Climate adaptation and resilience needs more innovative funding – here's how to design financing to unlock it

Despite receiving much-needed attention at COP28, the UN's most recent annual climate change conference, adaptation and resilience is often seen as the ‘lesser cousin’ of mitigation in the climate change discourse – both in terms of focus and finance. As the adverse effects of climate change become more immediate and climate disasters turn into a lived reality, however, climate adaptation and resilience has an increasingly important role to play. Unfortunately, the question of finance remains though, leaving the adaptation finance gap to widen every year.

Climate adaptation and resilience financing reached an all-time high of $63 billion in 2021-2022, according to the Climate Policy Initiative, with 86% of this funded by development finance institutions (DFIs). But this amount is just 20-30% of projected annual A&R financing needs, which are estimated to reach $215-387 billion in developing countries by 2030.

So, what is hindering climate adaptation and resilience finance? Commonly cited reasons include information gaps (the cost of inaction is not understood well enough, for instance), complex project financing structures, lack of a common language for measuring climate risks and the value of adaptation benefits, and the limited bankability of adaptation projects.

These challenges must be addressed to move the needle on climate adaptation and resilience financing.

The time has come to look beyond traditional finance approaches to create an adaptation and resilience financing stack.

The bottom of this stack would be formed by traditional investments – primarily debt, equity and grants. These instruments, while foundational and critical, are insufficient to meet the growing demands of climate adaptation. There simply isn’t enough traditional capital available, and debt-saddled developing countries lack the fiscal space to scale this traditional finance to the levels required.

Despite the challenges, we remain optimistic about the future of climate adaptation and resilience finance because of the emergence of innovative financial instruments. These instruments, many in their early stages, could mobilise significant new capital from the private sector, institutional and impact investors, as well as philanthropists. Through creative design and sharing risks more broadly, these innovative approaches make investments more attractive to a diverse range of investors.

There are three primary categories of innovative climate adaptation and resilience financing instruments:

1. Disaster risk instruments

This kind of finance has been around for some time and is gaining in popularity. These instruments are designed to provide quick liquidity and debt relief after climate disasters. Examples include parametric insurance products and regional insurance pools, which are scaling up the role of insurance in climate adaptation and resilience. Catastrophe bonds are also gaining momentum. These bonds serve as high-yield debt instruments that create risk sharing for climate-related financial risks, and can be accessed during specific catastrophic events.

Under the latest addition, climate-resilient debt clauses allow lenders to agree to a temporary moratorium on loan repayments if pre-agreed climate disasters occur. At the end of 2023, the World Bank announced that it would broaden the scope of Climate Resilient Debt Clauses in its loans to include all existing World Bank loans for the most vulnerable countries. It would also allow borrowers to defer interest payments on new and existing loans — a form of relief that wasn’t available before.

2. Catalytic instruments

This type of finance is structured to leverage commercial capital on the back of concessional capital, which help blend the capital structure by reducing the risk or enhancing the returns for commercial capital providers. Examples include risk guarantees, where entities like MDBs assure lenders that they will step in to cover loan repayments in case of defaults arising from certain events (non-payment of dues by a sovereign, for example).

Additionally, pooled investment funds combine finance from various sources into different risk-return tranches for projects with specific climate adaptation and resilience goals.

3. Outcome-based instruments

The most recent and novel approach in climate adaptation and resilience finance, these instruments focus on incentivising specific results. This ensures that financial resources are channelled towards projects that deliver tangible outcomes. Examples include debt-for-nature swaps, where countries receive debt waivers for prioritising quantifiable conservation targets, or adaptation benefits mechanisms (pioneered by the African Development Bank). The latter provide fiscal credits for achieving adaptation outcomes, which increases the bankability of a project.

The good news is that innovative financing instruments are moving from being discussed in the meeting rooms of climate conferences to being actioned by bankers and investors. Here are some recent examples:

Guarantees: The the Asian Development Bank’s (ADB’s) Innovative Finance Facility for Climate in Asia and the Pacific (IF-CAP) is the first leveraged climate finance guarantee mechanism by an MDB with a specific adaptation component. Using financial guarantees from partners, IF-CAP lowers ADB’s capital requirement for credit risk. This frees up resources for climate project lending, with simulations suggesting that each guaranteed dollar could generate up to $5 in new climate loans.

Pool investment funds: The Landscape Resilience Fund (LRF), co-developed by South Pole and the World Wide Fund for Nature (WWF), and supported by the Global Environment Facility (GEF) and fashion label Chanel, provides capital to small and medium-sized enterprises in the Global South that are prioritising resilience outcomes. The fund’s initial investment in Koa, a Swiss-Ghanaian cocoa company, has already secured over $5 million in additional private investment, which will enhance cocoa production and improve farmers’ resilience in Ghana.

Climate adaptation bonds: The Asian Infrastructure Investment Bank (AIIB) has successfully launched its first climate adaptation bond under its Sustainable Development Bond Framework. This five-year bond raised AUD500 million, earmarked for projects with at least 20% of total financing dedicated to climate adaptation. This bond aims to increase awareness and investment in climate-resilient infrastructure. It aligns with AIIB’s goals to boost adaptation financing from capital markets and support climate-resilient solutions through bond issuance, in line with its COP27 commitments.

The challenge posed by extreme weather events and temperature rises due to climate change has never been graver. This means our response also needs to be bolder.

The time has come for policymakers, MDBs, philanthropists and commercial funders to collaborate and mainstream the use of innovative financial instruments. Meeting the climate adaptation and resilience funding gap could help save the world from the worst effects of the climate crisis.