Climate mitigation has dominated the sustainability-linked loan (SLL) market – but rising climate impacts and concerns about nature loss are pushing adaptation and biodiversity finance up the agenda, says BBVA's Hedi Ben Salem.
Environmental Finance: Recent extreme weather events have shown that funding is urgently needed to adapt to climate change, as well as to mitigate it. What is the scale of the adaptation financing challenge?
Hedi Ben Salem: It is becoming clear that action on adaptation must accelerate to save lives and limit economic loss. That being said, risks related to climate change are not evenly distributed, with developing countries being the most exposed. According to UNEP's 2022 Adaptation Finance Gap Report, the annual costs of adaptation in developing countries could reach $160-340 billion by 2030 and $315-565 billion by 2050. In comparison, a global transformation to a low-carbon economy is expected to require investments of at least $4-6 trillion a year.
Meanwhile, in 2020, the global volume of adaptation finance stood at just $50 billion, representing around 8% of total climate finance flows. An estimated $29 billion of this went to developing countries, representing 35% of the climate finance flows they received. This figure is some five to 10 times below estimated needs.
EF: What investor interest are you seeing in adaptation finance? What are their prerequisites when it comes to how that finance is structured?
HBS: The Paris Agreement promotes both climate change mitigation and adaptation. Whilst the climate change mitigation finance markets have grown exponentially since it was signed in 2015, the development of adaptation finance has remained slow. We firmly believe that adaptation finance is gaining momentum, as the fast-growing impacts of climate are raising concerns among all private sector actors. Financial institutions are starting to incorporate climate-induced risk analysis in their risk assessments. As they do so, we should soon see banks strongly incentivising their clients to strengthen their resilience to climate change through adaptation strategies that financial institutions will be keen to finance. In addition, we expect to see banks strongly recommending the most exposed companies incorporate adaptation KPIs in sustainability-linked facilities, to encourage them to adapt to climate change as fast as possible.
In terms of loan structure, banks' requirements should be the same for all types of sustainable finance products and aligned with the Green and Sustainability-Linked Loan Principles issued by loan market associations. In fact, climate change adaptation already appears as one of the categories of eligible use of proceeds under the Green Loan Principles.
EF: What role do you see for the SLL market in generating adaptation finance?
HBS: We expect the SLL market to play a significant role in developing adaptation finance, as it did for climate change mitigation finance.
As financial institutions incorporate climate-induced risk analysis into their risk assessments and companies start implementing adaptation strategies, we should see an increase in the volume of climate adaptation bonds and loans to finance adaptation actions. In parallel, we expect banks to strongly encourage the most exposed companies to also link their loans to adaptation-related targets. This should lead to an increased focus by companies on their adaptation strategies and an acceleration of climate adaptation actions, which in turn should lead to an exponential growth of the adaptation finance markets.
EF: What adaptation measures is the SLL market best suited for?
HBS: SLLs are perfectly suited for companies looking for a financial incentive to encourage their entire organisation to carry out actions that aim at reducing their exposure to climate risks which could have a material effect on their business, operations, and financial performances.
For this to happen, companies should first assess their vulnerabilities to climate risks, develop adaptation strategies, define indicators and targets to monitor their progress, and set out a list of actions. This means that climate risks, adaptation actions, and their respective impacts should be measurable, which is one of the challenges that adaptation finance is currently facing.
One example is exposure to water availability. Over the past two years, a growing number of companies have linked loans to water consumption reduction targets.
Last year, as sole sustainability coordinator, BBVA helped Iberdrola, the Spanish energy company, design the world's first water footprint-linked loan. The €2.5 billion ($2.7 billion) syndicated facility was linked to two water-related indicators. It was the first time that the structure of a sustainability-linked loan was fully dedicated to fostering climate adaptation actions.
With a better understanding of the climate risks to which businesses are exposed and the reporting of a wider range of indicators of vulnerability and resilience, we can reasonably expect the scope of adaptation actions in the SLL market to expand.
EF: Adaptation financing has very different challenges compared with other types of green, social, and sustainability-linked funding – such as around KPI selection. What advice would you give to issuers?
HBS: With the guidance of loan market associations, the SLL has undergone several changes since its launch in 2017, which reflect market developments and strengthen the integrity of the product.
It is true that most of the SLLs arranged have been linked to climate mitigation. Nevertheless, our recommendation to future borrowers would be to use the experience gained from the design and arrangement of loans linked to mitigation targets and apply the SLL Principles to: (i) the selection of adaptation KPIs; (ii) the calibration of annual targets; (iii) the setting of pricing terms; and (iv) reporting and verification requirements.
Less than 8% of Global Climate Finance Goes to Adaptation (US$ Bn)
Adaptation KPIs must be material to the company's business and of strategic significance to its operations. They must be measurable and be able to be benchmarked, to the extent possible. Targets must be set annually, be ambitious, and be consistent with the borrower's adaptation strategy, which should ideally be publicly communicated to the market.
EF: To what extent can adaptation KPIs complement other sustainability measures within SLLs?
HBS: Article 2.1(c) of the Paris Agreement encourages actors to "make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development". That said, mitigation and adaptation actions have often been implemented and financed separately, and their potential impacts analysed in silos.
A number of adaptation and mitigation actions can have positive effects on both objectives of reducing exposure to climate risks and reducing greenhouse gas emissions (e.g., reduced coastal hazards from mangrove restoration or reduced landslide risk from reforestation). Conversely, certain measures that aim at having a positive effect on one objective can have unintended negative impacts on another (e.g., hydropower plants reducing food security or irrigation increasing energy consumption). Also, the role of climate change mitigation in reducing climate risks cannot be ignored. The greater global warming is, the more insufficient and ineffective certain adaptation measures are.
As a result, to foster synergies between adaptation and mitigation and limit trade-offs between the two, private sector actors should be encouraged to focus on both adaptation and mitigation objectives. We believe that combining adaptation and mitigation KPIs in SLLs can do so and would have the advantage of helping to raise awareness within organisations on possible synergies and risk trade-offs.
EF: Meanwhile, biodiversity loss is also rising up the corporate agenda. How are your clients responding?
HBS: Half of global GDP is generated in sectors that moderately or highly depend on nature. At COP 15, the UN biodiversity conference in December 2022, 190 states committed to the Global Biodiversity Framework (GBF), thus recognising biodiversity loss as an urgent global risk, like climate change. However, companies are still in the early stages of making biodiversity-related commitments. According to a review of Fortune Global 500 companies by McKinsey in 2022, 83% of the sample had climate-related targets, but few had commitments related to other dimensions of nature: only 5% had targets related to biodiversity loss.
Corporate targets are common for climate change but far less common for other dimensions of nature
Companies increasingly acknowledge the importance of nature – but identifying the impacts of their business on biodiversity and understanding how to address them are not easy tasks. This should be soon facilitated by the publication of the Taskforce on Nature-related Financial Disclosures (TNFD) framework, which will provide companies with a risk management and disclosure framework to identify, assess, respond and, where appropriate, disclose their nature-related issues.
Some sectors, particularly those that pose the greatest threat to biodiversity, such as agriculture, are ahead in terms of commitments. We saw agribusinesses incorporating some form of biodiversity-related KPIs into SLLs as early as 2019. That said, their number has been limited so far. We expect that to change on the back of COP 15 and the publication of the TNFD framework.
EF: Can biodiversity strategies be linked to sustainable finance structures? What are the challenges in so doing?
HBS: The progressive implementation of biodiversity strategies will generate a series of actions that financial institutions will be keen to fund through sustainable finance products. In fact, to promote biodiversity finance, loan market associations have included in their Green Loan Principles a number of eligible uses of proceeds that cover areas of biodiversity.
We also expect banks to strongly encourage companies whose activities pose the greatest risk to biodiversity to link their loans to biodiversity-related targets. Since 2019, we have seen borrowers from sectors such as airport services, forest product manufacturing, logistics, and agribusiness incorporating biodiversity-related KPIs in their SLLs.
We expect biodiversity finance to rapidly grow in the coming years as the challenges it faces are addressed. These include companies' current focus on climate and the lack of standardised metrics, as well as accessible, consistent, and good-quality data disclosures. In this respect, the GBF has greatly helped raise awareness of the importance of nature as well as its critical interconnection with climate change. Additionally, the TNFD framework should address some of the issues related to the assessment and disclosure of nature-related factors.
EF: Is there enough consensus around data to enable biodiversity-linked loans?
HBS: Consistency, accessibility, and quality of data disclosure are the biggest challenges for the further expansion of the biodiversity-linked loan market at the moment. Company-level reporting and targets on biodiversity are still in their early stages. There is an overall lack of standardised metrics to assess the impact of business activities on biodiversity, although a few are being proposed, such as mean species abundance, potentially disappeared fraction of species, and species threat abatement and recovery.
Biodiversity is not easy to quantify. It is even harder to find a unit of measurement that summarises biodiversity in its entirety, each ecosystem being unique, dynamic, and place-specific. Also, companies' understanding of nature and biodiversity issues varies considerably. In an ideal world, companies would report both quantitative and qualitative data on their exposure to biodiversity risks and policies, dependencies, and potential impacts of their business activities on nature. But we are still far away from that.
Having said that, we are at a tipping point and steps are being taken in the right direction. A number of ongoing initiatives should allow for greater transparency and guidance on companies' exposure to biodiversity-related risks and opportunities, such as the above-mentioned GBF, which requires signatory states to take proactive measures for large companies to disclose relevant nature-related data. In addition, the TNFD and other forthcoming regulations and initiatives – such as the EU's Corporate Sustainability Reporting Directive, the Nature Action 100, and the Global Reporting Initiative's revised topic standard for biodiversity – will either require or support corporate disclosure around biodiversity. This, in turn, will help support a biodiversity-linked loan market.
Hedi Ben Salem is head of corporate lending Europe and Asia at BBVA, based in London, UK. E-mail: firstname.lastname@example.org