Developing economies, excluding China, receive only 14 percent of total climate finance flows while they account for about one-quarter of global GDP. In addition, only 16 percent of these resources are dedicated to adaptation – with 98 percent of it provided by public actors.
Public finance alone, including donors and multilateral development banks, will not deliver the investment needed by developing countries to meet their development ambitions. We need to mobilize more private capital to support resilient, low-carbon growth.
Carbon markets have long been seen as part of the solution, offering win-win opportunities for developing countries and the private sector, and contributing to jobs and growth on a livable planet. If designed well, carbon markets can also help mobilize additional finance for adaptation and protect natural capital.
Yet, carbon markets are at an inflection point. COP 29 finalized the Article 6 rulebook which operationalizes carbon markets under the Paris Agreement, providing clear guidance on reporting, authorization, and registry systems. However, voluntary carbon markets (VCMs) saw a significant drop in the market value of traded carbon credits, from USD1.9 billion in 2022 to USD0.7 billion in 2023. This drop is primarily attributed to environmental integrity concerns and a loss of trust in carbon markets.
Fundamentally, for the investors, project developers and communities, the issue is risk. Risk of non-delivery of high-integrity carbon credits, risk of invalidation, reputational and legals risks (including greenwashing), as well as risks associated with additionality, permanence, and the potential for adverse social and human impacts. Most of this risk sits on the shoulders of project developers and communities.
Risk is certainly not unique to carbon markets. Indeed, a whole industry – the insurance industry – thrives on the effective measurement and management of risk. So, what can we learn from insurance?
Private investment flows only where the right conditions exist and where there is a return on investment. For risk markets, this includes: (i) strong market infrastructure, including data and models, (ii) processes and technologies to reduce risk; (iii) stable and predictable regulatory and policy environment; (iv) private capital mobilization within this enabling environment.
Building market infrastructure
A fundamental part of the risk market infrastructure for insurance, for example, is a trusted, shared and verifiable understanding of risk, based on robust data on hazard, exposure and loss. Governments play a critical role by investing in such essential market infrastructures. For example, global and national databases have been developed, usually as public-private partnerships, increasingly using remote sensing technology. Such database feed catastrophe risk models, which allow insurers to assess and price potential losses caused by natural hazards such as earthquakes, floods or hurricanes.
Carbon markets similarly need high integrity market infrastructure. Registries play a critical role. The Climate Action Data Trust collect registry data, currently covering 75 percent of market activities. The World Bank’s Carbon Assets Tracking System enables the issuance and transaction of carbon credits generated under World Bank’s emissions reductions programs. They also rely on methodologies and crediting frameworks to improve standardized and transparency of carbon credits.
Innovative financial products like parametric insurance have also been designed to reduce risks, speed transactions and increase transparency by relying on independently verifiable metrics. In carbon markets, a new generation of digital Monitoring-Reporting-Verification (MRV) systems measure emissions reductions and create market-grade carbon credits, analogous to the parametric indices used in catastrophe risk insurance.
Strengthening the policy and regulatory environment
A stable and predictable policy and regulatory environment is critical to develop sustainable risk markets. In insurance, risk-based regulation and supervision ensure that insurers have enough capital to fulfill their obligations in case of large payouts due to widespread disasters. In addition, catastrophe risk insurance can be made mandatory for homeowners as a stand-alone policy (like earthquake insurance in Turkey) or as an extension of guarantee under a property insurance policy (like in Morocco), stabilizing demand and so catalyzing private capital and innovation.
Likewise, carbon markets require a strong legal and regulatory framework to ensure their integrity and efficacy. One example of such a framework is the Standard Crediting Framework (SCF). This framework is a streamlined, country-owned governance process for the creation, monitoring, and trading of carbon credits. It enforces rigorous standards for emissions reductions and employs robust methodologies for verifying carbon credit authenticity. It aims to ensure transparency, hence fostering confidence among investors and participants.
Mobilizing private capital through risk sharing
Once the risk market infrastructure is in place and the legal environment is enabling, private capital can be deployed, sometimes blended with public funding to de-risk and makes it more attractive and affordable. Catastrophe risk insurance markets have strongly relied on public-private insurance programs, to protect governments, business and people against climate shocks and disasters while de-risking capital for private actors, for example in covering the first loss. They include national catastrophe risk pools (like the Turkish Catastrophe Insurance Pool) or sovereign catastrophe risk pools (like the Caribbean CCRIF).
Carbon markets are yet to deliver on their promise in this area. However, innovations are emerging that similarly mobilize capital via de-risking. For example, the World Bank issued in 2023 a $50 million Emission Reduction-Linked Bond for Vietnam to finance large scale water purification initiative in Vietnam, where the returns are linked to the issuance of carbon credits. The intermediary role of the World Bank provides assurance to investors. Likewise, the new generation of carbon facilities, like SCALE, uses limited donor funding to offer an offtake guarantee to countries in order to incentivize them to generate high-integrity carbon credits, as the carbon credit prices are volatile and the demand for carbon credits is still uncertain.
Insurance itself also offers promise to help build trusted high-integrity carbon markets. Insurers can help de-risk investments in carbon markets through insuring against risks, such as non-delivery risk or reversal risk, and can help build trust through acting as third-party verifiers. MIGA has developed a new guarantee instrument against legal uncertainties, including revocation risk, to support cross-border carbon trading under compliance carbon markets.
Countries can learn from their experience in developing insurance markets as they build their domestic carbon markets. Governments and the private insurance sector have set up public private insurance partnerships to develop their domestic catastrophe insurance and hence crowd-in private capital. Neither the governments nor the private insurance sector could have developed those markets alone. Likewise, countries and the private sector need to set up public private carbon partnerships, through trusted carbon markets, to set up the right conditions to crowd-in private capital so we can maintain a livable planet.
Dr Olivier Mahul, expert in climate finance and insurance and Manager at the World Bank, has joined the Oxford Martin School as a part-time Visiting Fellow to work with the Oxford Martin Systemic Resilience Initiative to help unlock progress in leveraging climate finance to address global challenges. This note is a primer to inform discussions on scaling high-integrity carbon markets through improved risk management.
This opinion piece reflects the views of the author, and does not necessarily reflect the position of the Oxford Martin School or the University of Oxford. Any errors or omissions are those of the author.