Adaptation Finance

Leader: Bruce Usher
Monday, April 22, 10:00am – 11:30am

About the Readings

Financing resilient communities and coastlines: How environmental impact bonds can accelerate wetland restoration in Louisiana and beyond
Environmental Defense Fund and Qualified Ventures, August 2018

To address growing land loss and storm impact concerns from Hurricane Katrina and subsequent storms, Louisiana’s Coastal Protection and Restoration Authority (CPRA) developed a robust $50 billion Coastal Master Plan (CMP). Last updated in 2017, the CMP guides actions to sustain the state’s coastal ecosystem, safeguard coastal populations, and protect vital economic and cultural resources. However, to date, only $9.16 billion to $11.76 billion in publicly available funding has been identified to support the plan. To help close the CMP funding gap and ensure existing funds are used as efficiently as possible, the Environmental Defense Fund (EDF) and Quantified Ventures (QV) explore how an environmental impact bond (EIB) could be designed to (1) help deliver critical infusions of private capital and (2) engage new classes of investors in support of restoration efforts in coastal Louisiana.

Discussion Summary

The challenge with financing adaptation is that there are very few opportunities using commercial market tools. There are not a lot of investments that will generate cash flow, and investors are rarely willing to try something new. Two tools discussed include environmental impact bonds (EIBs) and green bonds.

Environmental and Social Impact Bonds

Environmental impact bonds are very new, with only one reported implementation so far. It was done by Goldman Sachs, not for climate adaptation, but for storm water runoff in Washington D.C. What is less new is the background to the EIB structure. EIBs build off of a prior structure called a social impact bond, or SIB, which became very popular around 7-8 years ago. The idea behind a SIB is to align investors and put out capital with social outcomes. There are certain social issues where investing a little up front can mean saving a lot later. The first example of a SIB dealt with reducing recidivism. Housing prisoners is expensive, and recidivism rates are very high. Some individuals in the United Kingdom in 2011 suggested that if individuals invest in prisoners before their release, fewer would end up back in prison. This both betters society and saves a lot of money. If it works, the investors are then paid the savings that society is getting.

After the success of the first SIB, there was a huge boom in SIBs for all sorts of social ills. The problem is that there are very few opportunities to use SIBs effectively. First, it has to address a problem where the economic cost is very high. Second, it has to address a problem that has a known solution and is measurable. There are usually exogenous variables that affect the outcome, though, and that is where most SIBs fall apart. The SIB framework has been applied to EIBs because measuring environmental outcomes tends to be more straightforward. We generally know what the problem is, how to solve it, and can attribute our actions accordingly.

Green Bonds

Green bonds were also invented about 7-8 years ago, around the same time as SIBs. Like any other bond, a corporation issues a green bond, and investors gain money over time. The difference is that when the bond is issued, the corporation makes a promise about how they are going to use that money to do something “green” (e.g. a solar project). Green bonds are extremely popular with investors, as they are paid regardless of whether or not the intervention is successful. Green bonds don’t have any additionality. In comparison, with EIBs if the intervention fails, investors take on the loss.

Challenges with Environmental Impact Bonds

When it comes to EIBs, there are two, main issues of complexity that deter investors. The first is on the intervention side – how does the investor know that the intervention is going to be successful? Investors can quickly get lost in the complexity in the underlying science, particularly given how new EIBs are. The second issue is financial complexity. As soon as you structure a non-standard security, it becomes legally complex pretty quickly.

Investors also don’t like uncertainty. Catastrophe bonds issued by insurance companies work because they look at a portfolio of risk, or a whole range of outcomes, and operate off of a very specific trigger mechanism. Uncertainty, by comparison, is a binary outcome, and pertains to something that we don’t experience very often, like extreme weather events. If you are looking at storms across a country, that has to do with risk. But if you are looking at an adaptation intervention in Louisiana, the whole investment could be wiped out by a one-off storm. It becomes much harder to get investors on board, particularly commercial investors who are just looking for the best return.

This is why, in the early stages of figuring out how finance can go into a sector, the first players are typically foundations of high-net-worth individuals. The role that these foundations play is critical. They help figure out what does and doesn’t work. Once investors are more familiar with a financing tool, and see that someone is making money from it, they will follow. There was a similar discussion at first with mitigation financing. Over the last 10 years, we have gotten to a point where we can now raise large-scale capital because we understand the risks. We will get there with adaptation too, but we can’t afford to lose that much time in waiting.

Questions

  • Within the environmental impact bond structure, how do we measure the impacts of slow onset events? How can we channel adaptation financing for those types of problems?
  • The uptake of mitigation financing could be predicted by the lowering price of renewable energy. On the adaptation side, what is representative of adaptation costs, and can we predict them?
  • How can managed retreat be financed? There should be a benefit, but who is the beneficiary?