www.IFC.org/ThoughtLeadership Note 14 | September 2016 HOW TO MAKE INFRASTRUCTURE CLIMATE RESILIENT In emerging markets, climate change threatens infrastructure that is critical for development. Roads, airports, water systems, and power plants are vulnerable to weather changes. Severe storms and major droughts can disrupt economic activity. Because private companies and investors in emerging markets often manage infrastructure projects through public-private partnerships, they will now need to address climate change risks when planning and building these projects. The uncertainty of such risks has made incorporating them into project planning a challenge, but new tools and approaches, including insurance, are helping PPPs better respond to climate risks. Well-functioning infrastructure, such as roads, airports, water public-private partnerships even more problematic. Historically systems, and power plants, is a pre-requisite to economic PPP contracts have allocated risks to the party in the best position development. Yet in many emerging economies, weak to manage them, but ambiguity about the timing and severity of governance, regulatory uncertainty, poor public credit ratings, and climate risks presents major challenges for designing and pricing a shortage of bankable projects have hampered investment in PPP contracts that promote economic development in emerging infrastructure. As a result, emerging-market governments have markets. long turned to partnerships with private companies to help fill the gap in infrastructure financing. In particular, private players have little incentive to account for climate risks in project planning. Often private players in PPP These public-private partnerships have evolved over the years contracts are only paid for the life of the contract, not for the life with public and private entities shouldering various levels of of the project. As a result of that compensation structure, a private financial and management responsibility. Some are long-term player may not make decisions in the design and planning phase partnerships with defined roles and responsibilities, while others that increase a project’s longevity if they also increase costs. are more fluid with private enterprises receiving performance or Public entities reinforce this behavior because they often choose output-based payments. less expensive proposals and resilience measures can be costly. Finally, if the private player does want additional compensation In emerging markets, climate change is now one more challenge to manage climate change risks, the PPP structure might not be that these projects face in designing, operating, and maintaining cost effective for emerging-market governments. infrastructure crucial to growth. Water related projects are especially at risk. Water systems, hydropower plants, and coastal In general, the challenge of incorporating climate risks into PPP infrastructure will need to be overhauled to withstand the strain of contracts is that these contracts are ill suited to managing storms, floods, and droughts. But the changing climate and unpredictability. Uncertain and rare events outside the contract, warming temperatures will affect all types of infrastructure such as political unrest or floods, are often handled through force projects. Extremely hot days, for example, are cutting majeure provisions and insurance. With such provisions, “both construction workdays short and high winds and severe storms parties get equitable rights to terminate a PPP contract after a threaten cell phone towers. As a result, public-private partnerships prolonged risk event, perhaps lasting 180 days or longer. In a will need to account for climate risks in infrastructure planning, typical [force majeure] termination, both parties share the making sure that projects are resilient to the effects of climate financial impact; the public sector pays out debt obligations of change. lenders, paid-in equity including any breakage costs of investors (who forego future profits) in lieu of an affected infrastructure The lack of certainty about how temperatures and precipitation asset,” according to a 2016 World Bank report.1 will change makes planning for long-term projects and designing Examples of Public-Private Partnership Contracts Source: Public-Private Partnerships Reference Guide, Version 2.0 (2014) Climate change, however, is not easily managed through force changing weather patterns. Improved tools that provide more majeure provisions because extreme and unpredictable weather accurate forecasts—even decades into the future—will help all events in the present may become normal in the future. In parties better evaluate risks from the outset. 3 And scenario addition, because no standard definition for these provisions planning will also help parties better evaluate a range of exists in legislation and there is no standard approach to how possible climate situations. International financial institutions, they work in reality, force majeure clauses will likely be including IFC and the World Bank, are looking at new tools to inadequate to covering all types of weather and climate risks. better plan for climate risks in infrastructure projects. A World Bank conference in 2015, for example, focused on how When it comes to climate change, however, decisions made in investors can incorporate climate risks into infrastructure the present have an impact on future risks. The lack of planning essential for economic development in Africa. And a diverse for climate risks has already undermined some PPPs. In 2008, group of experts addressed challenges associated with for example, IFC reviewed and helped finance the $2.3 billion conflicting climate model forecasts.4 expansion of the Panama Canal. Even though climate experts from IFC raised questions about the impact of the region’s For some regions, short-term predictions of changes in changing climate on the project, the project sponsors didn’t precipitation are not consistent, but present day investment account for climate risks. As a result, the canal closed in decisions differ widely based on each prediction. For example, December 2010 due to flooding, when Panama received more if the future climate involves more rain, an emerging-market rain than at any time in its recorded history, causing significant government might expand hydropower. Yet if that rain didn’t disruptions and losses.2 materialize, investments into hydropower plants could be wasted. The experts found that one way to approach such a Analytical Tools to Address Uncertainties decision is to weigh the costs of making the investment, with Because PPPs are not equipped to deal with such types of the potential impact if it wasn’t made. If the benefits of reduced unpredictability, creating more certainty around climate risks is risk outweigh the costs, then the investment makes sense. 5 the key to building infrastructure projects that can withstand This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Source: The World Bank Group and PPIAF Public-Private infrastructure Advisory Facility Another approach to dealing with climate change uncertainty is droughts that may reduce hydropower generation and low wind to weigh different views based on their probability. This years that reduce wind power generation. approach has been used in other fields where uncertainty is coupled with the need for accurate forecasting. In this approach, Surety bond insurance may be one model for the broader and different expert opinions are “weighted” based on their longer coverage relevant to climate risks. This is a type of accuracy and then aggregated to create a projection.6 insurance that guarantees completion of a project in the event of financial default.7 IFC, together with Munich Re, established Insurance and PPPs a Risk Sharing Facility in both Brazil and Colombia for this Because insurance companies specialize in risk management, type of project completion risk. However, such coverage is not their analytical methods can be adapted to help public-private widely available in emerging markets and has yet to be applied partnerships assess and manage climate risks for infrastructure to climate risks. projects. Traditional insurance products are most relevant for short-term risks relevant to the design and approval of upfront Ultimately financiers, governments, and insurers will need to financing. Insurance companies can also encourage developers come together to identify innovative new products and to incorporate climate risk measures into infrastructure projects approaches to deal with climate change risks. The United by offering more favorable terms such as lower premiums. As Nations Economic Commission for Europe, for example, the availability of risk mitigation instruments grows, insurers created the International Public Private Partnership Center in can advise project companies and governments on the products New Orleans to share lessons from Hurricane Katrina with they could use to better manage long-term risks. developing nations. Insurers will have to experiment beyond traditional products In Uruguay, the World Bank, insurer Swiss Re, and state-owned and pricing to better match the climate change risks of utility company UTE, designed a way to adapt insurance to infrastructure projects in emerging markets. Lenders that fund boost the resilience of its hydropower systems, which supply a project generally require insurance to cover risks and ensure most of the country’s energy needs. When there is little rain the that their interests are protected. When it comes to risks from utility purchases oil and gas as an alternative energy source climate change, lenders will want new types of insurance in meaning that high oil prices during dry conditions can severely order to protect themselves against ongoing risks such as affect the national economy. In 2012, a year of water shortages, the utility spent $1.4 billion to meet the country’s energy needs, This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. beyond original projections of $953 million. In order to cover high oil prices. To gauge the extent of a drought and potential the gap, UTE borrowed funds, drew down the country’s Energy insurance payouts to the company, daily rainfall data at 39 Stabilization Fund, and increased rates to consumers. To help weather stations spread throughout two river basins are avoid such a destabilizing situation in the future, the World measured regularly. If precipitation falls below the level set up Bank executed a $450 million weather and oil price insurance as trigger of the contract, UTE receives a payout of up to $450 transaction, insuring UTE for 18 months against drought and million based on the severity of the drought and oil prices.8 The ability of infrastructure to cope with the changing climate erodes over time, unless adaption measures are put in place Source: United Kingdom Climate Impacts Programme Finally the PPP procurement process can include insurance international financial institutions are well placed to address the requirements that lower losses from disasters. This can help public intersection of climate risks and infrastructure. They are screening entities ensure that private companies include structural and such investments for climate risks, providing analytical tools to financial resilience measures in procurement proposals. measure those risks, and designing measures to respond to those risks, including innovative insurance approaches. Conclusion Alan Miller is an independent consultant on climate change finance and The need to address climate risks in infrastructure projects is policy, retired from the IFC Climate Change Business department becoming increasingly urgent for economic development in (astanley92@gmail.com). emerging markets. Countries most vulnerable to severe storms and rising sea levels are also among those with the greatest need Stacy Swann is the former Head of IFC’s Blended Finance Unit, Climate Change Business Department, and is currently the CEO of Climate for new roads, ports, power plants, and other forms of Finance Advisors, LLC (sswann@climate-fa.com). infrastructure to reduce poverty. The World Bank Group and other 1 Satheesh Sundararajan, Nuwan Suriyagoda, “Climate Risks and Resilience in 4 Raffaello Cervigni, Rikard Liden, James E. Neumann, and Kenneth M. Strzepek, Infrastructure PPPs: Issues to be Considered,” PPIAF Issue Brief, March 2016. “Enhancing the Climate Resilience of Africa’s Infrastructure,” United Nations 2 The World Bank, “Emerging Trends in Mainstreaming Climate Resilience in Large Economic Commission for Africa, 2015 Scale, Multi-sector Infrastructure PPPs,” World Bank Group and PPIAF Public- 5 Ibid. Private Infrastructure Advisory Facility, 2016. 6 M. Oppenheimer, C. Little, and R. Cooke, “Expert judgement and uncertainty 3 Handshake: IFC’s Quarterly Journal on Public-Private Partnerships, “Climate quantification for climate change,” Nature Climate Change, April 27, 2016. Change and PPPs,” 2011. 7 Ace Report, “Using Surety to Facilitate Infrastructure Investment,” 2015. 8 The World Bank, “Mitigating the Impact of Drought on Energy Production in Uruguay,” 2015. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.