There were two major announcements at the recently-concluded COP27 meeting. One, was the transition out all fossil fuels and not just coal. This was proposed by India, and supported by nearly 80 countries including the US and EU but which faced opposition about the inclusion of oil and gas.

Two was the announcement about setting up of a new ‘Loss and Damages’ fund for climate reparations.

This proposed fund is set to compensate the most vulnerable countries for damages from climate-linked disasters. Who will manage this fund, who will contribute what, how will the contribution share be split, whether contributions are expected from large developing countries and what the fair share of contributors will be — have been left to a “transitional committee” that will make recommendations to enable the actual adoption of the fund at the next Conference of the Parties (COP) of the UN’s Framework Convention for Climate Change, to be held in the United Arab Emirates next year.

There is no agreement yet over what should count as “loss and damage” caused by climate change, which could include damaged infrastructure and property, as well as harder-to-value natural ecosystems or cultural assets. A report by 55 vulnerable countries estimated their combined climate-linked losses over the last two decades totaled $525 billion, or 20 per cent of their collective gross domestic product (GDP).

Critically, the valuation challenges for the proposed new fund include templates of measuring and quantifying climate impact, verification of all such data or claims. This would necessitate a claimant and a verifier concept, built on trust and accountability. The fund is yet to moot if the claims could include damaged infrastructure and property, as well as difficult-to-value natural ecosystems, social assets and cultural sustenance.

Until these are agreed upon, the mere announcement of a fund seems like a placating tactic to push the climate actions by another year, without any cash flow from the fund donors. The agreement vaguely calls for the funds to come from a variety of existing sources, including financial institutions, rather than relying on rich nations to pay up.

Proposing a new formula

There is no formula present as of now, for estimating loss and damages due to climate change. A honest financial estimate, at the very outset, should include valuations of the losses in incomes and the losses in capital.

The issue of capital is crucial here, and should be on the basis of the Inclusive Wealth approach as designed by the UNEP. This will entail valuation of at least three forms of capital: (i) physical capital (infrastructure), (ii) human capital, and (iii) natural capital.

One needs to take into consideration the value of the ecosystem services provided by the natural capital here. The literature on estimating the values of the ecosystem services is replete in the developing and the underdeveloped regions, and needs to be taken up urgently. But who would arbitrate in case of a dispute in this valuation interpretation would be a challenging one.

For arriving at the Inclusive Wealth estimation, one needs to add up the values of the three capital forms. It is here that one needs to estimate the loss functions as the difference of the values of the Inclusive Wealth in the base period and the current period when climate-related events have already caused the loss and damage. One has to be mindful that the loss caused is not merely the difference of the two data points, but it has a cascading effect across the future time periods. This strengthens the argument that the loss and damage equation also needs to take into account the future opportunity losses.

In that case, the present value criterion needs to be the basis of compensation, and the present value taking into consideration at least 25 years needs to be considered with an appropriate rate of premium. The time horizon and the rate of discount need to be determined on the basis of resilience of the system and the prevailing market rates respectively.

Ghosh is a Director at the Observer Research Foundation; Sridharan is a Corporate Advisor, and Visiting Fellow, ORF