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Key takeaways

• With floods, droughts and storms ranging across the globe today, it is time for investors to wake up to the reality of climate change and invest not just in mitigating its causes, but also in adapting to its consequences.

• The adaptation finance gap is significant and widening. Annual adaptation costs in developing countries are estimated to be $160-340 billion by 2030. Adaptation finance needs are currently between 5 to 10 times higher than adaptation finance flows.

• It is clear that public finance alone is not going to close the widening gap, but less than 2% of adaptation finance currently comes from private sources. This is despite the growing evidence of the quantifiable benefits that adaptation can deliver.

• But existing barriers to private finance are being addressed and there are increasing opportunities for private investors to invest in adaptation solutions. These will only expand in the years ahead as temperatures continue to rise.

• Another important implication for investors is that the physical risks to assets need to be understood and incorporated into investment decision-making in order to mobilise capital towards climate resilient investments.

The urgent need for adaptation

Whilst much of the climate narrative focuses on achieving 'net zero' in the decades ahead, it is becoming increasingly apparent just how dramatically our climate is already changing.

The last year has once again delivered record climate events with devastating impacts - deadly heatwaves across Southern Asia, severe flooding in Pakistan, South Africa and Brazil, drought across China and south-western states in the US, and ice shelf collapse in Antarctica, to name a few. 2021 losses from climate related events were estimated by Munich Re to be the second highest in history and this is likely to be exceeded this year- with clear risks to society, businesses and the economy. Adapting to these physical impacts of climate change is therefore absolutely critical.

A year on from COP26, and Climate Action Tracker shows that country pledges will still fail to limit warming to below 2°C, let alone the 1.5°C target. But even the most optimistic climate scenarios result in an increase in warming and therefore a continuation of the rise in frequency and severity of extreme events and a worsening of chronic changes. It is therefore too late to focus on climate mitigation (i.e. decarbonisation) alone. We need to ensure that our communities, businesses and economies are resilient to these impacts.

The widening adaptation gap

The 2022 Adaptation Gap Report identifies that, whilst adaptation finance is rising as a proportion of total climate financing (34% in 2020 compared to 14% in 2019), combined mitigation and adaptation flows have actually fallen over the last reporting period. The UNEP report estimates that the annual adaptation costs in developing countries alone to be in the range of $160-340 billion by 2030, and almost doubling again by 2050. By this assessment, adaptation finance needs are currently between 5 to 10 times higher than adaptation finance flows, and growing. We highlight this adaptation gap as one of four critical interconnected gaps that need to be adequately addressed at COP27.

In addition, it was agreed at COP15 in 2009 that developed nations would provide climate finance of $100 billion a year by 2020 to developing nations for mitigation and adaptation. That promise was broken. A key minimum requirement for COP27 is ensuring that this commitment to public financing is met. However, even if this was met and it was all allocated to adaptation it would still fall far short of what is required. There needs to be a more integrated approach to mainstream adaptation finance- as current approaches tend to be piecemeal, localised and responsive to current impacts. Lessons learned from the pandemic need to be applied to ensure coordinated global, national and local response to improve resilience and adaptation financing.

The Global Commission on Adaptation has identified $1.8 trillion in adaptation investments that could deliver net benefits of $7.1 trillion by 2030. Despite this growing evidence of the benefits, less than 2% of adaptation finance currently comes from private sources.

There are a number of reasons why private investment in adaptation has been limited to date:

• The lack of adequate, disclosed climate-related risk data to inform investment planning;

• The need for clearer national-level action that ensures adaptation needs and goals are clearly identified and financial incentives for private participation are strengthened;

• The often limited clarity on financial returns which may be indirect and a generally stronger focus on social benefits rather than investor return

It is clear that public finance alone is not going to close the widening gap. So existing barriers to mobilising private finance need to be addressed to grow opportunities for private investors.

It is time for investors to wake up to the reality of climate change today and invest not just in mitigating its causes, but also in adapting to its consequences.

The importance of investing in adaptation

Physical impacts of climate change affect every sector and region on the planet. Some however are more severely impacted than others and we highlight three particular sectors below:

1. Real assets - Changes to the climate require the adaptation of many areas of the economy. Infrastructure and property are particularly vulnerable as they face storm and flood damage, rising insurance costs, greater energy costs and, potentially, the need for backup generators and emergency systems. The way we build will need to change, so that real assets can withstand severe rain, storms and, in some areas, much higher temperatures. In addition, cooling systems for high temperatures need to be compatible with a low emissions future.

2. Utilities - A world of increasing climate extremes will need different infrastructure: much better drainage systems and 'sponge city' capabilities that allow densely built-up areas to cope with the flash floods that severe rainfalls bring. Electric grid systems will need to be 'hardened' so that they can cope with extremes of weather and temperature. Durable electric microgrids have been trialled in Texas, that kept going and kept revenue flowing when there were widescale outages. In the US, utility companies like Consolidated Edison, are spending over $1 billion a year on resilience. Utility companies not building in resilience will be out of step as the world seeks to decarbonise.

3. Agriculture - Agriculture will also have to change so that planting and harvesting seasons won't be so affected by less predictable, and more extreme, weather. Restoring degraded pastures, maintaining and planting forests and many other adaptations will help to both capture carbon and protect against the effects of extreme weather. Emerging market regions are particularly vulnerable to damage from climate change. Acting and investing now in the necessary adaptations will lead to lower costs than repairing after further damage and decrease the threat to food security.

Without adaptation, businesses face physical damage and power outages. Extreme weather may also interfere with renewables providing a reliable energy source. It's likely there will also be more supply-chain disruptions, insurance losses, commodity shortages and inflation. This provides a clear financial case for incorporating climate adaptation into investment decisions to build resilience.

Investment opportunities for adaptation and resilience

1. Understanding and incorporating the physical risks of climate change into decision-making

Financial institutions need to understand how the assets they invest in assess and manage the physical risks of climate change in line with the recommendations of the TCFD and integrate this into asset valuations. The Coalition for Climate Resilient Investment (CCRI) is a private sector-led initiative launched in 2019 which abrdn are members of and aims to ensure that physical climate risks are systematically integrated into all investment decisions by 2025. The goal is to improve the pricing in of climate change in order to de-risk the investment for financial partners, provide investor confidence and help mobilise capital towards climate resilient investment. A key output of the initiative is the PCRAM framework which provides a methodology for pricing physical climate risks into infrastructure investments.

Incorporating an assessment of acute and chronic physical risks is a core part of our due diligence process for new infrastructure investments, but this can differ considerably depending on the type of asset and its location.

This is equally important for publicly-listed assets. Our bespoke climate scenario analysis framework provides a forward-looking view of the impact of climate change on asset values. Our approach to scenarios allows us to disaggregate the company-level results from different scenarios into the impact drivers, including physical risk and adaptation. This provides an indication of the potential direct physical impact on assets that companies are facing. Given the location-specific nature of physical risks, this then needs to be explored in more detail at individual-asset level. For this reason we are focussing on in-depth scenario analysis at building-level for our own real estate portfolio.

2. Investing in adaptation solutions

There are vast opportunities for investors to become involved in helping countries and businesses strengthen resilience against climate extremes. This includes utility companies creating more weather-resistant grids; homebuilders specialising in heat- and flood-resistant designs; and governments with innovative resilience projects. These opportunities will only expand in the years ahead. Research by Munich Re has shown that linking adaptation and insurance, for example by restoring coral reefs that reduce storm damage, or by planting to alleviate flooding, could lead to reduced premiums and a six-fold return on investment.

Adaptation investments should be a growing and important part of the investment universe for climate-focused strategies. By including these opportunities alongside climate change mitigation ideas, thematic investors can diversify their exposures while contributing to a critically underfunded part of the solution to climate change.

In fixed income at abrdn, this process seeks to determine an understanding of the link between a bond issuer and its impact on adaptation. Assessing the nature and extent of the relevant physical risks and how these are being addressed by the issuer's actions has led to several investment ideas that contribute to climate change adaptation. Three examples of bond issuers and their approaches to adaptation are highlighted in the table below.

It is time for investors to wake up to the reality of climate change today and invest not just in mitigating its causes, but also in adapting to its consequences. The need for adaptation solutions will only expand in the years ahead as temperatures continue to rise.

Author: Tzoulianna Leventi, Investment and ESG Analyst