How will the world fund the transition to net zero? Insurance will be an increasingly vital part of the solution, supporting capital markets to enable flows of finance to address the move to a lower carbon economy.
Time is short, with emissions of greenhouse gases (GHGs) continuing to rise globally, despite efforts aimed at reductions. Reversing that trend will require substantial investment. The latest report from the Independent High Level Expert Group on Climate Finance estimates that between 2025 – 2030, total climate incremental investment needs to reach $6.3-6.7 trillion.
A significant proportion of that investment will need to come from private capital. Financial flows and products will need to evolve to match this need.
However, there are significant risks associated with financing climate projects - from political and geopolitical uncertainty to the unknowns of new technologies. Many potential providers of capital are struggling to deliver funding at the scale required of them.
Insurance solutions can help to overcome some of these barriers. Derisking finance with insurance can unlock more of the capital that is critically needed.
Credit insurance solutions are an example of where insurers have a key role to play in supporting decarbonization. The use of insurance as a backstop in project finance can provide comfort for investors concerned about the risks typically associated with the construction and operational phases of climate transition technologies.
These risks are very real. Even in areas where new technology is more proven, there's concern about the potential for losses on project finance and broader lending activity. In the renewable energy field, for example, lenders worry about the current imbalances between generation and distribution infrastructure; projects to increase clean energy production may be undone by the difficulty of getting the energy to the market. Other issues such as high inflation, supply chain constraints and high costs can also break the economic viability of some of these projects.
In other areas, meanwhile, nervousness about the risks attached to emerging technology is holding finance back. By some estimates, for example, enhanced rock weathering – the process of accelerating how nature captures carbon through silicon rock weathering – has the potential to help contribute to between 6–30 Mt of CO2/year removal. Yet investment in this early-stage technology has so far been relatively modest, hampered by a lack of awareness and understanding.
Credit insurance solutions help finance providers overcome these understandable concerns. When banks, investors and financial institutions transfer some of the risk to insurers, they become more comfortable funding projects they might otherwise have avoided – or provide more funding than would otherwise have been possible.
These solutions can be augmented with cover such as political risk insurance. This mitigates country risk and losses stemming from conflict, expropriation and other disruption, a concern with many long-term infrastructure investments.
Importantly, this isn’t simply a question of satisfying banks’ credit committees or persuading asset allocation teams to support the climate finance transition. Working with highly rated insurers may prove critical in enabling banks and other institutions to be able to support a wide range of climate change initiatives while remaining compliant with the Basel standards.
Debt-for-nature swaps are another means of unlocking finance for climate change solutions. Debt-for-nature swaps are financial mechanisms enabling countries to channel funds into conservation and climate resilience initiatives without accumulating additional debt.
Often countries need swift resources for disaster response while still meeting their debt servicing obligations. Parametric insurance provides a risk transfer solution that swiftly pays out after a natural hazard event, with those funds available to use as desired by the insured. For example, pay-outs from parametric insurance can be used by a country to meet their debt servicing obligations after an extreme weather event, keeping the loan agreement intact. This is an example of parametric insurance helping to derisk this financial instrument, thus supporting and enabling countries to reinvest in conservation projects.
Insurers can also play an important role in supporting a more rapid evolution of global carbon markets. These markets, where carbon credits can be bought and sold, help organizations mitigate currently unavoidable GHG emissions, either through voluntary purchases or mandatory compliance with regulation. They represent an opportunity to help close substantial investment gaps.
Financing for carbon markets and carbon credits is growing, but not at the speed required. To meet this potential, the market needs to scale. It faces challenges in both supply and demand: while the market’s potential is high, it is currently small and lacks investment-grade infrastructure. Risk aversion is a critical issue; research from the World Bank points to “a diverse spectrum of risks” that included potential problems ranging from non-delivery and reversal of credits to counterparty, political, reputational and invalidation risk.
Insurance is now available, for example, to mitigate pre-issuance risk, where carbon credits are bought on a forward-purchase basis, becoming available once a new project reaches maturity. The insurance, bought to cover as much of the period until maturity as possible, pays out if the project underperforms and there is an underdelivery of carbon credits. This could be because a natural disaster destroys a project, for example.
Alternatively, cover can be purchased against post-issuance risk. Even once a project has generated a credit, this may not endure if an adverse event occurs, or the credit is invalidated for some reason. In which case, insurance, typically renewed annually, can provide crucial financial indemnity.
As with credit insurance, carbon insurance provides lenders and investors with greater confidence to support the carbon credit markets with capital – and therefore to facilitate the financing of new projects. It also has the same potential to ease regulated entities’ concerns around their Basel compliance responsibilities in the context of capital at risk (CaR).
This is a fast-growing sector; analysts estimate that the total addressable market for carbon credit insurance to be around $1bn of annual gross written premiums in 2030, rising to $10-30bn by 2050.
The imperative now is to unlock and scale up climate transition finance. Although the sweeping reallocation of capital presents compelling investment opportunities, insurers and financial institutions remain sharply focused on the spectrum of risks – from well-established exposures to emerging uncertainties. In this regard, insurance provides a crucial source of risk transfer. More widespread use of a range of insurance solutions can drive the sustained and rapid increase in investment now required to confront the climate change challenge.
To find out more about how we can help with unlocking finance for climate change initiatives, please get in touch.
