To insure, or not to insure? That is the (carbon) question.
In this post, Kita CEO and co-Founder, Natalia Dorfman investigates the necessity of insurance and the motivations for buyers of insurance; both across the general financial landscape but also within the nascent carbon markets. She explores the factors that are holding back the sector and considers the benefits that insurance brings.
Insurance has existed for centuries. The earliest tangible records of insurance-type mechanisms date from around 1792-1750BC. However, insurance has likely existed for even longer: even in non-monetary communities, forms of insurance were built into transactions (possibly originating as agreements of mutual aid in the event of a default or unexpected outcome).
Why the longevity?
Because regardless of the economy, insurance has clear utility in:
reducing and managing risk;
building resilience when things go wrong; and
enabling access to long-term, reliable finance, thus serving as an essential contributor to economic growth.
Nowhere is this more essential than the emerging climate change economy. For example, as noted in a recent report – No Insurance, No Sustainable Future – How insurance unlocks the growth of green projects – “while people often talk about green finance as the main driver of [green] projects, insurance is a crucial but often overlooked partner… unlocking, promoting, and facilitating the transition to net zero.” Some examples provided in the report include:
“Given the inherent investment risk associated with projects, potential investors and lenders will often require financing and credit guarantee mechanisms to protect their investment. Insurance is one such mechanism.”
“The insurance solutions applied during the construction and ongoing operation of green projects also help to secure financing by ensuring the projects run smoothly.”
Insurance for the Voluntary Carbon Market (VCM)
As new markets emerge, so too do new forms of insurance, serving to quantify and manage new risks, build trust and catalyse investment. A recent and relevant example here is renewables.
The VCM is another example of an emerging market – both in terms of the evolving nature of the market’s carbon-specific standards and solutions, as well as in relation to insurance industry engagement, with Kita being one of the insurance companies leading the way in terms of deploying carbon-specific insurance products to reduce risk and underpin growth.
So, let’s delve deeper into why companies buy insurance, and – more specifically – how this applies to the specific nature of the VCM.
Why buy insurance (generally)?
People/companies tend to buy insurance for three broad reasons:
It is a legal or regulatory requirement: e.g. in the UK, Employers Liability Insurance is required by law for businesses to provide cover if an employee is injured or becomes ill because of the work they do for you, whereas professional liability insurance is required by regulators for specific industries (e.g. healthcare).
It is a de facto business requirement: e.g. many companies require their counterparty in a transaction to have certain types of insurance, such as public liability. While not a legal requirement, lack of insurance would be a red flag and likely derail the transaction.
The impact of the loss is high, thus making risk transfer to an insurance company a financially and commercially logical thing to do: e.g. if you hold an asset of value that would be financially difficult to replace, instead of holding back reserves on your own balance sheet to handle the risk of loss, you can insure the asset with an insurance company instead. The upfront premium is a fraction of the value of the asset, and in the instance of a loss, you will be compensated by the insurer.
Note that in point 3, insurance can also help provide significant capital efficiencies, in that if companies don’t need to hold risk on their balance sheets (i.e. they can transfer the risk to an insurance company), then they can invest that capital in other things. Likewise, insurance can often enable better financing rates if accessing loans. This is why it is important for insurers to have high credit ratings (and why it matters that Kita is backed by Lloyd’s of London)
Why buy insurance (for carbon)?
Applying the above reasoning to the carbon markets:
Insurance is not a legal or regulatory requirement: given the overall lack of existing regulation in the VCM, this seems unlikely to change in the near-term (watch this space in the future, particularly around reversal risk)
Insurance is not YET a de facto business requirement: there are a few factors to consider here:
a. “Standard” insurance such as professional liability and public liability is often part of carbon credit transaction contracts, just like in other industries.
b. However, insurance protection for carbon specific risks such as delivery, reversal, invalidation, political risk etc. is not yet standard within the market.
c. We see this changing from 2024 onwards, as more insurance products come into the space and contracts are updated accordingly to allow for third party risk management as the norm.
d. The rise of disclosure requirements (e.g. TCFD) and their risk management sections will be a driver here as insurance is a helpful means of disclosing how risk is being managed.
e. Finally, we do increasingly see examples in this space, such as companies who have procurement requirements that all pre-payments must be insured, regardless of type of purchase.
Insurance already makes sense from the loss impact perspective: the financial and reputational impact of carbon-related loss is growing, and as insurance products enter the market in greater scale, the transfer of this risk to an insurance company makes increasing financial and commercial sense. Insurance can:
a. Protect companies against the risk that their carbon credit investments and holdings underperform. This is increasingly important as financial value of these investments increase – for example in-house risk and finance teams are increasingly noting both the growing size of carbon-related transactions on balance sheets, as well as the potential for uncapped liabilities in future years due to potential rising prices of carbon credits and the potential need to replace existing carbon credits at future prices if they suffer a loss.
b. Reputational risk is another factor, particularly as scrutiny and disclosures around climate-related targets increase. While insurance can’t magically fix reputational damage, insurance can demonstrate that (i) all steps were taken to perform due diligence on the transaction at time of purchase and (ii) provide a safeguard to make good any loss (e.g. in the form of insurance claims paid in replacement carbon credits).
c. Finally, insurance enables capital efficiencies on carbon investments. This can occur in three ways: companies that are starting to make larger purchases where they aren’t comfortable making the purchase/investment off balance sheet; or where they are considering pre-purchasing to lock in price and supply, but looking to see if the addition of insurance makes sense from a margin/risk perspective; or where they can access better terms of finance by insuring the risk (for example, insuring future deliveries of credits as a form of future asset stream).
Insurance is buying trust
There’s a saying in the insurance world: “Insurance is buying trust.” You pay the insurance company today, in the trust that the insurance company will pay your claim if in the future the risk you’re worried about happens.
From the perspective of the carbon markets, in addition to additional trust at the outset of a transaction – where insurance provides an additional level of due diligence, insurance also provides a stamp of confidence and safety if your carbon credits underperform.
In an evolving carbon market that requires trust, insurance can help build it, and in the process insurance can help to manage evolving risks and enable greater flows of finance to scale high quality projects.
At Kita, we look forward to seeing the carbon insurance market develop in 2024, evolving towards so many other traditional markets in which insurance is a standard part of every transaction.
To discuss where your team fits into the categories of insurance need above, please get in touch.