The European Climate Shield: a potential EU solution against climate disasters

This article is mostly based on the discussion paper “Policy Options to Reduce the Climate Insurance Protection Gap” published in April 2023 by the European Central Bank and the European Insurance and Occupational Pensions Authority (EIOPA).

Any opinions expressed in this article are exclusively those of the author and they cannot be regarded as an official opinion of the European Commission.

Europe faces rising climate-related human and economic?losses

Lives and livelihoods in Europe are ever more at risk against the human-induced climate crisis, with increasingly more frequent and severe heatwaves, wildfires, floods, and droughts.

Europe is warming twice faster than the rest of the world since 1980, and in 2022 it recorded temperatures about 2.3°C higher than pre-industrial levels (1850–1900)[1]. Higher temperatures imply a high human cost as heatwaves have a severe impact on vulnerable people. Seven out of the twenty cities with the most heat-related deaths attributed to the climate crisis in the period 1991–2018 are in Europe, including Paris, Rome, and Bucharest, all with more than 100 deaths per year[2]. The extreme temperatures recorded in the UK in July 2022 killed about 1,000 people. The heatwave was made 10 times more likely by rising temperatures[3]. But not only heatwaves claim lives. The floodings in Germany and Belgium in July 2021 killed more than 240 people, this event was found to be 9 times more probable due to the climate crisis[4]. Data from the Emergency Events Database (EM-DAT) indicate 16,365 reported deaths and 156,000 people affected by extreme climate events in Europe in 2022[5].

In addition to the tragic toll on human lives, the climate crisis is causing substantial and increasing economic costs in Europe. Between 1980 and 2022, extreme climate and weather events caused losses for €650 billion in the EU, of which €59.4 billion in 2021 and €52.3 billion in 2022[6]. The 2021 floods in Germany and Belgium and the 2022 continent-wide drought and heat events were among the most expensive in the period considered, costing €44 billion and €40 billion, respectively[6]. The magnitude of economic losses has shot up in these last few years. Swiss Re estimated global catastrophe losses to equal US $115 billion in 2022, well above the past ten-year average of US $81 billion[7]. Despite high variability, studies indicate that economic losses caused by climate disasters have been rising over time[6]. Such losses are expected to further escalate in the upcoming years as non-linearities and feedback loops exacerbate the climate crisis. In a global 3°C increase scenario, conservative estimates indicate annual welfare losses in Europe for at least €175 billion, 1.38% of GDP[8].

Insurance protection against climate risks is insufficient

Insurance solutions have been emerging in response to the increasing frequency and severity of climate-related disasters. However, the ECB and EIOPA identified a very large insurance protection gap against climate risk in the EU, which is expected to further wide[9]. Currently, the share of climate-related losses covered by insurance is only 25% in the EU, and less than 5% in eight Member States (MS)[9]. This major insurance gap entails great economic risks. For instance, about 75% of the euro area banks’ exposures to firms subject to high or increasing flood risk is uncollateralised or secured by physical collateral that is also exposed to physical risk, amounting to about € 370 billion[9]. And the insurance protection will probably decrease in the next decade as insurance becomes unaffordable in response to spiking climate risks. A widening insurance gap entails major macroeconomic, fiscal, and financial implications.

Direct losses related to climate disasters across the EU will almost double by 2050 and triple by the end of the century even in a 1.5°C global warming scenario[10]. Indirect losses will also surge as climate disasters can impair infrastructure and facilities as well as disrupt agricultural production, affecting in return both growth and inflation[11]. Insurance protection can play a crucial role to limit the impact of climate disasters on the economy. Indeed, it is estimated that the Euro Area GDP could be 3% higher in 2050 with full insurance compared to no insurance[12].

Without proper insurance protection, climate disasters jeopardise financial stability and undermine credit provision to countries where banks are highly exposed to climate risks. Indeed, the physical damage provoked by extreme climate events reduces the value of the collateral held by banks, sparking higher capital needs and lower credit supply. Concurrently, households and business may fail to repay their loans, increasing banks’ credit risk.

When the insurance protection gap is wide, climate disasters also affect public finances and debt sustainability. Climate disasters imply higher public spending to finance healthcare, relief and reconstruction. Governments may also need to intervene to help financial institutions in distress, further burdening public finances. Moreover, climate disasters impose direct losses of government assets and reduce tax revenue as output falls in the affected areas[10]. And highly exposed MS may face worse financing conditions and lower access to credit as their credit rating deteriorates[13]. This in turn would raise government debts and fuel economic divergence in the EU[9].

The “European Climate Shield” can protect from climate disasters

The ECB and EIOPA proposed the creation of a new instrument at the European level to address the insurance gap of large-scale climate disasters[9]. A “European Climate Shield” (ECS) could be a valid solution to tackle climate disasters, improve risk management and minimise the cost of disasters. The new EU instrument would consist of an EU-wide climate insurance scheme, covering a broad range of weakly correlated climate hazards across the Union. The ECS would promptly provide funding for reconstruction to MS following major disasters[14].

The ECS could leverage the experience and knowledge from the EU Solidarity Fund (EUSF). The EUSF, established in 2002, provides financial aid to MS and accession countries for emergency and recovery operations following natural disasters. It supports four types of interventions, including infrastructure restoration, temporary accommodation, preventive measures, and disaster area clean-up. Since 2002, the EUSF allocated €8.2 billion to 107 natural disasters and 20 interventions for public health emergencies, in 24 MS (plus the UK) and 3 accession countries, with Italy, Germany, and Croatia being the top beneficiaries[16, 17].

However, the EUSF is inadequate to tackle increasing threat from the climate crisis due to its scope and budget size. The EUSF is not focused on climate related disasters, as it covers earthquakes, volcanic eruptions, and since 2020 even major public health emergencies. The annual budget was up to €1 billion per year in 2002[15]. Since then, the budget size has been shrinking. In 2020, the EUSF’s budget was merged with the Emergency Aid Reserve, to create the Solidarity and Emergency Aid Reserve (SEAR), with an annual budget of €1.2 billion (in 2018 prices). This implies that maximum annual budget for the EUSF is only about €796 million (current prices)[16]. The advanced payment was increased from 10% to 25%, but still capped at only € 100 million per application[14]. Therefore, the EUSF cannot swiftly provide substantial support against major climate disasters such as the 2021 floodings, which costed € 40 billion just to the German government. Between 2002 and 2021, the Fund covered only 15% of the costs of eligible emergency operations and 3% of total direct damages of covered disasters[9]. The EUSF is not included in the Multiannual Financial Framework (MFF). Consequently, any disbursement to MS requires approval from both European Council and the European Parliament, implying an actual disbursement time averaging 56 weeks[16]. Most regrettably, the EUSF does not incentivise Member States to adopt risk reduction measures and bridge the climate insurance gap.

Conversely, access to the ECS would be granted to Members States upon proper implementation of adaptation strategies and respect of emission reduction targets. Additionally, as suggested by the ECB and EIOPA, access shall be conditional on the adoption of reforms aimed at bridging the gap in climate insurance in the private sector[9]. These conditions are essential for the instrument to foster climate risk management in MS and minimise disaster losses as well as ECS disbursements.

Benefits

1. Efficiency

The ECS can increase efficiency in public spending and reduce moral hazard compared to the current unconditional government reliefs. The ECS would urge Member States to adopt mitigation and adaptation measures and to address the climate insurance gap, reducing the costs of climate disasters and the share borne by governments.

2. Diversification

Large climate-related disasters have historically been weakly correlated across countries, rarely affecting multiple EU countries at once[9]. The ECS can enable EU to pool risks and reap the benefits of diversification.

3. Resilience

The cost of disasters depends both on the severity of the initial damage and the speed of reconstruction[9]. Lengthy or incomplete reconstructions cause lasting economic losses. The ECS can help the economy recover faster by making funding readily available for reconstruction limiting the impact on supply chains and growth.

4. Cohesion

The ECS can limit the burden of climate-related losses on national budgets, preventing economic divergence across the Union. And it can also help affected Member States to keep access to credit, reducing the risk of financial instability.

Drawbacks

1. Moral hazard

Moral hazard could arise in case Member States have unconditional access and receive full compensation from the ECS. To minimise moral hazard, access to the ECS shall be conditional on adoption of mitigation and adaptation measures, losses shall be only partially covered, and contributions shall be adjusted to Member States’ risk profiles.

2. Crowd-out

Uninsurable risks arising from large-scale infrequent disasters shall be the focus of the ECS to no crowd-out private insurers for climate-related risks. The role of private insurance shall remain central and its extensive expertise in prompt loss assessment shall be leveraged.

3. Additionality

The ECS shall be seen as complementary to ambitious climate policies, not as a substitute. And its resources shall be additional to existing funding for climate mitigation and adaptation.

4. Mismanagement

The ECS shall have a sound governance structure to prevent mismanagement of funds and ensure accountability and transparency. Disbursement of ECS funds shall be staged and matched with proper monitoring and reporting.

Timely reform is needed to tackle climate disasters

The creation of a European climate insurance scheme i.e., European Climate Shield shall be central in the discussions for the next EU MFF (2027–2033). To be effective, the European Climate Shield shall be part of the next MFF to enable a faster disbursement process. And the structure behind the ECS shall be allowed to proactively identify eligible disasters and to swiftly provide support. To be impactful, the new scheme shall be endowed with adequate resources to tackle the climate crisis. Following the example of the Next Generation EU, the scheme shall also be able to lend to MS in case of exceptional assistance needs, and to borrow on a discretionary basis up to a set threshold, above which any additional borrowing shall be politically agreed[9].

In the meantime, the EU shall start from reforming the EUSF to make it more effective. Currently, the EUSF can provide affected Member States with financial assistance only after an application and budgetary process which takes more than a year to complete[16]. The instrument shall be reformed to simplify the application procedures and cut the time required for disbursement.

In conclusion, while the political agreement on the creation of the ECS may take years, the EU must act now against climate disasters. Prompt reform of EU toolkit is key to increase efficiency, build resilience and protect people from the growing climate threat.

[1] World Meteorological Organization (WMO), “State of the Climate in Europe 2022,” World Meteorological Organization, 2022, https://library.wmo.int/idurl/4/66206..

[2] Damian Carrington, “Revealed: How Climate Breakdown Is Supercharging Toll of Extreme Weather,” The Guardian, August 4, 2022, https://www.theguardian.com/environment/2022/aug/04/climate-breakdown-supercharging-extreme-weather.

[3] Mariam Zachariah et al., “Without Human-Caused Climate Change Temperatures of 40C in the UK Would Have Been Extremely Unlikely,” World Weather Attribution, August 2, 2022, https://www.worldweatherattribution.org/wp-content/uploads/UK-heat-scientific-report.pdf.

[4] Damian Carrington, “Climate Crisis Made Deadly German Floods ‘up to Nine Times More Likely,’” the Guardian, August 23, 2021, https://www.theguardian.com/environment/2021/aug/23/climate-crisis-made-deadly-german-floods-up-to-nine-times-more-likely.

[5] World Meteorological Organization. “Climate Change Impacts Scar Europe, but Increase in Renewables Signals Hope for Future.” public.wmo.int, June 14, 2023. https://public.wmo.int/en/media/press-release/climate-change-impacts-scar-europe-increase-renewables-signals-hope-future.

[6] European Environment Agency, “Economic Losses from Climate-Related Extremes in Europe,” www.eea.europa.eu, October 6, 2023, https://www.eea.europa.eu/ims/economic-losses-from-climate-related.

[7] Swiss Re, “Hurricane Ian Drives Natural Catastrophe Year-To-Date Insured Losses to US $115 Billion, Swiss Re Institute Estimates | Swiss Re,” www.swissre.com, December 1, 2022, https://www.swissre.com/press-release/Hurricane-Ian-drives-natural-catastrophe-year-to-date-insured-losses-to-USD-115-billion-Swiss-Re-Institute-estimates/2ab3a681-6817-4862-8411-94f4b8385cee.

[8] W. Szewczyk et al., “Economic Analysis of Selected Climate Impacts JRC PESETA IV Project -Task 14,” Joint Research Centre Technical Report, May 15, 2020, https://doi.org/10.2760/845605.

[9] ECB and EIOPA, “Policy Options to Reduce the Climate Insurance Protection Gap Discussion Paper,” April 2023, https://www.ecb.europa.eu/pub/pdf/other/ecb.policyoptions_EIOPA~c0adae58b7.en.pdf.

[10] Nicola Gagliardi, Stéphanie Pamies, and Pedro Arévalo Sánchez, “The Fiscal Impact of Extreme Weather Events: First Evidence for EU Countries,” CEPR, December 23, 2022, https://cepr.org/voxeu/columns/fiscal-impact-extreme-weather-events-first-evidence-eu-countries.

[11] Serhan Cevik and Jo?o Tovar Jalles, “Eye of the Storm: The Impact of Climate Shocks on Inflation and Growth,” IMF, April 2023, https://www.imf.org/en/Publications/WP/Issues/2023/04/28/Eye-of-the-Storm-The-Impact-of-Climate-Shocks-on-Inflation-and-Growth-532661#:~:text=The%20results%20shows%20that%20both.

[12] Kristina Barauskait? Gri?kevi?ien? et al., “The Impact of Loan and Market-Based Credit Supply Shocks on Euro Area GDP Growth,” ed. European Central Bank, Financial Stability Review, November 2021., November 17, 2021, https://www.ecb.europa.eu/pub/financial-stability/fsr/focus/2021/html/ecb.fsrbox202111_07~83888507a6.en.html.

[13] Stavros A. Zenios, “The Risks from Climate Change to Sovereign Debt,” Climatic Change 172, no. 3–4 (June 2022), https://doi.org/10.1007/s10584-022-03373-4.

[14] The REGULATION (EU) 2020/461 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 30 March 2020. It defines major disasters as disasters incurring direct damage above € 3 billion in 2011 prices, or 0.6% of gross national income (GNI), or 1.5% of a NUTS 2 region’s GNI.

https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32020R0461

[15] Stefan Hochrainer‐Stigler et al., “Challenges of Instruments That Should Tackle Multi-Hazard and Multi-Risk Situations: An Assessment of the Recent Reforms of the European Solidarity Fund and the Solidarity and Emergency Aid Reserve,” Mitigation and Adaptation Strategies for Global Change 28, no. 8 (September 9, 2023), https://doi.org/10.1007/s11027-023-10075-4

[16] World Bank, “Economics for Disaster Prevention and Preparedness Financial Risk and Opportunities to Build Resilience in Europe,” June 4, 2021, https://documents1.worldbank.org/curated/en/231121622437102944/pdf/Economics-for-Disaster-Prevention-and-Preparedness-Financial-Risk-and-Opportunities-to-Build-Resilience-in-Europe.pdf

[17] European Commission, “Inforegio?—?EU Solidarity Fund,” ec.europa.eu, 2022, https://ec.europa.eu/regional_policy/funding/solidarity-fund_en.