Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
Jan-Peter Onstwedder, The London Accord
[An edited version of this article first appeared as "Carbon Debts: Index-Linked Carbon Bonds" in Ecosystem Marketplace, Katoomba Group (9 April 2009)]
Potential climate change investors have one big doubt – are governments committed to decarbonising the economy? Developers of low carbon projects, such as wind farms or solar companies, face two major problems turning ideas into reality. The first is showing attractive returns. The second is raising capital. Most low carbon projects will provide attractive returns only if government policies lead to lower emissions, higher fossil fuel prices and higher carbon prices. Uncertainty about government commitments creates risks which developers, and their investors, are not keen to bear.
Governments claim they are committed, but history raises doubts. Lack of confidence in government commitment impairs investment. Lack of confidence also leads to low prices for carbon. For example, the EU ETS market Phase 1 (2005 to 2007) carbon price crashed in 2007 when it became apparent that EU governments had jointly issued far too many permits to emit, i.e. clearly they weren’t committed to reductions. Despite numerous white papers, there is little confidence that the UK government will meet its carbon emission reduction targets. Further, the worsening economic environment leads governments to talk about ‘temporary’ easing of carbon reduction commitments at the same time as easing demand lowers carbon prices.
The uncertainty about government commitment manifests itself in three specific risks – government carbon emission targets being missed, fossil fuel prices remaining low, and carbon (emissions) prices remaining low. Missed targets, low fossil fuel prices and low carbon prices reduce the profitability of clean energy, or cause losses. How can these risks be hedged?
One traditional hedging mechanism is to issue index-linked bonds. Index-Linked bonds are not uncommon. Indices such as inflation and commodity prices have been used by governments and by corporations to set the amount of interest on debt. An attractive option would be for project developers to issue bonds indexed to the three key risks – government performance against targets, fossil fuel prices against a break-even level, and carbon prices against a break-even level? Such an index-linked bond would reduce the cost of capital for a developer exactly in those situations where the profitability of clean energy is threatened by government action, or inaction.
Bonds indexed to emissions, fossil fuel prices or carbon prices would transfer the risk from the developer to the investor. But we know that investors are not keen to bear those risks, either, from their reluctance to fund many clean energy projects. Investors cannot easily hedge those risks, but that is exactly where government can help – by issuing debt with the opposite risk profile. Index-Linked government carbon bonds would provide greater returns if government falls short of achieving its targets, if fossil fuel prices remain low, or if carbon prices remain low. That kind of index-linked gilt could easily be issued, and it would provide a natural hedge against our project developers’ government risk. An investor would invest in a low carbon project (either equity or debt), and simultaneously buy a proportion of index-linked government carbon bonds.
As an example, take an investor looking at investing in a 2010 wind farm that is competitive at £55/megawatt-hour. Say that the price of fossil fuel derived power is £50/megawatt-hour in 2010, with a government target of £75/megawatt hour in 2015.
The index-linked gilt to provide a hedge would pay a margin over normal gilts, with the margin a function of the fossil-fuel derived power price. For example, for every £1 below £75, the interest rate could go up by 1%, with a suitable cap at say 20%. For every £1 that the fossil-fuel derived power price is above £75, the interest would reduce by 1% with a minimum of zero. An investor in such gilts would be able to offset the price risk of his or her investment in the wind farm.
Other structures are possible, too, linking the principal repayment to fossil fuel prices, or either interest rate or principal to actual emissions in, say, 2020.
The UK government claims it is serious about meeting its carbon emission targets, serious about moving to a low carbon economy. The UK government is likely to issue a large number of gilts over the next few years due to the credit crunch. By issuing carbon bonds linked to independent, auditable index metrics such as emission targets, the price of fossil fuel and the future carbon price, the UK government would remove private investors’ objections that their biggest uncertainty is government commitment. Likewise, given that failure to perform will cost, government would have a real incentive to meet its emission targets.
So come on, UK government. Put your money where your mouth is and make a real commitment, issue index-linked gilts and remove the biggest risk stymying low carbon project developers, you.
We extend our thanks to Sean Kidney, Raj Thamotheram, Nicolas Véron and members of the Network for Sustainable Financial Markets for helping to provoke these thoughts.