Europe: Boosting public-private sector cooperation in DRR finance

By Oleksandr Sushchenko

Joint DG ECHO and UNDRR roundtable

24 October 2019, Brussels - Climate and disaster-related risks caused 426 billion EUR in economic losses for EU members in 2018–17, according to European Environment Agency data. As a result, climate change was acknowledged as a source of systemic risk for the entire European financial system.

The financial requirements of climate change adaptation (CCA) and disaster risk reduction (DRR) are enormous – up to 300 billion EUR annually. Public means alone cannot create the climate-resilient future we are aiming for. As a result, it is crucial to involve the private sector in mobilising finance  and sharing climate-related risks with other economic agents.

The event aimed to identify good practice in creating innovative instruments and mechanisms for both mobilisation of related financial resources, and transfer of climate-related risks to the financial market. In this context, CCA and DRR could be considered as two main strands for preparing the financial system for climate-related change. In addition, there are strong connections between CCA and DRR activities – both processes should be considered as a single complex issue.

Financial instruments and mechanisms in CCA and DRR

As a leader in providing a legal framework to build up sustainable financial system, the EU is exploring how to make the financial system more resilient to climate-related risks.

In 2019, European Commission published three reports about upcoming legal reforms and amendments on improving sustainability of the European financial system to climate-related risks. The Commission identified the following areas as extremely important:

• Non-financial reporting
• Standardisation of the green bonds issuance and labelling
• Incorporation of benchmarks for green projects.

In order to improve existing financial instruments, the EU Commission is looking for examples of best practice in mobilising climate-related finance and transferring related risks to the financial market. The meeting participants shared their experiences and highlighted the following schemes:

• Drought-index savings
• Climate Insurance and reinsurance tools
• Contingent & crisis financing.

As an example, financial transaction costs for small farmers are very high and the level of uptake for related insurance services is low. Drought-index savings products with Distributed Ledger Technologies (DLT) provide a potential solution when small farmers don’t want or are unable to afford to buy insurance products, for example, COIN22 Agri-wallet for farmers in Kenya.

In order to make insurance products affordable for small farmers, a broad range of innovative schemes are being used in different countries, applying parametric insurance (insurance that pays a predetermined amount when a defined threshold is reached) and DLT. Parametric insurance significantly reduces transaction costs as it eliminates the need for estimates and verification of actual losses on the ground. At the same time, basis risk remains the main obstacle to effective management of climate-related risks. In this case, DLT could provide the necessary tools to collect raw data and develop algorithms for self-improvement of parametric insurance schemes such as index-based insurance. Index-based insurance pays benefits based on a predetermined index, for example, rainfall level, for loss of assets and capital as the result of extreme events.

Implementation of innovative financial and insurance schemes such as index-based insurance, especially in developing countries, needs a solid backup with sufficient financial resources. The experience of multinational development banks such as the International Bank for Reconstruction and Development (IBRD) and humanitarian organisations such as the Red Cross could provide examples of successful innovative tools and mechanisms for the mobilisation of CCA and DDR finance. The best known example is the forecast-based financing scheme developed by the Red Cross and implemented in developing countries of Latin America and Africa.

Should climate-related risks be too large to be covered solely by national insurance schemes, those risks will need to be shared with other economic agents, or transferred to the financial market. Innovative instruments such as catastrophe bonds and Swaps could be effective solutions: a combination of these two instruments is being used by the World Bank Group to provide protection against climate-related risks in developing countries.

Challenges and solutions

As a result of the discussions, participants highlighted a set of the most urgent challenges:

• Investments need to be more resilient
• Disaster risks are not yet integrated into related processes
• Resilience is part of the social contract.

It is important to note that ignoring resilience while making investment decisions could result in an escalation of systemic threats and a cascade of financial risks. In addition, existing investment practices are examples of dealing with maladaptation: we need clear rules and requirements for self-regulated risk assessments, as well as being part of the legislative framework.

The participants concluded that an institutional body should be established to build a framework for managing disaster risks, including the following components:

• Identification of disaster risk-related contingent liabilities – legislation, insurance up-take, risk landscape
• Quantification of disaster risk-related contingent liabilities
• Disclosure of such liabilities and their integration into the fiscal and overall financial forecasting
• Mitigation of disaster risk-related contingent liabilities.