Key message 4 – Market mechanisms that lower agricultural risk can lead to greater investment and better management of shocks.

Climate change will inevitably bring unexpected weather outcomes and failed investments. Farmers face more risk and uncertainty, with yields and incomes threatened on a more frequent basis. As discussed, even with more accurate weather forecasts, increased weather variability can cause more variability in profits. This will require farmers to find strategies to smooth the relationship between variable incomes and consumption.

Risk is an important determinant of investment decisions (Karlan et al., 2014). As climate change increases risk, it may lead to adverse impacts on investment. Investment decisions made by farmers who face rainfall variability tend to be more risk-averse, which is even more pronounced for those in the lowest income groups (Rosenzweig & Binswanger, 1992, Dercon & Christiaensen, 2011). It has been linked with underinvestment (Rosenzweig & Udry, 2014) and less adoption of profitable technologies (Dercon & Christiaensen, 2011). Outside of investment, climate risk can influence many aspects of farmer decision-making, such as land and labour contracts, that in turn influence the probability of technological adoption and agricultural productivity (Melesse et al., 2017).

Role of insurance

Insurance markets can be a key tool for alleviating this risk. Weather-based index insurance products have become more prevalent over the past decade. In exchange for a premium, insurance products provide a payment when weather outcomes cross a certain threshold (Magruder, 2018). Research has found positive effects from the adoption of weather-based index insurance. It can lead to significantly larger and riskier investment decisions (Karlan et al., 2014), such as in more high-yielding and rainfall-sensitive crops (Mobarak & Rosenzweig, 2014, Cole et al., 2017). It has been linked with increased production and input expenditure (Elabed & Carter, 2014). IGC researchers have also shown it is related to higher investment and a smoothing of wages if offered to labourers (Mobarak & Rosenzweig, 2014).

Despite the apparent benefit of weather-index insurance, evidence varies on whether there is sufficient market demand for these products (J-PAL et al., 2016). Whilst Karlan et al. (2014) identifies sufficient demand for a viable market, demand for insurance products might be harmed by low levels of trust or a low frequency of pay-outs when weather outcomes are positive. Demand for insurance products might be improved through better product design, including the contract, measurement, and pricing (Carter et al., 2017). At the same time, as the frequency and severity of climate shocks increase, this will affect the capital and financing requirements of insurance providers (McKinsey, 2020).

Role of credit

Credit markets are another important mechanism that influences investment decisions and the capacity of farmers to deal with shocks. Uncertain weather can influence farmers’ decisions to borrow and invest, for fear of not being able to repay. Alternatively, credit providers may not be willing to lend or may increase interest rates in the face of greater yield uncertainty. The provision of insurance can foster greater borrowing and investment through the reduction of risk (Karlan et al., 2011). On the other hand, if insurance is too costly – or eliminates farmers’ ability to default in the case of low yields – it may lead to less borrowing (Brune et al., 2016). In the face of greater weather variability and risk, designing more tailored loan products may incentivise borrowing. Subsidised loans that are synchronised with seasonal flows in income and production can support agricultural output and wages (Fink et al., 2020). A guaranteed credit line for households to access when hit by a shock can have a double dividend by both incentivising riskier investment before the shock arrives, and smoothing consumption after it hits (Lane, 2018). In addition to smoothing through borrowing, increased access to low-cost and secure savings could help farmers adjust to more variable income and climate shocks (Somville & Vandewalle, 2019).

Minimising the risk that comes with climate change and increased weather variability will be an effective way to support incomes and investment. There will be a role for broader economic policy in doing so, such as social protection programmes that help households manage shocks and diversify their economic activities (Macours et al., 2012). Well-designed and affordable financial products, including insurance and credit, can be important catalysts to help farmers take on riskier investment decisions and adopt profitable technologies. These technologies can help farmers adapt to climate change and reduce their risk further. The benefits of climate-resilient technology can go beyond adaptation, and help crowd-in modern inputs and practices, further supporting climate resilience and productivity (Emerick et al., 2016).