This chapter explores the links between investment and climate change adaptation. It outlines how climate risks can affect investment returns, and how investments can be used to reduce physical climate risks. This chapter provides the foundation for the Framework by analysing the specific characteristics of investments in adaptation and how these characteristics relate to public and private investment.
Climate Adaptation Investment Framework
Green Finance and Investment
Abstract
The impacts of climate change are already being experienced, with changes in the frequency and severity of extreme events (such as heatwaves), as well as slow-onset changes (such as rising sea-levels and drought). In 2023, global average temperatures reached 1.45°C above the 1850–1900 average (WMO, 2024[1]). These impacts are projected to become more severe as the concentration of atmospheric greenhouse gasses increases. All sectors and regions will be affected, albeit with particularly severe consequences in developing countries due to their greater vulnerability. Urgent action is needed to address the source of these impacts by reducing emission of greenhouse gasses (climate mitigation), but also to increase resilience to the impacts of a changing climate (climate adaptation).
Investment has a critical role in tackling the impacts of climate change: it is critical for achieving the transition to net zero, which is the subject of complementary guidance (OECD, 2015[2]), as well as building resilience to the impacts of a changing climate. New investments will be required to address climate risks, while climate change will affect the risks and returns of current and future investments across all sectors of the economy.
This chapter provides further context for the Framework by exploring the links between investment and climate change adaptation, including the relationship with physical climate risks and the respective roles of the public and private sectors.
There is a two-way relationship between investment and physical climate risk1: these risks may affect the returns on investments, and investments can be used to reduce physical climate risks (OECD, 2024[3]).
The Intergovernmental Panel on Climate Change (IPCC)’s Sixth Assessment Report defines risk as the potential for adverse consequences to people or ecosystems (Figure 2.1). In the context of climate impacts, these risks (such as damage to property) arise from the interaction of hazard, vulnerability and exposure. The following definitions are adapted from (IPCC, 2022[4]):
Hazard: the potential occurrence of an event or trend that may cause negative impacts. For example, a heatwave is a hazard (see Table 2.1).
Exposure: the presence of people or assets in places or settings exposed to a hazard. For example, the number of people living in the area exposed to a heatwave.
Vulnerability: the propensity or predisposition to be adversely affected. For example, older people can be particularly vulnerable to the impacts of heatwaves.
Climate change is leading to an increase in hazards, but the consequences of this increase in hazard depends upon exposure and vulnerability. The trends in exposure and vulnerability are the cumulative result of choices made by decision-makers in the public and private sectors. For example, provision of flood defences can reduce the vulnerability of a region to flood risk (investment helping to reduce physical climate risk). Meanwhile, coastal real estate may be increasingly exposed to flood risk due to rising sea levels (investment returns being affected by physical climate risk). Efforts to reduce exposure and vulnerability will be critical to reduce the economic and social costs of climate change.
A diverse set of actions will be required to reduce and manage physical climate risks by adapting to climate change. Potential responses include capacity building, reforms to planning or management, new or improved infrastructure, provision of information and changes in practice and behaviour (Biagini et al., 2014[5]). The appropriate actions will depend upon the context, and often a combination of actions will be required to manage a given risk.
Source: IPCC AR5
Investment will be critical for implementing some of these adaptation actions. In a general sense, investment supports economic development, which helps to reduce vulnerability to climate impacts. Physical climate risk-informed investment decisions can reduce the exposure of assets to climate hazards, for example by redirecting development away from floodplains. Investment can be used to build adaptive capacity (such as training or data collection), reduce vulnerability by directly aiming to deliver adaptation actions (such as additional water storage capacity) or through the integration of adaptation actions into projects undertaken for other reasons (such as property-level flood resilience measures in a new housing development).
The desire to reduce risks and/or to realise potential opportunities provides a driver for adaptation investment. For example, farmers may change to a different crop that is more suitable for drier climates. Ski resorts may invest in facilities for summer tourism or expand access to higher altitudes in response to less reliable snowfall. Climate-related risks also create new opportunities for those supplying the goods and services that help others to address those risks through the provision of adaptation solutions, such as water-efficient industrial processes or technologies for precision agriculture that increase the efficiency of production.
Investments in adaptation can generally reduce exposure to physical climate risks, but it is neither possible nor desirable to completely eliminate these risks (OECD, 2014[6]). Managing the risk of mild flooding may be addressed by simple property-level measures, while severe flooding could require major structural changes. The degree of investment in adaptation that is motivated by a physical climate risk is therefore determined both by the characteristics of the risk, the costs and benefits of available adaptation options and the amount of residual risk that the decision-maker is willing to accept. The Sendai Framework for Disaster Risk Reduction highlights that each state has the responsibility to prevent and reduce disaster risk.
There are significant gaps in understanding physical climate risks and hence opportunities for investment in adaptation. In general, there are good data on potential climate hazards, albeit with significant gaps in coverage in developing countries. However, investors may not be fully aware of the vulnerability of their investments to climate risks (Noels et al., 2024[7]). This is particularly true of situations where climate change leads to the emergence of new risks, such as wildfires in areas that were not previously exposed, or to qualitative changes in existing risks (OECD, 2023[8]).
In addition to data gaps in the understanding of the impacts of climate hazards, there are several factors that may lead investors to underestimate their risk exposure, and hence the incentive to invest to reduce those risks:
Uncertainties and non-linear responses: the climate is a complex system and projections of future climate hazards are subject to multiple sources of uncertainty, particularly at the local scale (van Bree and van der Sluijs, 2014[9]). As such, decision-makers need to consider outcomes under a range of potential scenarios, rather than just the most likely outcome.
Interdependencies: climate risks may arise as a result of climate hazards occurring elsewhere, as impacts are propagated through supply chains, infrastructure networks or other sources of interdependencies.
Compound risks: multiple risks materialising at the same time may have a disproportionately large impact, and – in some cases – the same climate drivers may lead to multiple hazards. For example, high temperatures and drought can lead to wildfires (Zscheischler et al., 2018[10]), and electricity blackouts as power plants have to shut down due to lack of cooling water. These blackouts then lead to the loss of mechanical cooling, thereby exacerbating the impacts on health and productivity.
Timing: the impacts of a climate risk to an organisation may materialise at a different time to the occurrence of the climate hazard. For example, the economic impact of sea-level rise on a portfolio of coastal properties may occur when perceptions about risk exposure change (e.g. due to flooding elsewhere), rather than when the risk itself materialises.
In addition to potential underestimation of physical climate risks, there can be data gaps in understanding the benefits of measures to address those risks. This can lead to underestimation of the benefits of investment in adaptation and thereby make it difficult to build the business case for investment.
Firms’ behaviour will change as they start to factor in the physical evidence of climate change and this will drive investment decisions. This process is known as autonomous adaptation. For example, farmers may change the crops they grow, or building owners may install mechanical ventilation to address the consequences of hotter summers. In general, each actor will be best placed to decide on the appropriate adaptation responses for their circumstances, based on local knowledge and their own risk preferences. Changes in relative prices may encourage the conservation of scare resources, even in the absence of top-down planning.
There are, however, a set of distinctive features that apply to many investments in adaptation that mean autonomous adaptation alone is unlikely to lead to sufficient investment in adaptation (Cimato and Mullan, 2010[11]; Frontier Economics and PWA, 2022[12]):
Behavioural barriers, including short-termism: the direct benefits of adaptation investments may only be fully realised as a reduction in losses when an extreme climate event occurs. Climate change is affecting the probability and severity of some events occurring now (e.g., floods, heatwaves), but it may still be several years or decades before the relevant events occur and the direct benefits of the adaptation measure become visible.
Distributional issues: vulnerability to climate change is exacerbated by poverty and other forms of socio-economic disadvantage. The communities and countries with the greatest adaptation needs can also have the fewest resources to meet those needs. Public finance may have a role in supporting investment within low-income communities. At the international level, climate finance and development co-operation have a critical role in supporting adaptation in developing countries (OECD, 2022[13]; OECD, 2023[14]).
Strong government role: sectors that are particularly relevant for climate adaptation also tend to be the sectors with strong existing government involvement for other reasons. These sectors include agriculture, infrastructure and provision of social services. This government role includes the provision and financing of public goods and services, as is often the case for protective infrastructure, or regulation (e.g., agriculture, environmental protection, land-use planning and building codes, price regulation of infrastructure utilities).
Interdependencies and coordination challenges: the ability of an investment to enhance resilience depends upon the characteristics of the system in which it is embedded. Addressing a climate risk may require coordinated interventions across the system rather than piecemeal investments. For example, addressing drought risk may require investments on the demand side (e.g. drip irrigation) and the supply side (e.g. reducing leaks, increasing storage capacity). As such, there can be the need to address coordination challenges.
Externalities: adaptation investments can yield positive or negative externalities. For example, the use of air conditioning can exacerbate the urban heat island effect, while green roofs can have positive impacts. Effective regulatory environments should limit negative externalities, but conversely it is hard to monetise the benefits of positive externalities.
These factors can distort the relationship between the perceived private return and the social return, leading to underinvestment by the private sector. They can also deter investment by increasing transaction costs. Meanwhile, public investment can be hindered by coordination challenges, insufficient recognition of climate resilience benefits in policy appraisal, and procurement policies that fail to account for the benefits of climate resilience.
Investments made autonomously may also be ineffective or counter-productive from a societal level due to market failures or policy distortions (Mullan and Ranger, 2022[15]). For example, building flood defences to protect one area can increase the risk faced by downstream locations. Measures that may make sense from a short-term perspective, such as extracting groundwater to substitute for declining rainfall, may store up larger problems for the future when groundwater supplies are exhausted. The regulatory framework will be critical to encourage effective adaptation measures and discourage or prevent measures that increase the risks faced by others. Undertaking risk-based due diligence can help businesses avoid activities that undermine resilience of communities and ecosystems.
The public sector has a critical role in supporting adaptation investment, both through investments made directly and through the effect of public policy on the broader enabling environment for investment. For the former, critical investments relevant for climate change adaptation are often provided by governments because they are inherently difficult to fund privately. For example, governments are usually responsible for investing in protective infrastructure, even if some of that infrastructure is supplied by the private sector. Public goods, such as early warning systems and hydro-met services, are central to reducing damages from extreme events.
More generally, public investment is critical for climate adaptation because it is driven by policy objectives rather than profit maximisation. Investments are still expected to deliver a stream of benefits in return for the capital invested, but these can be wider social or economic benefits rather than a purely financial return. This is particularly relevant for adaptation, given the importance of equity as a driver for investment in adaptation, as well as the existence of non-market benefits for adaptation (such as health benefits from reduced risk of overheating). The extent to which public investment flows to adaptation depends upon the overall fiscal envelope of the public sector, the priority placed on climate adaptation and the extent to which the allocation of public funds is influenced by potential resilience benefits.
There are no comprehensive datasets covering existing domestic public finance flows for adaptation, but some initiatives have shed light on this issue. In Germany, a pilot study undertaken by UBA identified EUR 48 billion of public spending that was potentially relevant to climate change adaptation, of which EUR 1.6 – 2.5 billion was directly linked to adaptation (Haße, Hölscher and Kohli, 2024[16]). In France, an independent analysis estimated that implementing priority adaptation measures would require a budget of EUR 2.3 billion per year (I4CE, 2022[17]). A synthesis of domestic spending by developing countries found that up to 7% of domestic budgets were currently contributing to climate change adaptation (UNFCCC, 2022[18]).
International public finance has a critical role in supporting adaptation in developing countries, including through bilateral co-operation, the activities of multi-lateral development banks and dedicated climate funds. This finance source is particularly significant because the countries that are most vulnerable to climate change often lack the resources and capacity that are needed for adaptation (OECD, 2023[14]). In 2022, developed countries provided and mobilised USD 32.4 billion to support adaptation in developing countries, of which USD 29 billion was from public sources (OECD, 2024[19]). A broader approach is used by the Climate Policy Initiative, which identified a total of USD 63 billion of adaptation finance in 2021/22, of which 98% was from public sources. However, this is based on limited coverage of domestic public investment for adaptation.
Beyond public investment in adaptation, the other critical role of the public sector lies in the creation of a suitable enabling environment for private investment in adaptation. This entails ensuring that regulations and policies do not inadvertently deter investment in adaptation, for example by distorting prices or hindering the adoption of innovative approaches. It also encompasses the provision of public goods, such as climate risk maps, that can support risk-informed investment decisions. There may also be a case for providing positive incentives to support private investment that deliver wider social benefits.
The public sector’s contribution to supporting investment in climate change adaptation can be constrained by a range of factors, including:
Fiscal constraints – due to high levels of government debt and limitations on revenue raising, which are a particular challenge for developing countries with limited fiscal space.
Institutional barriers – responsibility for climate change adaptation often lies within environment ministries, while the policy levers needed to influence public investment lie within finance and sectoral ministries. As such, there can be a lack of capacity or coordination, particularly where investments in adaptation may cut across institutional boundaries.
Information gaps – lack of data or understanding of the impact of climate-related risks, such as disruption to service delivery or contingent liabilities to public finances. Insufficient evidence or tools to consider the value of adaptation benefits to inform the allocation of public funds.
Private sector investment will be a critical element of overall efforts to adapt to climate change. The private sector is a diverse category, encompassing micro-enterprises, Small and Medium Enterprises (SMEs) to large multinational corporations. Firms will have varying capacities and opportunities in relation to climate change adaptation. However, in general terms, the private sector can contribute to adaptation across three dimensions (Cochu, Hausotter and Henzler, 2019[20]):
Investing itself in adaptation – undertaking adaptation within the boundary of the firm or in the resilience of its supply chain (e.g. retrofitting facilities to make them more resilient), ideally within the context of a broader adaptation plan.
Providing finance for investment by others – providing the capital needed for investments that are expected to generate a market-rate return. For larger projects, this could be undertaken via project finance, while smaller projects could be funded via corporate finance (See Box 2.1).
Providing solutions for adaptation by others – developing the goods and services that can facilitate adaptation by others (e.g. energy efficient cooling or crops suitable for a broader range of climate conditions).
Private investment across these dimensions will be primarily driven by the profit motive, and the degree of transparency, predictability, and adherence to the rule of law in a particular market. These factors provide a powerful driver to seek out opportunities, undertake innovation and deploy capital where it can earn the greatest risk-adjusted return. Effective management of climate-related risks can also serve to support long-term profitability, by reducing potential costs such as business disruption, loss of markets, legal liabilities and fines for regulatory non-compliance. Beyond the direct profit and investor confidence motives, companies may also be influenced by compliance with standards such as the OECD’s Guidelines for Multinational Enterprises on Responsible Business Conduct, which call for proactive measures to adapt to climate change and avoid negative impacts on communities, workers and ecosystems (OECD, 2023[21]).
Despite the importance of private investment in adaptation, recorded private finance flows for adaptation remain very limited. Just over half (56%) of the respondents to the CDP Climate Survey 2022 identified acute physical climate risks as having a substantive impact on their business, predominantly due to concerns about losing revenues due to reduced production capacity (TCFD, 2023[22]). Climate Policy Initiative identified just USD 4.7 billion of annual private finance for adaptation between 2019 and 2022 (CPI, 2024[23])
Firms do not generally collect nor publish data on the extent to which their investments contribute to climate adaptation, nor is it readily possible to undertake a top-down analysis given that adaptation will often be embedded in investments made for other reasons. Emerging frameworks, such as the International Sustainability Standards Board (ISSB) Standards aim to provide greater transparency on private sector activity (See section 3.5). UN-led efforts on national capital accounting have made also significant strides to quantify adaptation-relevant metrics that can feed into statistical estimates of gross national product (See section 3.1). However, there is currently no systematic tracking of private finance contributing to adaptation, and reported estimates are likely to be underestimated.
Private enterprises at all scales can raise capital for investment by drawing upon their existing assets (particularly their retained earnings) and/or securing external finance through borrowing or equity (shares on future profits). The mechanics for doing this will vary by scale and context: a small business may only be able to borrow from a local bank, while a larger corporation could issue bonds or issue shares.
In this process, generically known as corporate finance, the repayment of external finance is an obligation linked to the performance of the enterprise, rather than to that of a specific activity or project. The terms under which finance is available will depend upon the financial strength and credit risk of the enterprise. Corporate finance can be used to finance projects at all scales and does not have to be tied to a specific cash flow.
Project finance provides a mechanism for financing long-lived projects, where repayment is largely or entirely based on the cash-flow from the project itself, such as the sale of electricity from a renewable energy project. The benefit of this approach is that it can provide flexibility in sharing project risks. In project finance, borrowing is based on the strength of the project proposal, rather than the balance sheet of the project sponsor. However, there are higher transaction costs for project finance (e.g. legal fees, commercial advisors) which mean that its use is restricted to larger scale projects.
Corporate finance, particularly through financial intermediaries such as banks, will be critical for financing adaptation investment by SMEs and even larger firms in countries without well-developed capital markets. It will also be critical for financing worthwhile activities that do not necessarily have a direct cash flow attached, for example installing cooling to improve working conditions. Project finance is better suited to financing climate-resilient infrastructure, where there are direct revenues (such as toll roads), or under a Public-private Partnership (PPP) arrangement.
Source: Steffen (2018[24]); ADB-EBRD-IDB-IsDB-WBG (2016[25]).
Notwithstanding these reporting challenges, recorded flows of private investment in adaptation are also low due to substantive barriers to investment in adaptation. These barriers include (Tall et al., 2021[26])
Lack of data on climate risks: investors may lack the underlying data required to understand the risks that they are exposed to, particularly in developing countries.
Low (real or perceived) returns on investment: investors may be unable to capture the benefits of investments in adaptation due to market failures, externalities, or other market distortions. Transaction costs can be high relative to the size of the project, particularly where innovative technologies are being used, or the investment involves multiple beneficiaries.
Lack of strategic direction: a lack of clear strategic direction by governments can hinder investment by increasing uncertainty (and hence perceived risk) around the future direction of government policies and investment needs. Given interdependencies, the effectiveness of a given adaptation investment will depend upon the resilience of other components of the system. A lack of clarity about the governments adaptation priorities can make it difficult for the private sector to plan.
Low investor confidence: Based on existing regulatory frameworks and historic actions of governments, potential investors may have low confidence that they will encounter the transparency, predictability, and non-discriminatory enforcement of the rule of law that is required to commit capital. Particularly in the rapidly evolving context of climate adaptation, potential investors must be provided strong evidence that they will be treated fairly, including when regulations must be modified according to the evolving situation.
Systematic efforts will be needed to address these barriers to private investment. These include the development of a supportive policy environment to overcome these barriers, while recognising the specific roles that can be played by private investment. In addition to the interventions at the policy-level, project-level interventions may also be needed to align project characteristics with the requirements of private sector participants using approaches such as blended finance for adaptation (OECD, 2024[27]).
Policies will be needed to increase real economy investments in climate change adaptation. The costs of these investments can be financed from a variety (or combination) of public and private sources, via direct investment or through project finance (Figure 2.2). For these investments to occur, the characteristics of the investment need to be aligned with the requirements of potential financers and the characteristics of the finance mechanism. All finance sources expect a return commensurate with the risk and capital deployed, but the nature of this return can vary significantly (Box 2.2). For example:
Financial sector: revenue stream that achieves a competitive market rate financial return, whether resulting from project finance or loans to direct investors (e.g. agri-SMEs).
Direct investment by corporates and SMEs: wider variety of benefits may justify the investment, such as reduction in insurance costs, reduced risk to future profits, or potential new market opportunities.
Investment by the public sector: achievement of policy goals, which could include protection of lives and livelihoods, enhancement of the natural environment.
Blended finance provides an important tool for combining public and private funding sources to achieve the desired combination of risk and return. The OECD defines blended finance as “the strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries” (OECD, 2018[28]). Concessional public finance is used to reduce risks or improve the expected returns on a project, such that it becomes attractive to private finance. For example, certain risks can be transferred to bilateral or multilateral providers through the issuance of guarantees (Garbacz, Vilalta and Moller, 2021[29]). The OECD is currently developing a guidance on Blended Finance for Adaptation (OECD, 2024[27])).
Finance for climate-resilient investments depends on securing sufficient funding to repay the capital costs, cover ongoing operations and maintenance, and provide a return to investors. Funding sources will depend on the type of investment and broader context, but typically include public funding, user charges, land value capture and asset revenues (OECD, 2022[30]; OECD, 2024[3]). User charges can support efficiency and generate additional resources but may have adverse distributional impacts. New funding models focusing on asset recycling and land value capture can provide important sources of revenue to pay for climate resilience. These are examined in more detail in the OECD report on Infrastructure for a Climate-Resilient Future (OECD, 2024[3]).
Source: Adapted from (OECD, 2023[14])
The characteristics of the project need to be aligned with the requirements of different finance sources. Blended finance approaches can be used to combine different sources to ensure project viability (see (OECD, 2024[27]))
Projects with no or below market rate returns
This type of project includes those being undertaken predominantly for equity reasons (such as supporting vulnerable communities), as well as those that have the characteristics of public good (such as capacity building). Potential funding sources include:
Domestic public finance
Bilateral and multilateral development co-operation
Multilateral climate funds
Philanthropy
Projects with some revenue streams
This category covers projects that are expected to create revenues, but the expected risk and return is not commensurate with market rates. These projects could include the deployment of nature-based solutions, or the development and deployment of innovative technologies. Financing sources include:
Development finance institutions
National development banks
Impact investors
Projects with market rate returns
This covers projects where the level of risk and projected returns are commensurate with market requirements. This could include climate-resilient infrastructure, such as toll roads or electricity distribution. It could also include investments to increase the efficiency of resource use, such as drip irrigation. Financing sources include:
Banks
Institutional investors
Corporate investors
Source: OECD (2023[31]).
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← 1. Physical climate risks are those that result directly from the impacts of climate change (such as heatwaves or wildfires), as contrasted with transition risks which are those that may arise from the process of moving to net zero (e.g. impact of carbon pricing on carbon intensive industries).