CHAPTER 3: Private Sector Focus

Key take aways

This chapter identifies seven potential sources of private sector finance for developing countries vulnerable to climate change induced loss and damage (L&D). It sets out how these sources might be implemented and adapted to offer solutions which address their financial needs in the event of L&D. The seven sources are summarized below:

A catastrophe (‘cat’) bond is a particular type of debt instrument which permits the issuer of the bond to defer, reduce or cancel its obligation to repay the debt and /or interest due to investors where a predefined trigger event – being some form of catastrophe – occurs. As a result, when cat bonds are issued by countries (a sovereign Cat Bond), the debt that would otherwise be owing to investors can be directed toward vulnerable citizens rather than foreign creditors in the event that the catastrophe predefined in the sovereign Cat Bond occurs. Cat bonds have significant potential as a source of private finance towards L&D, i.e., an L&D Cat Bond. However, to realize this potential the design of the bonds will need to be adapted as follows: a) an expanded range of trigger events covered within a single product and, if possible, inclusion of slow onset events; b) the provision of subsidies which can cover the higher structuring costs and interest rates that these bonds attract, and; c) the provision of guarantees in favour of countries with low sovereign credit risk ratings in order to attract investors to these bonds.

A debt swap is a transaction that typically takes place when a lender and a borrower agree to renegotiate debt typically due to borrower’s cash flow problems and for debt relief. Debt swaps are often used to restructure sovereign debt of highly indebted countries. In climate finance, debt for nature swaps have become an increasingly popular alternative to provide debt relief to highly indebted countries while also encouraging these countries to earmark a portion of the forgiven debt proceeds towards environmental conservation. A debt for L&D swap would require limited adjustments to the existing template used for debt for nature swaps. The most significant adjustment would be to agree with the borrowing country on a set of L&D criteria for the deployment of the funds towards L&D uses. This capital may be deployed from a national L&D trust fund, similar to the conservation trust funds that are typically set up in debt for nature swaps.

A private sector guarantee is a risk transfer mechanism whereby a third party (a guarantor) agrees to pay to a private investor if there is a default or loss of value on an individual investment or portfolio. Guarantees are typically designed to mitigate a range of risks for investors and to help attract more risk-averse private investment capital. Additionally, guarantees are only claimed and paid out in the case of a loss and hence allow for a more optimal use of resources. Donors and the public sector often offer guarantees to support investments that can generate social and environmental outcomes. This includes climate finance, where guarantees can support investments with positive climate mitigation and adaptation outcomes but have comparatively weak risk-return profiles. L&D guarantees that can catalyze private sector finance need to provide explicit coverage and support in the event of defaults or loss in value due to extreme and slow onset L&D events, as compared with the indirect blanket coverage that guarantees currently offer. This may include: a) concessionary support to mitigate a higher proportion of portfolio losses due to L&D than due to other shocks; b) subsidized guarantee utilization fees for L&D guaranties as compared with ‘standard’ guarantee products; and c) offering direct support for post-L&D actions that may help investees and their communities and landscapes recover more quickly from L&D.

Risk pooling is an alternative form of risk management that takes place when individual risk holders agree to jointly support each other in the event of a negative exogenous shock. In climate finance, multi-country risk pooling (e.g., the Caribbean Catastrophe and Risk Insurance Facility) has become increasingly common among countries as an alternative to individual sovereign climate insurance solutions, which can sometimes be more costly or not available. Private sector businesses, especially small businesses in emerging markets, are also often receptive to local risk pooling to protect themselves against risks that are too expensive to insure, or for which there is no locally available insurance solution. These private sector risk pooling facilities are increasingly devoted to managing their members’ own climate-related risks, including their impact on member health and incomes. The key challenge for potential private risk pooling facilities seeking to mitigate L&D extreme and slow onset events risks is scale such that its members’ risks are uncorrelated. There are several potential venues for risk pooling facilities to reach necessary scale. The public sector at a national level may seek to spread risk pooling facilities across its geography, potentially by leveraging organizations under common ownership models (e.g., a network of cooperatives or business associations). Governments may also further seek to potentially roll-up those risks within its own, multi-country risk pooling facilities for additional risk diversification (such as the Livelihoods Protection Policy currently offered by the Caribbean Catastrophe and Risk Insurance Facility). Large businesses that are encouraging the adoption of climate adaptation practices by suppliers operating within their value chains may also support the development of risk pooling solutions among their supply chain and potentially in partnership with other larger businesses in the area.

In addition to the L&D financial products above there may be other innovative opportunities to mobilize the private sector for L&D finance. This includes the following:

‘Frontloading’ binding and undisbursed grant commitments by issuing bonds to be purchased by retail investors that will be paid against those upcoming grants. ‘Frontloading’ would allow for earlier L&D investments before the climate crisis worsens and L&D funding needs increase. Frontloading requires a relatively complex financial set-up which incurs significant fixed fees payable to financial institutions and professional financial services firms, and which is only cost-efficient at scale. A L&D Fund could leverage long term and binding grant commitments from donor countries to issue its own L&D bonds but would require total binding commitments from donors to be long term commitments and significant in value.
Offering L&D ‘Results-Based Payments’ to the private sector. ‘Results-based payments’ is an umbrella term to describe initiatives where donors make payments upon the accomplishment of results rather than for the efforts to accomplish those results. Examples of results-based finance solutions that may be especially well suited for L&D include: a) natural climate solutions focused on agriculture, forestry, land-use and oceans; and b) sustainable infrastructure in energy, water, transport, urban, and other sectors that provide public goods to better address L&D. Importantly, L&D ‘Results-Based Payments’ would require donors to define measurable L&D target outcomes, have available data sources and monitoring systems to track and validate L&D outcomes, and ensure that the costs of achieving those L&D outcomes are fairly priced.
Credit card fees to help capitalize a L&D Fund. Credit cards companies charge fees both to customers and merchants, including interest and late payment charges and annual fees (for the former) and processing fees between 1.5% and 3.5% (for the latter). Some credit cards in the past have earmarked a portion of those fees to fund projects that fight climate change. A L&D Fund may explore engaging these credit card companies to agree for one or several cards to allocate a portion of its fees to finance its L&D activities. This would involve having the credit card company allow a portion of its existing credit card profits to be passed on to a L&D Fund (as a CSR activity), or to increase its credit card fees to cover this additional expense, which would result in increased fees for merchants and, ultimately, for consumers.
Philanthropic funding is a source of finance that historically has been focused on financing other issues such as health and education. However, climate change, including L&D, has clear potential of being a more prominent motivation for philanthropic donors, which could increase donations towards the funding arrangements and the fund for responding to L&D

Catastrophe (“cat”) bonds

Overview

One solution which has been identified to enable the costs flowing from L&D to be financed by the private sector is through issuances of catastrophe or ‘cat’ bonds. Cat bonds are debt instruments that, until relatively recently, were typically issued by companies in the insurance industry, allowing them to receive funding from the bond in the event of the occurrence of a natural disaster or extreme climate event. The cat bond market is worth over $40 billion.

Reuters (2023). Cat Bond Funds Ranked Among 2023's Top Performing Credit Funds. Available at: https://www.reuters.com/markets/rates-bonds/cat-bond-funds-ranked-among-2023s-top-performing-credit-funds-2023-08-09

Where a cat bond was being issued by an insurance company, it would be issued by insurance companies to investors such as hedge funds and the insurance company making periodic interest payments to those investors and ultimately repayment of the bond at the end of its term. Notably, however, the terms of the cat bond would specify that where a predefined trigger event occurred, the obligation to pay interest and/or repay the principal to investors was either deferred, reduced, or cancelled.

See definition in Ando, S. et al. (2022). Sovereign Climate Debt Instruments: An Overview of the Green and Catastrophe Bond Markets. IMF Staff Climate Note. Available at: https://www.elibrary.imf.org/downloadpdf/journals/066/2022/004/066.2022.issue-004-en.xml, and brief history of the Cat bond market in https://www.artemis.bm/library/what-is-a-catastrophe-bond/

Within the insurance industry, these trigger events have been defined under the terms of cat bonds as actual losses experienced and thereby creating an obligation for investors to indemnify the insurance company for those pay outs made. Such trigger events can also be industry-wide losses beyond a critical point (industry loss trigger), or a weather or disaster index (parametric index trigger). As a result, the benefit to the insurance company of issuing the cat bond is that the defined catastrophe, e.g., weather reaching a particular index, is transferred to the investors in the bond.

Although cat bonds have typically been issued by countries in the insurance industry, some countries, particularly those highly exposed to climate-related risks, have started issuing sovereign cat bonds (or restructuring their existing sovereign debt into cat bonds) to ensure that when a disaster hits, resources are directed toward vulnerable citizens, not foreign creditors.

Ando, S. et al. (2022). Sovereign Climate Debt Instruments: An Overview of the Green and Catastrophe Bond Markets. IMF Staff Climate Note. Available at: https://www.elibrary.imf.org/downloadpdf/journals/066/2022/004/066.2022.issue-004-en.xml

Many of these sovereign cat bonds are structured based on parametric triggers and do not require significant upfront public cash disbursements by the issuer.

Braun, A., and Kousky, C. (2021). Catastrophe Bonds. Wharton Risk Center Primer. Available at: https://riskcenter.wharton.upenn.edu/wp-content/uploads/2021/07/Cat-Bond-Primer-July-2021.pdf

These sovereign bonds are typically issued outside of the UN system and marketed directly to public and private bond buyers.

For an updated list of Cat Bonds see: https://www.artemis.bm/deal-directory/

The cat bond market is worth over $40 billion.

Jamaica is one instance of a country that has used cat bonds in its strategy to protect against losses arising from potential, future natural disasters.

World Bank (n.d.). World Bank Catastrophe Bond provides Jamaica with Financial Protection against Tropical Cyclones. Available at: https://thedocs.worldbank.org/en/doc/43a111757d3b1ff1cabde80ee7eb0535-0340012021/original/Case-Study-Jamaica-Cat-Bond.pdf and World Bank Blogs (2021). How the Catastrophe Bond Market Is Supporting Financial Resilience in Jamaica. Available at: https://blogs.worldbank.org/latinamerica/how-catastrophe-bond-market-supporting-financial-resilience-jamaica

Following estimated costs of USD 1.2 billion between 2001 and 2010 from the effects of natural disasters such as hurricanes and earthquakes, the Jamaican government implemented a series of climate finance/risk measures, one of which was to issue a USD 185 million cat bond to account for the country’s tropical cyclones, the premium of which was partially paid by the US, UK and Germany. The measure was significant because it was the first time a small island state had issued a cat bond and it is regarded a useful precedent.

Limitations

As has been described above, Cat bonds have significant potential to provide funding towards L&D, i.e., an “L&D Cat Bond”. However, there are certain characteristics of the current structure of cat bonds which limit their potential for use as L&D Cat Bonds and require addressing.

International Capital Market Association (2022), ICMA publishes new climate resilient debt clauses to facilitate sovereign debt relief and financial stability. Available at: https://www.icmagroup.org/News/news-in-brief/icma-publishes-new-climate-resilient-debt-clauses-to-facilitate-sovereign-debt-relief-and-financial-stability/

First, a key characteristic of cat bonds as currently structured is that they only insure against a small number of trigger events and cover only a small portion of the total possible loss and damage that a ‘catastrophe’ entails.

DiFiore, P. et al. (2021). Catastrophe Bonds: Natural Diversification. Neuberger Berman. Available at:
https://www.nb.com/en/global/insights/white-paper-catastrophe-bonds-natural-diversification

They do not provide full coverage against possible damages, and they often come with stricter terms and conditions than traditional insurance.

Second, issuers of cat bonds also find that cat bonds are a more expensive financial product than vanilla sovereign bonds. There are two reasons for this. The first is that cat bonds are typically complicated and time consuming to structure, which increases the fees incurred when putting them in place. The second is that since a cat bond offers a bond product and an insurance product combined the interest paid by the issuer of a cat bond is higher than the interest paid for a vanilla sovereign bond.

Third, cat bond issuances are restrictive with respect to the nature of the issuer and the duration of the bond offering. Cat bond issuances are typically restricted to sovereign states which have satisfactory credit risk ratings and have relatively short bond maturities, often of between 3–4 years, but sometimes less so the bond needs to be reissued frequently.

DiFiore, P. et al. (2021). Catastrophe Bonds: Natural Diversification. Neuberger Berman. Available at:
https://www.nb.com/en/global/insights/white-paper-catastrophe-bonds-natural-diversification

As a result, the market for cat bonds, although growing, is still relatively small and few countries have insured themselves against natural disasters.

Potential for Financing L&D

The International Capital Markets Association has proposed using climate resilient debt clauses to defer countries’ debt repayments in the event of predefined, severe climate shocks or natural disasters, including slow onset events.

International Capital Market Association (2022). ICMA publishes new climate resilient debt clauses to facilitate sovereign debt relief and financial stability. Available at: https://www.icmagroup.org/News/news-in-brief/icma-publishes-new-climate-resilient-debt-clauses-to-facilitate-sovereign-debt-relief-and-financial-stability/

Despite current limitations in the design of cat bonds for L&D purposes, there are several innovations which could result in an effective L&D financial product. First, the range of trigger events covered within a single product needs to be expanded. These trigger events can include a broad range of extreme climate-related risks to address L&D more comprehensively, by simultaneously covering events such as heatwaves, storms, and cyclones. These L&D Cat bonds, like non-L&D Cat bonds, will not be issued under the UN system, and instead will be marketed directly to public and private bond buyers and cannot capitalize an international L&D fund.

An expansion in the insured risks and insurance coverage, which will be required in order to cover a broad range of L&D risks, is likely to result in increased structuring costs and higher interest rates and further limit access to low-income countries. The Global Risk Financing Facility, funded by Germany and the UK and housed in the World Bank, is exploring providing financial and technical support for accessing and underwriting disaster-risk insurance.

World Bank Press Release (2018). World Bank Group, Germany, and UK Launch $145 Million Financing Facility to Support Earlier Action on Climate and Disaster Shocks. Available at: https://www.worldbank.org/en/news/press-release/2018/10/12/world-bank-group-germany-and-uk-launch-145-million-financing-facility-to-support-earlier-action-on-climate-and-disaster-shocks

It could expand its remit by covering similar expenses in the structuring of L&D Cat Bonds. The Global Shield is also exploring offering insurance premium subsidies that can partially offset insurance costs.

Given this mission, the Global Shield may also explore covering the differential interest payments of a plain vanilla sovereign bond and a L&D Cat Bond for a given issuer, which would account for the additional insurance costs.

There could also be an opportunity to address the limits in the amount of L&D funding that a cat bond is able to offer given that debt/interest payments are rarely enough to fully cover the costs of L&D event.

When a trigger event for an L&D Cat Bond takes place, Global Shield (which is exploring directly subsidizing national L&D insurance schemes) may consider matching any additional funding (from reallocated debt expenses) to address L&D with its own additional complementary funding.

Additionally, donors and any upcoming L&D funds could encourage the cat bond market to expand into countries with lower sovereign risk ratings by, for example, providing an additional partial guarantee to sovereign debt investors to guarantee the issuers interest/principal repayments.

Finally, and more technically challenging, pricing and availability of L&D Cat Bonds will depend on the quality of the underlying L&D risk forecasts and data, including projected frequency and severity, which is often lacking in emerging markets. Technically, slow onset L&D events can be built into a parametric trigger, but it will likely need increased research and could result in a significant increase the bond’s price.

Debt swaps

Overview

A debt swap is a transaction that typically takes place when a lender and a borrower agree to renegotiate debt typically due to borrower’s cash flow problems and for debt relief. In legal terms, it usually requires the parties to sign agreements to terminate the existing debt obligations and enter into fresh debt obligations. As part of a debt swap, a third party may decide to cover a portion of the outstanding debt or purchase it from the original lender.

For an overview of debt swaps see Marcos, M. et al. (2022). Debt-For-Climate Swaps. Analysis, Design, and Implementation. IMF Working Papers, Volume 2022 issue 162. Available at: https://www.elibrary.imf.org/view/journals/001/2022/162/001.2022.issue-162-en.xml and OECD (n.d.). Debt for Environment Swaps. Available at: https://www.oecd.org/env/outreach/debt-for-environmentswaps.htm

Debt swaps are often used to restructure sovereign debt. In the last few years and partially due to the COVID-19 pandemic, developing countries have increased their public debt as a percentage of GDP from 41% in 2010 to nearly 66% in 2021.

Bank for International Settlements, 2022. Retrieved from: https://www.bis.org/statistics/

In addition to this, rising interest rates are increasing the costs of servicing sovereign debt payments.

Bloomberg (2022). Historic Cascade of Defaults Is Coming for Emerging Markets. Available at: https://www.bloomberg.com/news/articles/2022-07-07/why-developing-countries-are-facing-a-debt-default-crisis

As of 2021, the International Monetary Fund estimates that 60% of low-income countries are either at high risk of debt distress or already experiencing it — an increase from 30% in 2015.

Bloomberg (2021). IMF Warns of Economic Collapse in Poor Nations Without Debt Fix. Available at: https://www.bloomberg.com/news/articles/2021-12-02/imf-warns-of-economic-collapse-in-some-nations-without-debt-fix IMF considers public debt to be distressed when a country is unable to fulfill its financial obligations and debt restructuring is required. For more details, see: Fournier, J. et al (2022). Governments Need Agile Fiscal Policies As Food And Fuel Prices Spike. IMF Blog. Available at: https://www.imf.org/en/Blogs/Articles/2022/04/20/blog-fm-govs-need-agile-fiscalpolicies-042022

Notably, the UNDP recently called for international debt relief for 54 developing economies to avoid a larger debt crisis.

UN Development Programme (2022). UN Development Programme Calls for Debt Relief Now for 54 Countries. Available at: https://news.un.org/en/story/2022/10/1129427

In circumstances such as these, debt swaps can provide a form of debt relief for a country whereby its debt burden is reduced subject to the condition that the borrowing country mobilizes its domestic resources for a designated purpose with social or environmental impact.

Within climate finance, debt for nature swaps have become an increasingly popular alternative in order to provide debt relief to highly indebted countries while also encouraging these countries to earmark a portion of the forgiven debt proceeds towards environmental conservation. As the Bridgetown Initiative highlights,

The 2022 Bridgetown Agenda, available at: https://pmo.gov.bb/wp-content/uploads/2022/10/The-2022-Bridgetown-Initiative.pdf

the majority of the world’s most climate vulnerable economies are also the among the world’s most debt vulnerable countries. In the UNFCCC negotiations there is also an increasing awareness that funding for L&D should take into consideration developing countries’ debt levels.

As part of a debt for nature swap agreement, the borrowing country usually agrees to place in part or in full the proceeds of the forgiven debt towards the endowment of a conservation trust fund – which may then be further capitalized with additional donations from other aid agencies. In the circumstance where a conservation trust fund is established, the terms of a debt for nature swap will also specify the capital deployment criteria for the conservation trust fund. For instance, these criteria may include protected parks and sustainable landscapes, enhancing adaptive capacity, or reducing the vulnerability of rural population.

For examples of conditionalities used for the Debt for Nature swap in Belize, please see here: The Nature Conservancy (n.d.). Belize Blue Bond Annex A. Available at: https://www.nature.org/content/dam/tnc/nature/en/documents/Belize_Blue_Bond_Annex_A.pdf

The Seychelles became the first country to successfully complete a debt-for-nature swap in 2018. The terms of the swap involved the Seychelles agreeing to protect a third of its marine and coastal area in exchange for a USD 21.6 million reduction of its sovereign debt and debt relief.

The Commonwealth (2020). Case Study. Innovative Financing – Debt-for-Conservation Swap Seychelles Conservation and Climate Adaptation Trust Fund. Available at: https://thecommonwealth.org/case-study/case-study-innovative-financing-debt-conservation-swap-seychelles-conservation-and

The USD 21.6 million sovereign debt was mostly owed to the UK, France, Belgium, and Italy and was purchased at a discount for USD 20.2 million by the Nature Conservancy.

Blended Finance Earth (n.d.). Seychelles Debt Swap. Available at: https://www.blendedfinance.earth/sustainability-linked-debt/2020/11/16/seychelles-debt-swap

The Nature Conservancy forgave USD 5 million of that debt (by raising the same amount in grants from its donors) and restructured the remaining USD 15.2 million as a 10-year blue bond with a discounted 3% annual interest rate (by raising an impact loan from impact investors).

Separately, the Seychelles' Conservation and Climate Adaptation Trust (“SeyCCAT”) was created by the Government of Seychelles and The Nature Conservancy. SeyCCAT was capitalized with proceeds from the debt conversion and has raised additional grant funding from partner donors. Since inception, it has issued over USD 1.5 million in grants to more than 25 grantees, implementing a total of 33 projects.

UNFCCC (2023). Lessons from the Seychelles. Slide 2. Available at: https://unfccc.int/sites/default/files/resource/1_TC_Lessons%20from%20the%20Seychelles.pdf

As a result of the debt swap and coordinated activities of the Government of Seychelles and SeyCCAT, the country has progressed from protecting 0.04% to 30% of its national waters, covering 410,000 square kilometers (158,000 square miles) of ocean – an area larger than Germany.

BBC Future (2020). The Deal That Saved Seychelles' Troubled Waters. Available at: https://www.bbc.com/future/article/20200803-the-deal-that-saved-seychelles-troubled-waters

Challenges and Limitations

Debt swaps have been proposed as a key tool for debt relief for highly indebted nations while also increasing funding for L&D, including debt for development swaps for climate action,

Jensen, L. (2022). Avoiding ‘Too Little Too Late’ on International Debt Relief. UNDP Development Futures Series Working Papers. Available at: https://www.undp.org/publications/dfs-avoiding-too-little-too-late-international-debt-relief

debt for adaptation swaps,

Hebbale, C., and Urpelainen, J. (2023). Debt-for-Adaptation Swaps: A Financial Tool to Help Climate-Vulnerable Nations. Brookings Institution. Available at: https://www.brookings.edu/articles/debt-for-adaptation-swaps-a-financial-tool-to-help-climate-vulnerable-nations

or debt for climate swaps

Singh, D., and Widge, V (2021). Debt-for-Climate Swaps Blueprint. Climate Policy Initiative. Available at: https://www.climatepolicyinitiative.org/wp-content/uploads/2021/05/Debt-for-Climate-Swaps-Blueprint-May-2021.pdf

. However, currently these proposed swaps do not explicitly include criteria for L&D and are typically focused on mitigation and adaptation, which often limits the potential for a given country to fully address L&D.

Additionally, the funding earmarked for environmental impact is often deployed through national trust funds. This funding may be subject to political capture and requires robust verification and audit processes, which can sometimes be comparatively costly as compared with the total size of the national trust fund.

Potential Financing L&D

The innovations required for the design of debt for L&D swaps are limited and the required adjustments can be based on the existing template used for debt for nature swaps. The refinancing terms for a debt for L&D swap are similar to those of a debt for nature swap. The only difference is that the country’s financing commitments (which would have originally gone to repay now forgiven debt) would be earmarked to uses that reduce potential L&D, as compared with environmental impact. The L&D criteria for the approval of fund deployment would ideally include conditions to ensure that funding is deployed to both economic and non-economic L&D. Examples of L&D criteria for fund deployment could be assisted migration and resettlement, safeguarding biodiversity, including relocation of animals or ecosystem support, and supporting the development of contingency plans to ensure the functioning of essential sectors (such as healthcare, and food production and distribution). The positive impact of debt swaps would be maximized if the mobilization requirements of domestic resources for such environmental impact are structured to be de facto senior to debt service requirements.

Marcos, M. et al. (2022), Debt-For-Climate Swaps: Analysis, Design, and Implementation. IMF Working Papers, Volume 2022 issue 162. Available at: https://www.elibrary.imf.org/view/journals/001/2022/162/001.2022.issue-162-en.xml

The capital from the refinancing could be held within in a L&D trust fund under a similar structure to the conservation trust funds that are typically set up in debt for nature swaps and would be subject to strong governance and verification standards. In the event that the capital in the L&D trust fund is too small, stakeholders involved may consider placing that capital under the prospective L&D fund established under the UNFCCC/Paris Agreement to benefit from a larger fund’s existing governance and processes, which would then be responsible for capital deployment within that country under L&D criteria.

Debt swaps can also be combined with Cat bonds. For example, in March 2023, the International Bank for Reconstruction and Development executed its largest single-country cat bond and debt swap transaction with Chile against earthquake risks, consisting of USD 350 million of cat bonds and USD 280 million of debt swaps.

World Bank Press Release (2023). World Bank Executes Its Largest Single-Country Catastrophe Bond and Swap Transaction to Provide Chile $630 Million in Financing. Available at: https://www.worldbank.org/en/news/press-release/2023/03/17/world-bank-executes-its-largest-single-country-catastrophe-bond-and-swap-transaction-to-provide-chile-630-million-in-fin

Private sector guarantees

Overview

A guarantee is a risk transfer mechanism whereby a third party, a guarantor, agrees to pay to a private investor, a beneficiary, in part or in full an amount if there is a default or loss of value on an individual investment or portfolio. Guarantees may cover all or part of scheduled repayments of private sector investments against the risk of default. They may be designed to share equally a portion of the losses with an investor up to a certain amount, i.e., a partial guarantee, or to cover the first losses of an investor up to a certain amount i.e., a first loss guarantee. For example, in the event of an investment default which results in a USD 100 loss to investors, a guarantor could put in place a partial debt guarantee guaranteeing 50% of the loss (i.e., USD 50). A first loss guarantee may agree to cover 20% of the loss (e.g., the guarantee covers the first USD 20 of the loss, but the remainder is covered by investors.

Definitions and overview adapted from Bartz-Zuccala, W. et al. (2021). Making Blended Finance Work for Sustainable Development: The Role of Risk Transfer Mechanisms. OECD PF4SD Perspective Series, p 38. Available at: https://one.oecd.org/document/DCD(2021)16/en/pdf

Guarantees can therefore be structured to cover different percentages of loss on a default, but they can also be structured to address different investor risks. Typically, guarantees are designed to mitigate the risk of an investment loss following a loss in value of an underlying asset, for example, when a borrower defaults on a loan. However, there are also a broad range of specialized guarantee products designed to mitigate other types of investment risks that are tailored to the investor’s particular needs. For instance, political risk guarantees can be put in place to mitigate risks, such as of a government breaching its contract, the risk of expropriation or nationalization of investor assets, adverse changes in local regulation, or even of losses caused by war, revolution, or terrorism.

For some representative political risk guarantee products see World Bank Multilateral Investment Guarantee Agency (MIGA): https://www.miga.org/product/; and US Development Finance Corporation (DFC)): https://www.dfc.gov/what-we-offer/our-products/political-risk-insurance

Additionally, foreign exchange guarantees can be put in place to protect investors against losses from local currency devaluation against investor currency, typically US Dollars, Euros, or British Pounds.

https://www.exim.gov/solutions/loan-guarantee/foreign-currency-guarantee

As a result of the key role that guarantees play in reducing investor risk, they are frequently given for the benefit of more risk-averse investors in order to attract investment capital from these investors.

For a broader discussion on the benefits for using guarantees for development see Garbacz W. et al (2021). The Role of Guarantees in Blended Finance. OECD Development Co-operation Working Papers, No 97 OECD Publishing, Paris, p. 25. Available at: https://www.oecd.org/dac/the-role-of-guarantees-in-blended-finance-730e1498-en.htm

Many donors and concessionary investors favor guarantees to support investments that generate social and environmental outcomes. The public sector is increasingly seeking to share the risk through guarantee products to crowd-in private sector financiers, as compared with directly providing grants or concessionary debt.

International Finance Corporation (2023). DFI Working Group on Blended Concessional Finance for Private Sector Projects Joint Report, pp. 21 and 22. Available at: https://www.convergence.finance/resource/dfi-working-group-on-blended-concessional-finance-for-private-sector/view

The channels through which the public sector supports guarantees may include funding through donor agencies, national development financial institutions, and multilateral agencies – depending on each country’s staff capacity and policy hurdles.

Convergence (2023). Best Practices for Donor Governments Engaging in Blended Finance, p. 23. Available at: https://www.convergence.finance/resource/best-practices-for-donor-governments-engaging-in-blended-finance/view

A key bottleneck to public sector support for offer guarantees includes the fact that guarantees often do not count as Official Development Assistance (“ODA”) unless they are deployed, that is unless there has been a default or loss in value. Due to “use it or lose it” budgetary rules common in many aid agencies, many public donors deploy grant funding to financial intermediaries, such as the World Bank Multilateral Investment Guarantee Agency

https://www.miga.org/

or Guarantco

https://guarantco.com/

, for these intermediaries to offer guarantees on their behalf.

In climate finance, guarantees are also provided to support investments with positive climate mitigation and adaptation outcomes. They are commonly used to help overcome barriers for private investors such as high perceived or real risks and/or poor returns for the risk relative of climate investments to comparable investments.

Blended Finance Taskforce (2023). Better Guarantees, Better Finance. Available at: https://www.blendedfinance.earth/better-guarantees-better-finance

The Althelia Sustainable Ocean Fund (“SOF”) is a USD 132 million impact investment fund that provides loans, equity, and quasi equity to marine and coastal projects in emerging markets. SOF is managed by Mirova, an investment manager that specializes in sustainable investing

For fund profile, see Mirova (2022). Sustainable Ocean Fund Impact Report, p. 6. Available at: https://www.mirova.com/sites/default/files/2023-07/Rapport-impact-SOF-2022-EN_bd.pdf

and focuses on three key areas being, sustainable seafood, the circular economy and ocean conservation.

When SOF was being launched in 2017 and 2018, most blue economy investments had come from grant-making bodies and private philanthropic foundations. To support its fundraising, Althelia closed a USD 50 million partial debt guarantee from USAID’s Development Credit Authority (now under the US Development Finance Corporation). The guarantee covers up to 50% of the principal on eligible loans that SOF extends throughout its portfolio. Thanks to the guarantee

As stated by the Principal of the Sustainable Ocean Fund in the following interview: Green Finance Institute (n.d.). Sustainable Ocean Fund. Available at: https://www.greenfinanceinstitute.co.uk/gfihive/case-studies/sustainable-ocean-fund/

SOF was able to attract investment from risk averse investors, including AXA Investment Managers and BNP Paribas.

The Economist (2020). Financing the Ocean: Technologies of Tomorrow. Available at: https://ocean.economist.com/blue-finance/articles/financing-the-ocean-technologies-of-tomorrow

Challenges and Limitations

L&D constitutes a growing risk to private investors, who are also increasingly required by regulatory agencies and shareholders to report on their exposure to climate-related risks and proactively mitigate them. However, in some instances private investors may not be able to fully adapt against climate-related risks and the value of their portfolio may be impacted by climate-related L&D.

Guarantees, including those offered by the public sector, often provide broad coverage to events that may result in a default or a loss in value, such as those arising from L&D, extreme weather events such as cyclones, droughts, a heatwave, or, from slow-onset changes such as sea level rises or desertification. However, guarantees are rarely purposefully designed to help private investors address the impact of L&D on their investments and the underlying community and landscape on which their investments depend on. As a result, investors may be less willing to provide funding to investment opportunities that are embedded in communities and geographies that are highly exposed to L&D.

The public sector may build on its experience and current channels to provide guarantees for development to support L&D guarantees. Many of these public donors seeking to provide L&D guarantees may also face a similar bottleneck in directly supporting L&D guarantees because guarantees often do not count as Official Development Assistance (“ODA”) unless they are deployed. In this case, public donors could deploy grant funding to financial intermediaries with the mandate to support L&D guarantees, such as a L&D Fund.

Potential for Financing L&D

Typically, guarantees are drafted to provide blanket coverage in the event of a loss in value or default. However, if guarantees are to be effective tools in mitigating L&D risks, they should be drafted to state explicitly that coverage and support will be provided in the event of a default or loss in value that is due to both extreme and slow onset L&D events.

Additionally, public guarantors have been developing innovative forms of guarantees by offering concessionary terms in guarantees, which address the negative impacts of L&D events. By way of example:

Public guarantors may offer more advantageous guaranteed percentages to mitigate portfolio losses resulting from L&D. An example of this would be where, a guarantor offers a guarantee which covers 25% or 50% in respect of general portfolio losses but provides increased coverage for example to 60% or 70% in respect of losses originating from L&D events.
Public guarantors may also offer subsidized guarantee utilization fees for L&D guarantees. These are fees charged to an investor for benefiting from the guarantee. These reduced utilization fees may encourage investors to protect themselves against L&D events within their portfolio.
L&D guarantees may also be drafted to support quicker rebuilding after a climate related event hits by supporting post-L&D actions that may help in recovering from L&D, even though they may not necessarily be aligned the investor’s profit-seeking mission. These actions may include having the investor suspend debt payment requirements for a period, supporting debt restructuring without increased rates, offering emergency credit lines at low interest rates to ensure business continuity and mitigate supply chain disruptions, and agreeing to (partial or full) debt forgiveness to an investee affected by a L&D event.
Some of these actions were also adopted to mitigate the impact on the private sector in response to the COVID-19 pandemic. See: Bank for International Settlements (2021). A global database on central banks’ monetary responses to Covid-19, pp. 4 and 5. Available at https://www.bis.org/publ/work934.pdf

These innovations in L&D guarantees would by their nature result in offers of preferential terms to investors and guarantors should therefore ensure that they mitigate the moral hazard risk that would arise. One option to mitigate this moral hazard risk would be to ensure that guarantees with preferential terms are only offered to investors once those investors have mitigated L&D risks to the extent possible by carrying out due diligence, investment structuring, and supervision processes.

Private sector risk pooling

Overview

Risk pooling is a form of risk management whereby individual risk holders agree to jointly support each other in the event of a negative exogenous shock and under the principle of solidarity. Under a risk pooling agreement, members typically agree to fund collectively a pooling facility with contributions or premiums, and to share any expenses and potential losses. Historically, risk pooling has been practiced by individuals or households living close to each other or belonging to similar professions to support each other against specific and unpredictable needs. Examples of these needs include sick-leave benefits, health insurance, life insurance and funeral costs. In many cases, risk pooling has been part of a wider set of shared services provided by organizations under shared-ownership models such as cooperatives, associations, or unions.

Definition and overview adjusted from Cronk, L.; Aktipis, A. (2021). Design Principles for Risk-Pooling Systems. Nat Hum Behav 5, pp. 825–833. DOI: https://doi.org/10.1038/s41562-021-01121-9

In climate finance, multi-country risk pooling has become increasingly common among countries as an alternative to individual sovereign climate insurance solutions, which can sometimes be more costly or not available.

Richards, J. et al. (2023). The Loss and Damage Finance Landscape. Heinrich-Böll-Stiftung, p. 59. Available at: https://us.boell.org/sites/default/files/2023-05/the_loss_and_damage_finance_landscape_hbf_ldc_15052023.pdf, and Durand, A. et al. (2016). Financing Options for Loss and Damage: A Review and Roadmap. Deutsches Institut für Entwicklungspolitik, p. 6. Available at: https://www.idos-research.de/en/discussion-paper/article/financing-options-for-loss-and-damage-a-review-and-roadmap

Under this arrangement, countries agree to set aside a common funding pool as a contingency in the face of specific climate-related shocks. The common pool is capitalized with premium payments from member countries, or by third-party donors on their behalf. This common pool is typically designed to provide a relatively quick source of liquidity for immediate local needs (e.g., water, food, emergency healthcare) and as a as a “first response” mechanism. They are not capitalized to fully address L&D impact due to their members’ limited ability to contribute larger funding.

Franczak, M. (2023). Financing Loss and Damage at Scale: Toward a Mosaic Approach. International Peace Institute, p. 14. Available at: https://www.ipinst.org/2023/05/financing-loss-and-damage-at-scale-toward-a-mosaic-approach

Some notable examples from such public risk pools in emerging markets include the Caribbean Catastrophe and Risk Insurance Facility (CCRIF) or the Pacific Catastrophic Risk Insurance Company (PCRIC).

Durand, A. et al. (2016). Financing Options for Loss and Damage: A Review and Roadmap. Deutsches Institut für Entwicklungspolitik, p. 6. Available at: https://www.idos-research.de/en/discussion-paper/article/financing-options-for-loss-and-damage-a-review-and-roadmap

These multi-country risk pooling facilities also operate under the principle of solidarity, rather than under Polluter Pays Principles or weighted based on individual country incomes.

In addition to country risk pooling facilities, private sector businesses, especially small businesses in emerging markets, are often receptive to local risk pooling to protect themselves against risks that are too expensive to insure, or for which there is no locally available insurance solution.

Cronk, L.; Aktipis, A. (2021). Design Principles for Risk-Pooling Systems. Nat Hum Behav 5, 825–833 (2021). DOI: https://doi.org/10.1038/s41562-021-01121-9

These private facilities are sometimes set up with support of local public actors or by non-profits who provide start-up capital to bring together potential members, draft articles of membership, and provide initial support in the management of the risk pooling facility. Private sector risk pooling facilities are increasing devoted to managing their members’ own climate-related risks, including their impact on member health and incomes.

This climate focus could be extended to avert, minimize and address L&D risks.

Challenges and Limitations

The key challenge for potential private risk pooling facilities seeking to mitigate L&D extreme and slow onset events risks is scale. Risk pooling facilities need to be designed at a scale such that its member risks are uncorrelated and help insulate risk-pooling networks from common shocks.

Cronk, L.; Aktipis, A. (2021). Design Principles for Risk-Pooling Systems. Nat Hum Behav 5, pp. 825–833 (2021). DOI: https://doi.org/10.1038/s41562-021-01121-9

However, both extreme and slow onset L&D events are often geographically broad, so private sector members that are physically close will tend to be all exposed to the same L&D risks.

Additionally, a further challenge relating to the use of risk pools is adverse selection risk. Adverse selection risk is where a prospective member wishes to join a pool because of their abnormally high exposure to that risk, and upon joining therefore forces every other member to contribute more. Geographically close risk pools will typically manage adverse selection challenges by carrying out due diligence on potential candidates through social networks, but as the risk pool grows, social networks become a weaker selection tool and are less useful as a method of evaluating potential new members.

Cronk, L.; Aktipis, A. (2021). Design Principles for Risk-Pooling Systems. Nat Hum Behav 5, pp. 825–833. DOI: https://doi.org/10.1038/s41562-021-01121-9

To mitigate adverse selection challenges, risk pooling facilities need to adopt formal application screening processes, which increases their costs.

Adverse election is a particularly pervasive issue in large health care risk pools. For more detail see American Academy of Actuaries (2009). Critical Issues in Health Reform: Risk Pooling. Available at: https://www.actuary.org/sites/default/files/pdf/health/pool_july09.pdf

Potential for Financing L&D

Private sector risk pooling may be a useful tool for the private sector as it seeks to protect itself against extreme and slow-onset L&D event risks, including hurricanes, droughts, or land degradation. In terms of their design, private risk pooling facilities are well suited to managing L&D events risks and do not require significant changes to current risk pooling structures to make them suitable for L&D risks. If the L&D risk pool is large enough in size it may cover economic and non-economic L&D. However, it is important that these pooling facilities have sufficient geographic scale such that member L&D risks are not correlated.

There are several potential avenues that might allow risk pooling facilities to reach the scale required for them to effective:

The public sector could seek to spread risk pooling facilities across its national geography, potentially by leveraging organizations under common ownership models (e.g., a network of cooperatives or business associations). The public sector may further seek to potentially roll-up those risks within its own multi-country risk pooling facilities for additional risk diversification. For example, private sector risk pooling facilities from a given country in the Caribbean could be rolled up into CCRIF, similar to its current Livelihood Protection Policy.
Caribbean Catastrophe Risk Insurance Facility (n.d.). Livelihood Protection Policy (LPP). Available at: https://www.ccrif.org/projects/crai/livelihood-protection-policy-lpp
A key challenge for the public sector in supporting risk pooling is often the limited experience of governments with such insurance solutions.
Durand, A. et al. (2016). Financing Options for Loss and Damage: A Review and Roadmap. Deutsches Institut für Entwicklungspolitik, p. 6. Available at: https://www.idos-research.de/en/discussion-paper/article/financing-options-for-loss-and-damage-a-review-and-roadmap
Many large businesses are encouraging the adoption of climate adaptation practices by suppliers operating within their value chains.
For example, Danone has committed to sustainable water extraction rates across its supply chain (see: https://www.danone.com/impact/planet/protecting-water-cycles.html) and General Mills has developed a supplier program focused on regenerative agriculture and productive ecosystems (see: https://www.generalmills.com/how-we-make-it/healthier-planet/environmental-impact/regenerative-agriculture)
Given their close engagement with their supply chains, these same businesses may support the development of risk pooling solutions among their suppliers and in partnership with other larger businesses operating in the same area.

Multi-country private risk pooling facilities, if of sufficient scale, could potentially be aggregated within a L&D Fund in place of being managed under regional sovereign risk pools, for example, the CCRIF or by the private sector.

Given the capitalization requirements on an L&D risk pool (especially if it seeks to cover economic and non-economic L&D), donors may contribute funding during its early stages and until these pools reach a minimum capitalization size through member contributions. Third-party donors such as Global Shield, with its focus on mobilizing private capital for improved financial resilience,

World Bank Press Release (2022). World Bank Group Launches Global Shield Financing Facility to Help Developing Countries Adapt to Climate Change. Available at: https://www.worldbank.org/en/news/press-release/2022/11/14/world-bank-group-launches-global-shield-financing-facility-to-help-developing-countries-adapt-to-climate-change

may be able to sponsor these facilities and provide initial capital or a backstop in case an L&D event takes place before the risk pool is fully funded. Moreover, private sector members may be able to contribute non-financially to the pool, for example, by making available their distribution network or storage facilities to other affected members.

Pill, M. (2022). Towards a Funding Mechanism for Loss and Damage from Climate Change. Climate Risk Management, Volume 35, p. 6. Available at: https://doi.org/10.1016/j.crm.2021.100391

Given their size, these private L&D risk pooling facilities will likely also need to adopt stringent screening against adverse selection concerns and require members to adopt minimum adaptation practices in advance of joining the pool.

Additional Private Sector Opportunities

In addition to the potential L&D financial products this section presents additional exploratory opportunities to mobilize the private sector for L&D.

Frontloading

A key issue for the capitalization of L&D funds is that, although many countries and donors have pledged such funding, very few have effectively disbursed these funds. These delays in receiving L&D funding will result in increased L&D costs as the climate crisis intensifies.

Gallagher, C.; Addison, S. (2022). Financing Loss and Damage: Four Key Challenges. IIED, p. 1. Available at: https://www.iied.org/21141iied

To avoid the challenge of increased L&D costs, “frontloading” may allow L&D donor recipients to issue a bond product that will be repaid with the upcoming cash flows of the donor.

Frontloading has been pioneered by the International Finance Facility for Immunisation (“IFFIm”), which issues vaccine bonds in partnership with Gavi, the Vaccine Alliance. In order to front-load the funding needed to pursue vaccination its initiatives, IFFIm secures legally binding grant commitments from donors. These donors mainly consist of a group of ten countries which provide grant pledges of between 15 and 23 years.

International Finance Facility for Immunisation (n.d.). The International Finance. Facility for Immunisation. Vaccine Bonds. Slide 10. Available at: https://iffim.org/sites/default/files/library/audio-visual/presentations/iffim-investor-presentation/IFFIm%20Investor%20Presentation.pdf

The IFFIm then structures and issues bonds where a) all funding has been earmarked to cover the costs incurred in making available life-saving vaccines for children in emerging markets; and b) where payment for these bonds will originate from the binding grant commitments from donor countries.

IFFIm also enters into hedging agreements with the World Bank to mitigate any foreign exchange risk between donor currency and currency under which the vaccine bond is issued, and interest rate risks between different currencies’ deposit rates. International Finance Facility for Immunisation (2022). Resource Guide 2022, p. 24. Available at: https://iffim.org/sites/default/files/IFFIm-Resource-Guide-2022.pdf

These bonds are typically structured to mature within 3–5 years.

International Finance Facility for Immunisation (n.d.). The International Finance Facility for Immunisation. Vaccine Bonds. Slide 14. Available at: https://iffim.org/sites/default/files/library/audio-visual/presentations/iffim-investor-presentation/IFFIm%20Investor%20Presentation.pdf

Given IFFm’s healthy balance sheet, the bonds have secured a good credit rating,

International Finance Facility for Immunisation (2022 and 2023). Ratings Reports. Available at: https://iffim.org/investor-centre/ratings-reports

which has resulted in interest rates of between 0.375% and 1% between 2020 and 2021.

For bonds issued between in 2022 to support COVID-19 vaccination efforts interest rates jumped to 2.75% and 4.75%. This was due to the uncertain macroeconomic situation and increased overall market risk. International Finance Facility for Immunisation (2022). Trustees' Reports 2022, p. 39. Available at: https://iffim.org/sites/default/files/trustees-reports/IFFIm-2022-Trustees-Report-and-Financial-Statements.pdf

Between 2006 and 2021, the IFFIm has raised nearly USD 7.9 billion from retail and institutional private investors on the back of the future grant pledges from donor countries.

Franczak, M. (2023). Financing Loss and Damage at Scale: Toward a Mosaic Approach. International Peace Institute, p. 13. Available at: https://www.ipinst.org/2023/05/financing-loss-and-damage-at-scale-toward-a-mosaic-approach. International Finance Facility for Immunisation (2022). Resource Guide 2022, p. 18. Available at: https://iffim.org/sites/default/files/IFFIm-Resource-Guide-2022.pdf

It is important to note that frontloading involves a relatively complex financial set-up which incurs a significant fixed fees due to financial institutions and professional financial services firms, which is only cost-efficient at scale.

Based on the vaccine bond template, a prospective L&D Fund could leverage long term and binding grant commitments from donor countries to issue its own L&D bonds. As a result, the L&D Fund would be able to access such funding earlier (at a cost) which would then reduce future potential L&D costs and deploy its capital to support economic and non-economic L&D. However, for this option to be economically feasible total binding commitments from donors to a given L&D Fund need to be significant in size and long term.

L&D Results-Based Payments for the Private Sector

Results-based payments is an umbrella term for initiatives where donors pay upon the accomplishment of results rather than for the efforts to accomplish those results. Under these grant funding models, the principal or funder sets financial or other incentives for an entity (or individual in the case of cash transfers) to deliver predefined outcomes, and rewards achievement of the results upon verification, rather than for inputs or “best efforts” in achieving the outcomes.

Camp, L., and Fernandez, A. (2017). Pay for Results in Development. USAID, p.3. Available at: https://pages.usaid.gov/sites/default/files/pay_for_performance_letter_v5_final_dec_5_2017.pdf

As a result, the donor transfers implementation risk from the funder to the implementer.

USAID (2016). Mainstreaming Results-Based Finance: Actionable Recommendations for USAID, p. 1. Available at: https://pdf.usaid.gov/pdf_docs/PA00TK3C.pdf

In general, results-based payments are most appropriate when targeted outputs and outcomes are well defined, measurable, and plausible to accomplish. Additionally, there need to be data sources and monitoring systems to track and validate outcomes, and the costs of achieving outcomes need to be priced fairly. It is also important to design the incentive payment amount and structure to avoid overpayment or perverse incentives (e.g., reduced service quality, fraud, encouraging demand for unnecessary services, etc.). These solutions are preferrable when the donor is interested in encouraging innovation in development initiatives and is comfortable giving service providers room to innovate to achieve outcomes.

Camp, L., and Fernandez, A. (2017). Pay for Results in Development. USAID, p. 8. Available at: https://pages.usaid.gov/sites/default/files/pay_for_performance_letter_v5_final_dec_5_2017.pdf

The recipient of such payments is often the private sector with a focus on achieving efficiencies in realizing those outcomes for increased profitability.

Escalante, D., and Orrego, C. (2021). Results-Based Financing Blueprint. Climate Policy Initiative, p. 5. Available at: https://www.climatepolicyinitiative.org/wp-content/uploads/2021/05/Results-Based-Financing-Blueprint-May-2021.pdf

Results-based payments are therefore an increasingly popular alternative to the traditional direct grant model for accomplishing social and environmental outcomes, especially in sectors with measurable outcomes and demand for innovation, including education, energy, healthcare, and water, sanitation and hygiene (WASH).

USAID (2016). Mainstreaming Results-Based Finance: Actionable Recommendations for USAID, p. 5. Available at: https://pdf.usaid.gov/pdf_docs/PA00TK3C.pdf

This sector focus has supported the rise of Results-Based Climate Financing, where payments are made for climate mitigation or adaptation results after they have been achieved and independently verified. A commonly used Results-Based Climate Finance instrument is carbon finance, which makes payments upon the achievement of a specific climate mitigation action. Additional examples of Results-Based Climate Finance may include planting trees on degraded land, expanding access to clean energy, or making industrial and manufacturing processes more energy efficient.

Results-Based Climate Finance solutions may help finance private sector activities that address L&D economic and non-economic L&D from extreme and slow onset events, and payments may originate from a L&D Fund. Some potential results-based finance solutions that may be especially well suited for L&D include

World Bank (2022). What You Need to Know About Results-Based Climate Finance. Available at: https://www.worldbank.org/en/news/feature/2022/08/17/what-you-need-to-know-about-results-based-climate-finance

a) Natural climate solutions focused on agriculture, forestry, land-use, oceans, and other sectors that support natural capital assets to mitigate the impact of L&D events; b) Sustainable infrastructure in energy, water, transport, urban, and other sectors that provide public goods to better address L&D. Importantly, this would require that donors define measurable L&D target outcomes, available data sources and monitoring systems to track and validate L&D outcomes, and ensuring that the costs of achieving those L&D outcomes have been priced fairly.

Credit Card Fees

Credit cards companies charge fees both to customers and merchants. The main credit card fees to customers include interest and late payment charges and annual fees.

Federal Reserve (2022). Credit Card Profitability. Available at: https://www.federalreserve.gov/econres/notes/feds-notes/credit-card-profitability-20220909.html

Credit cards also charge fees to merchants through processing fees, which are the fees that a business must pay every time it accepts a credit card payment. Average credit card processing fees range between 1.5% and 3.5%, the most significant of which is the interchange fee (a payment made directly to the card issuer for the swiped transaction) and a payment processor fee (e.g., fee charged by the bank that completes the financial transaction).

Forbes (2023). Credit Card Processing Fees. Available at: https://www.forbes.com/advisor/business/credit-card-processing-fees/

Merchants often pass a portion of the credit fees to customers.

The Wall Street Journal (2023). Visa, Mastercard Prepare to Raise Credit Card Fees. Available at: https://www.wsj.com/finance/visa-mastercard-prepare-to-raise-credit-card-fees-ed779be1

Some credit cards have earmarked a portion of those fees to fund projects that fight climate change, such as Aspiration Zero, FutureCard Visa, Green America Rewards Platinum Visa, and Amalgamated Bank Maximum Rewards. Many banks are currently experimenting on the potential size of these earmarked fees as part of their Corporate Social Responsibility practices while also ensuring that these cards remain commercially viable due to the need to charge higher customer/merchant fees than competitors or to accept lower profits.

It could be worth exploring the potential of engaging with these credit card companies in allocating a portion of their fees to the L&D fund, perhaps depending on the level of consumption, or the products consumed (i.e., flights, car purchases and so on). This means that credit card companies would need to allow a portion of their existing credit card profits to be passed on to a L&D Fund (as a CSR activity), or, alternatively, increase credit card fees to cover this additional expense.

Mastercard credit card fees paid in 2022 was USD 90 billion. In a scenario where between 2–10% of that is channeled to the L&D fund, that would result in USD 0.18–0.9 billion of revenues for the L&D fund per year, as an additional and stable source of income. However, if the fee increases, it would result in increased fees for merchants and, ultimately, for consumers – and perhaps making it less competitive against other credit cards in the market.

Philanthropic Funding

Another potential private funding stream for L&D is philanthropy.

Please see also Cathrine Wenger. A Gap Analysis of Finance Flows for Addressing Loss and Damage Technical Paper, C2ES, June 2023, pp. 9-10. Available at: https://www.c2es.org/wp-content/uploads/2023/06/LD-Funding-Arrangements-Gap-Analysis.pdf

Philanthropic funding for L&D made headlines at COP26 when a group of philanthropists came forward with a commitment of GBP 3 million to address L&D.

The group included the Children’s Climate Investment Fund (CIFF), Open Society Foundation (ECF), the European Climate Foundation (ECF) and Global Greengrants Fund (GGF).

In addition, the Action of Churches Together Alliance (“ACT”), a coalition established in 2010 with of over 150 churches and faith-based organizations working in 127 countries, has been engaging. ACT’s secretariat administers a global Rapid Response Fund (“RRF”). The RRF aims to fund gaps in current funding structures, including those for addressing L&D and, in particular, those in relation to forced migration and/or displacement. ACT mobilizes more than USD 2 billion each year.

Please see: https://actalliance.org/who-we-are/.

The majority of philanthropic organizations and assets are concentrated in the United States and Western Europe.

The Global Philanthropy Environment Index 2022, pp. 10-22, available at: https://www.developmentaid.org/news-stream/post/140507/global-philanthropy-environment-index-2022

Overall, reliable information on the value of these financial assets and the expenditures is limited. However, one study identifies a financial potential close to USD 1.5 trillion held by organizations within 23 countries, with foundations’ expenditures exceeding USD 150 billion per year.

Harvard Kennedy School, The Hauser Institute. Global Philanthropy Report, Perspectives on the global foundation sector, 2018, pp. 16-19, available at: https://cpl.hks.harvard.edu/files/cpl/files/global_philanthropy_report_final_april_2018.pdf

According to a study by UBS, philanthropy continued expansion in 2023, with wealthy individuals across the world wishing to leave a legacy. UBS expects to see more radical and well-resourced philanthropy in the coming years; however, the study also identifies that philanthropists often want that legacy to be more about challenges solved in their lifetimes (rather than giving to future, long-term projects.

UBS. Trends in philanthropy in 2023. Report can be downloaded at: https://www.ubs.com/global/en/ubs-society/philanthropy/blog/2023/five-trends-for-philanthropy-in-2023.html An analysis of philanthropic organizations that adopted a time-limited model: Rockefeller Philanthropy Advisors. Global Trends and Strategic Time Horizons in Philanthropy 2022, available at: https://www.rockpa.org/wp-content/uploads/2022/07/Time-Horizons-2022-1.pdf

Generally, this seems to be an obstacle towards increased contributions to L&D.

According to one report, philanthropic giving focused on climate change grew by almost 14% from 2019 to 2020. A contribution of between USD 6–10 billion was made in 2020, with individuals being the largest source of this funding donating between 67–80% of the total amount – followed by foundations, which donated between 20–33% of it.

ClimateWorks Global Intelligence. Funding trends 2021: Climate change mitigation philanthropy. Available at: https://www.climateworks.org/wp-content/uploads/2021/10/CWF_Funding_Trends_2021.pdf

In addition to direct giving towards climate-related projects, the UBS study identified a trend among philanthropists of “adding a climate lens” to all giving, without losing the focus on their main, “traditional” subject areas – like education, health or protection.

UBS. Trends in philanthropy in 2023. Report can be downloaded at: https://www.ubs.com/global/en/ubs-society/philanthropy/blog/2023/five-trends-for-philanthropy-in-2023.html

However, despite philanthropists increasingly directing their attention and resources to climate change and L&D (whether directly or indirectly), total giving to climate change mitigation from individuals and foundations still represents less than 2% of overall global philanthropic giving;

UBS. Trends in philanthropy in 2023. Report can be downloaded at: https://www.ubs.com/global/en/ubs-society/philanthropy/blog/2023/five-trends-for-philanthropy-in-2023.html

hence highlighting clear potential for current philanthropic funding streams to be directed even further towards L&D.

Despite growing effort on climate-related donations, the assets of individual philanthropists are relatively modest when compared to the financial potential that countries have, and usually do not exceed 5% of the GDP of a country.

Harvard Kennedy School, The Hauser Institute. Global Philanthropy Report, Perspectives on the global foundation sector, 2018, p. 18, available at: https://cpl.hks.harvard.edu/files/cpl/files/global_philanthropy_report_final_april_2018.pdf

Moreover, the vast majority of financial assets (approximately 80%), when excluding the US and Australia, are currently delivered through internal programs of the foundations, and only to a lesser degree as loans, equity investments or impact investments.

Harvard Kennedy School, The Hauser Institute. Global Philanthropy Report, Perspectives on the global foundation sector, 2018, p. 28, available at: https://cpl.hks.harvard.edu/files/cpl/files/global_philanthropy_report_final_april_2018.pdf

While not the global norm, grantmaking is central to philanthropies in a few countries, including the US, Australia, UK and South Africa. Some of the reasons for choosing to deliver through own programs include: a search for maximum impact, personal fulfilment gained by engaging directly with communities and individuals, and limited confidence in the capacity of nonprofit institutions.

Harvard Kennedy School, The Hauser Institute. Global Philanthropy Report, Perspectives on the global foundation sector, 2018, p. 27, available at: https://cpl.hks.harvard.edu/files/cpl/files/global_philanthropy_report_final_april_2018.pdf

For finance to flow to L&D, therefore, the philanthropic strategies and approaches should include programs for funding activities that avert, minimize and address L&D for those that rely on their own internal programs. Thus, finance for L&D will flow to ‘funding arrangements’ for L&D. For those philanthropic foundations that mainly utilize grants, direct grants to the L&D fund could be included as a key objective in their strategic operations, and as such these philanthropic foundations could replenish the L&D fund.

In conclusion, climate change is one of the top 7 reasons for philanthropic giving and climate change is increasingly recognized as a key issue.

Rockefeller Philanthropy Advisors. Global Trends and Strategic Time Horizons in Philanthropy 2022, available at: https://www.rockpa.org/wp-content/uploads/2022/07/Time-Horizons-2022-1.pdf, p. 13.

Climate change, including L&D, has clear potential of being a more prominent motivation for philanthropic donors, which could increase donations towards the funding arrangements and the fund for responding to L&D. However, philanthropic donations only constitute one component of the sources that could be enhanced for L&D and philanthropic donations should not be viewed as a ‘silver bullet’.

Conclusion

Despite the potential for growth in private sector financing for L&D and the existence of drivers to propel its potential, the implementation of these solutions (and replication across geographies) may be slow as a result of their financial and operational complexity. More specifically, L&D cat bonds and debt-for-L&D-swaps may take significant time to structure and close due to their complexity and the number of actors involved. Further, L&D frontloading solutions may have less potential in the short term due to the need for binding and long-term grant commitments, which the L&D fund has not secured to date.

Solutions such as L&D private risk pooling facilities or L&D guarantees may be less operationally complex and hence quicker to implement and replicate. However, they may need significant effort to scale in order to meet the demand for L&D actions. Further, L&D results-based payments may be useful in helping businesses identify profitable L&D investments as well.

Additional credit card fees for L&D may also be a viable alternative to capitalize a potential L&D Fund contingent on credit card appetite for CSR donations. In comparison, the L&D Visa Collective platform, although relatively easy to implement, has not been shown to result in significant fundraising and is not recommended as a solution to mobilize private sector capital at scale.

Finally, climate change, including L&D, has clear potential of being a more prominent motivation for philanthropic donors, which could increase donations towards L&D funding for the L&D fund and the funding arrangements.