Many people, companies, institutions, and governments have increased their commitments and plans to act. However, these commitments and plans usually focus solely on mitigating greenhouse gas emissions to avoid negative physical climate risks. While these commitments and initiatives are important, plans for how to adapt to and manage unavoidable physical risks must also be included for a climate strategy to be considered comprehensive.

Climate adaptation can be a difficult subject to tackle: Often, we encounter an unspoken sentiment that to focus on adapting to climate change means giving up on mitigation. It can be sometimes viewed as acknowledging a failure to meet the goals of the Paris Agreement or the aim of limiting warming to 1.5°C above preindustrial levels. It can be challenging for other reasons that we explore later, and it can be easier to ignore the topic and focus elsewhere when the solutions seem unclear.

Not only does this sentiment leave markets exposed to physical risks that have already been locked in, but it wrongly presumes that mitigation and adaptation are mutually exclusive. In fact, both are necessary and complementary parts to a well-developed climate strategy. 

It’s critical to accelerate adaptation activities

New methodologies are increasingly able to determine the cost of extreme weather events that are attributable to climate change. It’s not exactly news that these costs are high and rising, but the quantification and attribution provide more clarity on the risks we are facing. Recent estimates suggest that, without decisive action, growth in global GDP would be 30% lower by 2100 due to climate change (150% instead of 215%). Meanwhile, a study from Nature estimated the cost from the last 20 years at US$2.86 trillion—or an average of US$143 billion per year. That figure, however, covers only the cost of extreme weather. Other models estimate an additional cost attributable to climate change of more than US$3 trillion over the same time period due to physical hazards that result from nonextreme weather, such as lower crop yields, higher sea levels, disruptions, and other impacts.

That figure is predicted to only get larger. Costs incurred from climate change-induced extreme weather are projected to increase by between US$1.7 trillion and US$3.1 trillion every single year by 2050. However, it’s important to understand that these increases are unlikely to be linear. Many of the physical risks of climate change could materialize in step changes that are the result of tipping points. 

Robust climate strategies should include adaptation

Mitigation and adaptation are often discussed separately, but the two are closely and inversely related. If the world mitigates more successfully toward lower temperature scenarios, the need to adapt to climate change is reduced. Conversely, the less we mitigate, the more we must adapt and become resilient to the climate events resulting from higher temperature scenarios. The two are intertwined, with connected implications for the economy, business, and financing.

Mitigating climate change creates transition risks, and transition risks are inversely related to physical risks. Lower temperature scenarios have higher transition risks but lower physical risks. This contrasts with higher temperature scenarios that result in less transition risk, but greater physical risks.

Two sides of climate risks

This means that the more we invest in mitigation the less we’ll need to invest in adaptation and resilience. Another way of looking at this is that if we don’t adequately invest in mitigation and accept the risks associated with transition, then we’ll incur higher costs (both economic and social) associated with physical risks.

Companies can benefit from adaptation in multiple ways, including:

• Reduced insurance premiums
• Maintenance of core revenue streams
• Increased energy efficiency
• Reduced damage from extreme climate events
• Faster recovery after extreme climate events

Mitigation and adaptation are inversely related

This may seem obvious, but it’s rarely front of mind when climate action is discussed. The relationship between the two topics can also be confusing because in reality, aspects of both are exponential rather than linear and include step changes related to tipping points. Complex modeling and long-term forecasts, often based on incomplete data, can also result in a range of outcomes and possibilities that need to be considered.

However, in our view it’s worth remembering that a robust climate strategy should include a margin of safety where planning aims to adapt toward a level above where it’s mitigating. Currently, we’re mitigating towards 2.9°C and failing to adapt to the extreme weather of the 1.2°C levels of current warming. That means we either need to be mitigating down to the current levels of warming or adapting up to the temperatures we are tracking toward. Ideally, and as agreed on in the Paris Agreement, we should be mitigating toward well below 2°C while adapting and building resilience to a level above that. Put another way, current policies have us on a path where key climate risks remain unaddressed, a strategy that is destined to fail in its current form. The necessary course correction requires accelerated action—not just on mitigation, but adaptation as well.

Creating a safety buffer between mitigation and resilience

Adaptation is not an alternative to mitigation

Because adaptation has clear limits, climate risk cannot be addressed by allowing adaptation to take the place of mitigation. While we consider the benefits of adaptation to be underappreciated and untapped, they aren’t a substitute for mitigation. The two are intertwined and complementary to focus on adaptation instead of mitigation in our view misses the point.

The IPCC has warned that beyond 1.5°C and 2°C, adaptation becomes less effective and, in some cases, impossible. As temperatures rise, climate risks grow exponentially and the benefits of adaptation level off. Tipping points are irreversible and render adaptation impossible. Additionally, higher temperatures increase the risk of maladaptation. A robust climate strategy should include mitigation and adaptation but must also be clear about the limits of both.

Understanding the limitations of both approaches

Financing needs for adaption

Current financing is disproportionately allocated toward mitigation. The Climate Policy Initiative estimates that less than 10% of climate finance goes toward adaptation, 90% of which comes from the public sector. That means only 1% is going from the private sector into adaptation and resilience.

• Climate adaptation finance reached around US$76 billion in 2022 globally, of which around US$32.4 billion was mobilized for adaptation for developing countries
• Adaptation is an underinvested theme: Projected demand for adaptation and resilience investments is US$0.5 trillion to US$1.3 trillion annually by 2030.
• The adaptation finance gap remains stark: The United Nations Environment Programme estimates a shortfall of US$187 billion to US$359 billion per year.
• Private sector contributions remain fragmented and underreported: OECD data shows that, in 2022, almost 90% of adaptation finance provided and mobilized for developing countries came from bilateral and multilateral public sources

Challenges

It can be challenging to develop effective plans for adaptation and resilience. It can be difficult to even conceptualize, because past extreme weather events aren’t indicative of the potential physical risks of climate change. Physical risks grow exponentially, and if tipping points are breached then ecosystems will irreversibly change. This can make solutions seem unclear. They do exist, but they require local knowledge, complex modeling, and practical considerations.

Additionally, unlike the cross-boundary emissions driving global climate change, physical adaptation risks are location specific. This creates challenges for investors because companies aggregate their economic activities. We usually receive corporate reporting of consolidated financial statements and aggregated sustainability disclosures, with limited information on the details of specific assets. We know from the companies that we invest in that it can also be difficult for them to assess the different locations of assets, types of assets, and utilization that are needed to evaluate various types of physical risks. This is all further complicated with various climate scenarios, models, and forecasting assumptions. The analysis becomes exponentially more complex when considering supply chains.

There are also political challenges due to the reluctance to publicize identified risks. Companies or governments that have done quality physical risk assessments may not want to be transparent about their findings for fear of scaring investors and stakeholders. This also creates an incentive for understating physical risks and claiming that they’re manageable, when in fact there may be gaps that need capital to be addressed. Another political challenge is around common interests. We often hear from companies that they know there is an issue but addressing it requires action from others.

For example, a company successfully addresses flood risk at its factory, but it knows that the road or rail required for transportation into and out of the factory is also at risk. Alternatively, a company may want to build a seawall, but this is only effective if their neighbors do the same. These can introduce a free-rider problem where multiple companies rely on the same road and are all waiting for the others to invest in it. Manulife Investment Management has been working with Concordia University in Canada and the AIGCC in Asia to help address these challenges by encouraging sovereign and sub-sovereign forward-looking climate mapping and planning.

Adaptation is often seen as a cost, rather than an investment, which makes financing a challenge. While a solar panel can create new revenue for the manufacturer or decrease electricity costs for the user, an adaptation project only prevents a future loss and has no impact on cash flow. The upfront expenditure required to protect future cash flows is a tougher sell than investing to create new cash flows today.

Solutions

There are positive case studies and a variety of adaptation solutions available, but all of them start with a good assessment of physical risks. A quality assessment can ideally avoid the need for adaptation at a later stage by including physical risks in the initial planning stage. Proper physical risk assessments, however, don’t appear to be occurring. An infrastructure investor survey found that despite 97% of investors believing physical climate risk is significant, only 16% believe that there’s adequate understanding of how it’ll affect infrastructure assets; 66% of respondents had yet to conduct any evaluation of physical climate risk themselves. If there isn’t adequate understanding, there can’t be adequate incorporation of preventative measures in the planning stage. We know this leaves the economy exposed to risks, and these risks aren’t being adequately addressed or financed. Evidence indicates that every dollar spent on adaption results in US$12 of loss avoided.

Scaling green bond markets: We estimate that this is mirrored in sustainable debt markets. A study by Sustainable Fitch reviewed 500 labeled bonds and found that around 2% to 3% included use of proceeds explicitly marked for adaptation. Furthermore, while adaptation sometimes represents an eligible category for proceeds, it isn’t always used in post-issuance allocations, and even when it’s used, it often represents only a small portion of allocated proceeds. We believe this represents an opportunity for the market to use tools that already exist, like green bonds, to further scale adaptation finance. One promising area is sovereign issuance where we’ve seen adaptation projects increasingly included in Asia-Pacific sovereign green bonds. For example, part of the green bonds issued by Hong Kong government has been allocated to climate intelligence solutions and drainage improvement. In addition, there are also some voluntary classification systems for climate resilience investments such as Climate Bonds Resilience Taxonomy to provide a consistent, transparent, and systematic approach in defining and identifying adaptation and resilience investments. There should be plenty of opportunities to increase this further for both sovereign and corporate issuers.

Protecting future cash flows—Semiconductor companies have especially water intensive businesses and are already facing the climate effects of water stress. Droughts have disrupted operations and increased expenses while causing missed revenue opportunities. However, adaptive actions are helping and better preparing these operations for similar events in the future. The protected cash flows can be used to finance these adaptation projects, which is true for not just semiconductors but many sectors.

Adaptation as a service—Adaptation projects are often an expense paid today for avoided losses and multiple paybacks tomorrow. However, some companies are using climate adaptation to increase revenues. One example is a South Korean water management company that’s been helping clients improve water efficiency and adapt to water stress. This not only provides service revenue, but also supports the cross-selling of technology and hardware. Another example is a Singaporean engineering firm that has been identifying adaptation needs, then helping clients to execute coastal protection and urban development projects.

Innovative finance—The bulk of adaptation finance is currently occurring in the public sector. This creates potential opportunities for blended finance which can help public and private capital go further towards addressing adaptation funding gaps. Blended finance can be innovative and challenging, but organizations like GARI (Global Adaptation & Resilient Investment) and Convergence are helping to drive these developments.

Incorporating adaptation into climate strategy  

We regard physical climate risks and opportunities as material in many sectors, and incorporate them into our analysis of corporates, sovereigns, and private market investments. We also believe these material adaptation and resilience issues can be managed, leading to stronger stewardship initiatives. These can include engagement with portfolio companies and leading industry groups working on the topic, such as the AIGCC Physical Risk Working Group AIGCC Physical Risk Working Group that Manulife Investment Management founded and has chaired for the past five years. We’re also supporting the development and enhancement of national adaptation plans and efforts that will help with disclosure and benchmarking, such as taxonomies and reporting standards. We look forward to continuing this work with our investment, clients, and industry partners.   

We view adaptation as a key part of a robust climate strategy and necessary for successfully managing climate-related financial risks. It’s an approach with meaningful potential that hasn’t always received the attention it deserves. However, as extreme weather events intensify and temperatures hit meaningful levels, the issue sees growing interest and action. Challenging though it will be, there are solutions to be had with the right local knowledge, relationships, and collaboration.