Private investment for climate change adaptation – difficult to finance or difficult to see the finance?
Finance for adaptation to climate change needs to be scaled up urgently. Developing countries, which are often the most vulnerable to climate change and also the least able to muster the financial resources for adaptation, rightly stress the importance of more financial support for climate adaptation so that they can continue to achieve economic development amidst increasing climate impacts. The world’s largest donor countries, through the OECD Development Assistance Committee (DAC), have made commitments to increase finance flows for climate adaptation. Now they need to follow through.
In this context, unlocking private investment for adaptation assumes a central place, given the massive financing needs, large climate adaptation gaps and the limited public resources available to address them. Climate mitigation investments such as in renewable energy infrastructure have received more finance than adaptation investments, as they are considered more easily ‘investable’. Such projects typically take the form of project finance and are linked to a cash-flow generating activity. On the other hand, adaptation investments in, for example, more robust housing, decision-making procedures to address extreme weather events, or modernised irrigation systems, are typically considered less well-suited for private sector financing. While 32% (US$15.5 billion) of all private finance mobilised by official development interventions between 2018 and 2020 targeted climate-related issues, only 4% ($1.8 billion) was earmarked exclusively for adaptation.
But is private investment in adaptation really so weak? Climate change adaptation finance is often understood in terms of project finance, which is typical of public development finance, and in particular infrastructure investments. In reality, however, most private sector financing does not go to distinct project finance but is part of the financial management of businesses. And infrastructure financing is rarely a purely private investment.
Considering private adaptation finance from a different angle
Continuous adaptation is an inherent feature of the private sector and a core function of the market. We are not only talking about adapting to climate change here, but also adapting to changing demand (customer needs and preferences) and supply-side shifts (business processes, supply chains and sourcing), for example. In this sense, adaptation is a function of business optimisation in response to changing external circumstances, and it is driven by the profit motive.
While uncertainties remain around the extent of future climate change impacts, many other factors that determine business outcomes make the future similarly unpredictable. But this uncertainty does not need to prevent private sector decision-makers from taking adaptation decisions now. For instance, choosing drought-resistant crops will protect, and ideally enhance, agricultural yields and income for farmers in the short term. Over the medium and long term, adaptation action will likely continue in response to the evolving impacts of climate change, more precise understandings of its trajectory and emerging solutions and technologies. Returning to the farming example, in five or 10 years from now weather patterns may have shifted significantly and agricultural technologies evolved. The best options for preserving and increasing farmers’ yields will be continually assessed to enhance profitability: decisions taken now on how to adapt are not final and irreversible, but part of a continuous process.
It is normal for firms to invest in adaptation to climate change through a business motive – even if they do not define such actions as ‘adaptation’. Empirical research on small- and medium-sized enterprises (SMEs) in developing countries finds that firm vulnerability to climate change is positively associated with R&D expenditure, implying that SMEs are already investing in innovation efforts to address climate vulnerability.
Private firms will invest in adaptation if it is relevant to their continued ability to be profitable and serve the market. They also have an incentive to adapt as efficiently as possible, i.e. to optimise the cost–benefit results of adaptation expenditure. That can mean no money is invested in adaptation if there is no need or direct benefit to the firm. Many local economic actors may not consider themselves responsible for spending on climate adaptation, instead looking to public adaptation investment to protect their businesses and livelihoods from large-scale catastrophic events such as floods or hurricanes – which is a government responsibility.
Private sector enterprises will not build dams. But they will make a substantial investment if doing so would yield better economic outcomes. In this respect the private sector has a natural incentive to respond to and service market demand for goods and services that simultaneously cater to adaptation needs.
However, there is an important caveat: access to finance is a basic condition for effective private sector investment in adaptation. This money does not have to be specifically designated as ‘adaptation’ finance, and businesses may not need to tap into dedicated external resources such as adaptation loans or adaptation equity: they might use existing funds from credit lines or retained earnings instead. Such activity would therefore not show up in adaptation finance statistics. Adaptation can be hampered by financial constraints if, for example, a business is unsuccessful in accessing external finance through borrowing. Adaptation responses therefore depend to some extent on access to finance and the broader enabling environment, and it is this ability to access finance in general that enables or constrains investment decisions.
Unlocking private finance flows for adaptation
The mobilisation of private (i.e. commercial) finance can unlock further private investment in adaptation by facilitating access to finance for enterprises that want to invest in adaptation projects and that may be constrained from accessing the external finance needed. Provision of such finance by banks, asset managers, asset owners or insurance companies is invariably linked to the ability to generate a financial return for the investor given the key impulse of (private) investment to select and support economic activities that will generate a financial return. Typically, private sector investment aims to generate predictable returns at sensible risk levels. Difficulties in evaluating the financial benefits from adaptation, as well as pricing the cost of inaction, make the mobilisation of private sources of capital less straightforward.
Nevertheless, there is an increasing understanding of the business opportunity in financing adaptation. Analysts at Bank of America point to a growing market for climate adaptation, suggesting that it could be worth US$2 trillion annually within the next five years. J.P. Morgan Asset Management view adaptation services as a business model and investments into climate-resilient regions and projects as opportunities to generate higher returns, for instance on real estate portfolios.
The role of development financiers and policymakers
Development finance can play a critical role in unlocking private finance for strengthened climate adaptation. When private investment into adaptation solutions is constrained by access to private financing sources, development finance – both in the form of concessional official development assistance (ODA) and market-rate development finance from bilateral or multilateral development finance institutions (DFIs) – can help break through the bottleneck. Blended finance – the strategic use of development finance to attract private finance – can contribute to building markets by enabling private investors to familiarise themselves with a new business model, region or type of investee. Critically, by improving the commercial viability of such projects, development finance could unlock additional, standalone sources of private finance in the future.
But blended finance cannot make up for the absence of an enabling policy environment. Rather, it can be part of an integrated approach to strengthen and support an enabling environment conducive to private investment. For instance, improving data from weather and climate observations has the potential to catalyse private investment into adaptive action by providing the foundation for local data processing and forecasting services. Further, such weather and climate data may improve the availability of insurance products, thereby increasing private investment that may otherwise be constrained in the absence of adequate tools for risk management.
It is critical that there is an environment generally conducive to private sector investment if we are to attract private investment into adaptation at the scale required. Development finance providers need to exploit all opportunities for scaling up financing available for climate adaptation, including from the private sector.