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Imperial College suggests US style muni bonds will address adaptation gap

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Creating special adaptation bonds modelled on US municipal bonds is suggested as a way to narrow the gap between funding for adaptation and mitigation measures to fight climate change. The favourable tax treatment feature of municipal bonds may be a sticking point.

  • An Imperial College London paper proposes adaptation bonds as a new global asset class, specifically modelled on the US municipal bond market.
  • Aimed at adaptation and resilience projects to combat climate change, it also looks to address the gap to the higher amount of funding raised by mitigation projects.
  • Funding adaptation measures need to increase, but should be combined with mitigation efforts, which are already being addressed by a robust range of financial instruments.  

Addressing adaptation measures to combat climate change separately from mitigation measures has resulted in a gap in funding that favours mitigation. The two need to be considered together, as marginalising adaptation may exaggerate future mitigation needs.

The Imperial College London paper suggests the use of US style municipal bonds to address adaptation funding globally, but ignores key features contributing to their domestic popularity, including tax exemption and the financial strength of issuers, which would limit their translation to other parts of the world.

Adaptation and mitigation need to be addressed together

According to the IPCC, adaptation and mitigation must be considered together to combat the effects of climate change. Common enabling factors for a combined response currently exist, but implementation has been constrained by inertia.

Grouping mitigation goals like energy transition and net zero with common targets to be achieved in the future, which may also be contributing to the relative inaction by  companies and governments on implementing adaptation measures.

Adaptation is usually a localised problem, and requires solutions that address local cultural, economic and physical challenges. Regional differences in resource consumption, infrastructure development, trade barriers, the role of institutions, and the availability of technology and resources add further complexities.

Addressing adaptation and mitigation together requires a greater deal of cooperation between the developed and developing world, to help create a more balanced approach globally to combating climate change.

US municipal bond popularity stems from tax deferred feature

Municipal bonds seem like the perfect instrument to finance climate-related infrastructure assets, having traditionally been used by state and local governments to fund the development of schools, transportation, housing and utilities.

These bonds are highly popular in the US, although China has become the largest market for local government bonds, according to the Reserve Bank of Australia

A key feature of US municipal bonds is the exclusion of interest income from federal income tax, which makes them attractive to investors in high tax brackets. They are typically owned by investors at or above retirement age in the US, either directly or through mutual funds and life insurance policy investments. 

A further feature of US municipal bonds is their safety and stability, owing to the strength of issuers. Compared to corporate bonds, municipal bonds have a negligible default rate. In fact, federal debt levels in the US far exceed those of state and local debt governments, adding to the safety aspect of the asset class. 

These factors, however, may not translate globally, especially in countries where local governments do not have the authority to issue debt, the tax system does not provide investors to invest in them, and the financial stability of the issuers may not meet the investment criteria of a lot of investors.

Do we need another asset class to address climate change?

The paper by Imperial College London suggests the launch of a new asset class, adaptation bonds, to boost funding in adaptation measures globally, modelled specifically on US municipal bonds. 

The primary justification for this is to extend the ability of local governments to finance sustainability and resilience measures, which the paper equates with adaptation, rather than leaving it up to central governments.

In addition to a similarity in the types of projects funded, it also sees the use of proceeds being tied to specific projects, as further justification.

The paper also acknowledges the advances made in funding resilience and sustainability projects from green bond financing. It cites a growing trend to include adaptation criteria in green bond frameworks, which it expects to continue in the future. 

The paper’s call to action comes from a growing adaptation finance gap cited by the UN Environment Program (UNEP). However, in its latest Adaptation Gap Report (AGR), UNEP states that 79% of countries have adopted at least one national level adaptation planning instrument.

Addressing adaptation along with mitigation needs will require greater policy commitment from governments, rather than another specialised financial instrument, which could bring additional defining criteria, standards, and required oversight to an already complicated sustainable finance marketplace.

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