Risk and reward

Redefining infrastructure finance in the age of climate change

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With news headlines increasingly dominated by images of extreme weather events across the world, from storms, floods and landslides to extreme temperatures, droughts and wildfires, there is little doubt that such events are increasing in magnitude and frequency as a result of climate change. There is also little doubt that they are putting the world’s critical infrastructure at risk.

The cost of adapting to increasing climate change shocks is rapidly outpacing the ability of governments to fund the necessary investments, and there is a growing need for private sector capital and expertise to step in. While there is growing evidence of public-private partnership (PPP) arrangements helping to bring forward investment in large-scale infrastructure, climate resilience is still not being adequately integrated into PPP policy frameworks, jeopardizing the performance of these investments.

Climate risks have a hefty price tag

Countries around the world will need to spend trillions of dollars on infrastructure in the coming years to resolve decades of deferred maintenance. This will only be exacerbated by rapid urbanization and population growth in emerging markets, increasing demand for new infrastructure.

The public sector can only provide a small share of the capital required to enhance the resilience of a country’s infrastructure. This creates a critical role for the private sector to not only invest, but to also support the development of innovative delivery solutions to maximize their impact at the lowest cost.

A clear need to adapt

There is growing evidence that both the public and private sectors are already starting to embrace new opportunities to address increasing climate risks through the development of more resilient assets.

An increasing amount of private capital is being channeled toward investments in carbon-reduction projects. However, investment in climate adaptation infrastructure is arguably even more critical given the urgent need to address increasingly severe climate-related events. The adoption of PPPs to bring forward investment in climate-resilient infrastructure is not yet meeting the need for such assets, but change is in motion as countries are piloting projects and evaluating potential solutions.

And while significant progress has been made by governments and multilateral development agencies to develop policy frameworks, processes, tools and knowledge that promote climate resilience, there is still an increasing need to bring these into the mainstream PPP process.

Climate events alter the environmental conditions that infrastructure projects need to withstand, shifting the calculus for how infrastructure should be planned, designed, financed, constructed and maintained. Failure to manage the impacts of climate hazards will most certainly result in construction delays, asset failures, poor project performance, increased cost and decreases in financial returns.

The dynamic nature of climate risks makes quantifying and apportioning risk difficult

Using design and performance specifications to capture what is effectively a new breed of risk is no mean feat. Challenges include:

  • Defining resiliency objectives
    • Dynamic and uncertain nature of climate-related events: This poses a significant challenge to define what the required infrastructure is to be resilient against. Whereas climate risks in the past could be characterized using probability distributions based on decades of data, climate change has created new uncertainties about the frequency and magnitude of events.
    • Asymmetry of information and technical knowledge: Defining the objectives of the technical solution through performance specification means that requirements will need to be more prescriptive. Simply requiring that the infrastructure remain operational in storm conditions will not be adequate to ensure resiliency objectives are properly embedded in solutions.
    • Building to the extreme: Even where sufficient technological knowledge and forecast data exists to understand the potential climate change-related risks, the public sector must also take a view on where its project should sit on the resiliency spectrum. This is both to clarify the project’s objectives and given potential implications for the trade-off between capital and operating costs.
  • Evaluating projects and establishing contractual responsibilities
    • Challenge to accommodate climate-resilient solutions in the procurement process: There may be concerns that innovative resilience measures will require additional compensation, or that procurement bias will unfairly penalize those projects driving long-term resilience in favor of those with a lower upfront cost.
    • Disconnect between the design parameter and the life of the project: The whole-life costing approach to PPPs is primarily focused on the life of the contract rather than the asset, giving the private sector little incentive to spend more on making the asset sustainable in the long term.
    • Seasonality: Some projects will face a potential dilemma that the public sector is paying year-round for an asset that may only be required two or three times a year, if at all.
    • Event frequency risk: Even when a project is designed to achieve a particular degree of resiliency, and some degree of seasonality exists, the risks associated with the unpredictability of the magnitude and frequency of even less severe events will still need to be addressed.
  • Operations and performance
    • Acceptance testing: The contractual provisions will need to determine how the parties will be able to confirm that the infrastructure asset is fit for purpose.
    • Measuring performance: The unpredictable and dynamic nature of many climate-related events may impact how and when performance is best measured, and how it is rewarded or penalized.
    • Reactive maintenance: Allocating post-weather event clean-up or remedial responsibilities to the private sector risks an unusually high spike in reactive maintenance costs.

Key principles for action

Though there is no single handbook on how to achieve this, three key principles can guide policymakers in how to incorporate and allocate climate risks better in infrastructure PPPs.

  • Integrate climate resilience into the project appraisal and contract framework: Although design and performance specifications are critical tools for embedding resiliency objectives into a project and lifting historically unallocated risks out of the “force majeure” bucket, broader integration of climate risk is still necessary for successful execution.
  • Drive resilient, adaptive policy and regulation: For proposals to be executed at a project level, there is also a need for complementary and enabling policy and regulations at a federal or local level. Mainstreaming adaptation and resilience requires an understanding of the policy and institutional landscape.
  • Pioneer tailored financing, knowledge-sharing and best practice mechanisms: While national or state-level policy frameworks are an important starting point for systematic inclusion of climate risks in infrastructure PPPs, the global imperative is to develop efficient and effective regulatory, technical and financial models that address climate-resilient infrastructure needs.

 

Learn more in our full report, Risk and reward