
are focused on addressing, combating or developing solutions to offset and overcome the effects of climate change” (HSBC 2010, p.6). An investment analyst explained how sector performance correlates to government policy: analysts watch very carefully for regional and national policy initiatives or changes in order to ascertain investment targets. The targets are then fed into the Indices, which in turn inform the investment allocations made by fund managers.
In addition to institutional barriers, policy barriers also exist that inhibit private finance for adaptation. Such barriers to financing adaptation in physical assets or infrastructure are brought into stark relief when contrasted with the ‘investment-grade’ low-carbon policy framework. There are no equivalent market policy mechanisms that encourage finance for adaptation in physical assets or infrastructure. NPA grants, existing building guidelines and company reporting requirements are all insufficient to incentivise private investment, especially for existing assets and large portfolios. Moreover, disparate sources of information and conflicting planning regulations at different government levels impede private adaptation endeavours.
With respect to what needs to be done to address information barriers, the finance market case study this paper recommends the creation of a central repository of climate-related information to assist investment decision-making. Its purpose: to minimise gaps in available information particularly about the extent of likely local impacts; and to remove or at least coordinate disparate multi-jurisdictional sources of information. A central information resource will redress the institutional barriers of information asymmetry and skewed risk perceptions that create investment reticence, and the policy barrier of conflicting requirements between levels of government.
The repository must provide general access to standardised historical and predicted weather information in order to ensure a common reference framework for the private and the public sector at all levels (UNEPFI and SBI 2011). Moreover, financial actors require ‘applied’ research and information, tailored to specific sectors or geographies; they are not interested in pure climate information. They require specific information such as sectoral analyses, regional scenarios, databases of adaptation and clean tech projects, and extreme weather events (historical and predicted) (UNEPFI and SBI 2011); Economics of Climate Adaptation Working Group 2009).
Leading insurers and other financial service providers have developed statistics and competencies in these areas, including extreme weather and loss databases and catastrophe models. UNEPFI found that finance actors desire collaboration with research institutes and other partners to help develop information services and formats. Thus, a further benefit of a national repository is to provide opportunity for co-operation between private and public actors with different experience and knowledge.
Finance actors, particularly lenders and investors, also require climate-related company data upon which to base their decisions. Current ASX rules are insufficient to motivate voluntary corporate disclosure of the effects of climate risks. Disclosure of ‘material business risks’ occurs only at a board’s discretion and it is unlikely that directors currently consider climate-related risks in this light. Accordingly, a Corporations Act 2001 (Cth) amendment could be considered to obligate companies operating in Australia to report on their adaptation risks and strategies explicitly. At the very least a new ASX guidance on the climate change disclosures that public companies ought to provide in financial filings must be established, similar to that of the US SEC.
In either case, what would companies be required to disclose? An indicative list is this: climate risk management strategies; investment strategies; market segment vulnerabilities; climate impacts on pricing and capital; capturing climate opportunities; coastal and non-coastal analyses; stakeholder and local community engagement (Grossman 2012; Anderson 2006; IGCC et al. 2012). The finance market case study is very detailed in its recommendations, divided into non-coercive and coercive options for government. Non-coercive options can stimulate 1) climate change mitigation by supporting a business case for renewable energy and clean-tech, which surpasses a competing business case for fossil fuels, and brings low-carbon options to scale; and 2) climate change adaptation by supporting a business case for the replacement and refurbishment of existing and future physical assets/infrastructure to increase resilience. The recommendations cover blended finance options involving public-private co-financing of adaptation responses, use of tax credits, use of grants and use of climate bonds.
In contrast to the steering nature of non-coercive policy, coercive climate finance legislation would mandate how private finance actors must facilitate climate change adaptation. Two examples of coercing private finance actors to facilitate adaptation investment are discussed at length in the case study. These include taxation and legislative mechanisms. In the case of taxation, a financial activities tax (FAT) could be levied on defined ‘private finance institutions’ to tithe a specific percentage of their annual profits, which is then funnelled into specified initiatives. Indeed, a 2010 Australia Institute poll found that 81% of Australians wanted government consideration of a bank industry 'super profits' tax (The Australia Institute, 2010), which would require banks to tithe annual profits that reach a certain threshold.
Finance from this type of tax is usually funnelled into a national sovereign fund; in the case of a ‘climate finance tax’ however, funds could be directed into prescribed climate change adaptation initiatives.
In the case of legislation, prescriptions could stipulate that financiers must lend at preferential rates for infrastructure adaptation projects and household adaptation measures, or that institutional investors are prohibited from financially supporting listed carbon-intense projects or industries. Importantly, development/planning requirements (such as Environmental Impact Assessments) need to obligate developers and owners to consider climate impacts on existing physical assets.