Professor Michael Mainelli and Jan-Peter Onstwedder The Z/Yen Group
[An edited version of this article first appeared as “Living Up To Their Promises” (index-linked carbon bonds), Environmental Finance, Fulton Publishing (February 2010) page 17.]
Sometimes a simple idea can be used to solve two problems. So it is with index linked carbon bonds, an idea that emerged early in 2009 from discussions with a number of participants in the City of London’s London Accord community.
Index linked carbon bonds create a hedge for a risk that hitherto has flummoxed investors in low carbon technologies and projects: the risk that changes in government regulations destroy the economics of their investment. Equally, at a time of increasing oversupply of government debt, index linked carbon bonds help governments diversify their funding by tapping into a new investor base.
An index-linked carbon bond is a government issued bond where, in its simplest form, interest payments are linked to the actual greenhouse gas emissions of the issuing country against published targets. An investor in this bond receives an excess return if the issuing country’s emissions are above the government’s published target. An index-linked carbon bond thus provides a hedge against the issuing country’s government not delivering on its commitments or targets. The ability to hedge this government regulation (regulatory inaction) risk enables the same investor to invest more confidently in projects or technologies that pay off in a low-carbon future: if the low-carbon future fails to arrive the index linked carbon bond pays a higher return, thus making up for the shortfall in return from the low carbon project.
Like many simple ideas, this one is powerful in its simplest form, yet lends itself to extensions, for example leverage or different payment scales. Possible indices include:
- levels of greenhouse gas emissions;
- levels of feed-in tariffs for renewable energy;
- percentage of renewable energy in overall energy supply;
- prices of emission (reduction) certificates in a trading system;
- levels of taxes on fossil fuels or fossil fuel end-user prices.
The choice of index allows the public sector to eliminate quite specific risks and so, akin to a surgical strike, take out a policy confidence blockage and enable private sector investment to flow. The ability to choose any of a range of indices provides flexibility to target one or more specific risks in a single structure. Index-linked carbon bonds could easily be issued by any government (supra-national, national, state, province) or multi-lateral agency without any need for a global initiative. Documentation would be simple as most existing government treasury mandates already allow for these types of instrument.
Governments claim they are serious about meeting carbon emission targets and moving to a low carbon economy. If they do fulfil their indexed promises, they get cheaper debt through issuing index linked carbon bonds. For countries at risk from climate change, analysts are already questioning their ability to pay back traditional bonds of 15, 20 or 25 years’ duration. Index linked carbon bonds might enhance traditional debt by proving that a government recognises its country’s vulnerability to climate change.
Moreover due to the credit crunch the IMF estimates that G10 governments are likely to issue over US$9 trillion in bonds over the next three years. Governments will need ways to distinguish themselves in a crowded bond market. Index linked carbon bonds appeal to different investors than straight government debt does, thus helping to diversify and stabilise the investor base.
Governments are interested. The idea was first presented at the World Bank Government Borrowers' Forum in Ljubljana by Dr Kevin Parker in May 2009 and has been developed further by Professor Michael Mainelli of Z/Yen and Jan-Peter Onstwedder, formerly project director of the London Accord. Discussions have been held with a number of government debt offices and Treasuries. Several investment banks are prepared to support researching bond issues. Anecdotal evidence suggests there is investor appetite too. For investors, these function as “bond-cuffs” on governments, increasing confidence that governments will implement their policies. Clearly a next step might be in-depth market research on supply and demand for index linked carbon bonds.
But perhaps most importantly, at this time of uncertainty over the outcomes of multi-lateral international negotiations, index linked carbon bonds are a way for individual governments and investors to make serious commitments to a low carbon future, in a commercially sensible and realistic way. Such commitments, delivered in the one place where government promises are still credible (the financial marketplace), have other benefits, too, for example for plans to restore public sector balance sheets. Will governments take the opportunity?