LONDON, Oct 5 (Reuters) - Climate change commentators haveoften spoken of capital markets as a source of funding, but manyhurdles have to be overcome before institutional investors willallocate money to environmental projects in developingcountries, according to Standard & Poor's (S&P).

There is a yawning gap of around $200 billion between thecurrent level of climate change finance and even theconservative estimates by the World Bank of the amount requiredby developing countries, the ratings agency said in a reportreleased on Tuesday.

Climate action in developing countries -- specificallymitigation and adaptation initiatives -- requires importantfinancing by the international community, from both public andprivate sources.

Risk transfer instruments, especially insurance, can play ahuge role in offsetting the barriers faced by capital marketinvestors, who will invest only if they can earn adequaterisk-adjusted returns on their capital, said S&P.

"The harsh reality facing both policymakers and climatecampaigners is that soft capital is in limited supply --investors tend to seek an appropriate return, even in climatechange investments," the report said.

The long-term nature of capital commitments in climatechange financing and the relatively short time frame of climatechange regulations are deterrents for capital market investors,as is the high probability of insufficient returns.

Some countries pose a risk for climate change investmentbecause the possibility of war or expropriation may scare off climate change finance -- but this could be countered bypolitical risk insurance, said S&P.

Finance structures such as bond markets have the depth andscale of investment required to cater for climate changeinvestments, said S&P. Investors are already familiar with bondinstruments, and as of 2009, the size of the worldwide bondmarket was an estimated $82.2 trillion, the report said.

"Since international policymakers view the mobilization ofsubstantial amounts of private sector capital into climatechange financing within the next two years as a major priority,we see the results of this risk-ranking exercise as a usefulillustration of the obstacles that need to be cleared in orderto achieve this aim," said S&P.

Some investors have bought green bonds, which help poorcountries cut greenhouse gas emissions and adapt to climatechange. In December 2009, the California State Teachers'Retirement System, one of the world's largest pension funds,bought green bonds in a $130 million issuance by the World Bank.

Other alternative risk transfer instruments have been usedto protect countries from the risk of natural catastrophes,which will increase the frequency of bad weather according toclimate change commentators.

Munich Re, the world's biggest reinsurer, said there hadbeen 725 natural hazard occurrences linked to weather in thefirst nine months of the year, which is a strong indication ofclimate change.

Catastrophe bonds, in which insurers transfer the risk ofnatural hazards such as hurricanes to the capital markets, havebeen used to protect countries from such risks.

In October 2009, Swiss Re worked with the Fund for NaturalDisasters of Mexico to issue a $290 million cat bond to protectMexico against earthquake risk.

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