A quantitative model for climate change adaptation resilience bonds

This paper introduces a model designed to support green transition and climate change adaptation, focusing on the role of insurance compa- nies and public authorities. As climate change accelerates, climate risks are seen as uninsurable, unless alternative risk transfer methods are em- ployed. One such method is the issuance of Catastrophe (CAT) bonds, which allow insurers to transfer risks to financial investors. However, these instruments alone do not guarantee a reduction in climate risk or foster a green transition. Our model assumes that firms (policyholders) are exposed to catastrophic risks, which can be mitigated by adopting green technologies. To encour- age this transition, insurance companies, with support from a public au- thority, periodically issue resilience bonds, similar to CAT bonds. If a sufficient number of “virtuous” firms adopt green technologies, the risk - and thus interest rates - on these bonds decrease, allowing the bonds to finance the green transition, such as offering premium discounts to the adopting firms. This creates a dynamic interaction between bond rates and the proportion of firms using green technologies. The model outlines two scenarios: one where all trajectories converge to an optimal equilibrium (where all firms adopt green technologies and bond rates are minimal), and another where a sub-optimal equilibrium occurs with fewer firms adopting green technologies and higher bond rates. The paper’s main contribution is the development of a quantitative model for a green transition supported by financial instruments and public interven- tion, with a specific application to mitigating flood risk in Italy.