Slide 1

Professor Michael Mainelli, Executive Chairman, The Z/Yen Group

[An edited version of this article appeared as “Redirected Energy” Innovation & Corporate Finance & Green Bonds) in Corporate Financier, Issue 129, Institute of Chartered Accountants in England and Wales (February 2011), page 13.]

Folks easily bandy about enormous sums for future infrastructure - in the USA $300 billion for sewers over 20 years, in Brazil’s accelerated growth programme (PAC) $560 million for general infrastructure from 2011 to 2014, in Europe €1 trillion for energy over the next 10 years. In the UK, HM Treasury published its “National Infrastructure Plan 2010” in October 2010, setting out an estimate for infrastructure investment of £200 billion over the next five years. These plans all assume significant government funding of infrastructure yet, historically, government infrastructure investment has a history of waste, inefficiency and rapid obsolescence. Aligning public and private risks and rewards should lead to better and greater provision of infrastructure by the private sector.

Nations have tried numerous ways of funding infrastructure. Many of the biggest infrastructure transformations, such as canals, water supplies, railways, gas works, electrification, telecommunications, or information technology, were provided largely by the private sector. Other infrastructure provision, such as defence or most roads, have been provided by the public sector. Over time many bits of infrastructure have been nationalised or privatised, and quite often both. In between private provision and public provision, nations have experimented with blending private and public finance with price support, price controls, private finance initiatives (PFI), public-private partnerships (PPP) and mutuals.

Why is so much public sector finance involved in infrastructure? Is it needed? Is it helpful? A crass view might conclude that there is so much intervention because there are votes in providing, or seeming to provide, infrastructure. It is clear that some intervention is often needed to get some markets moving, but that intervention doesn’t necessarily have to be financial. Changing government regulations and policies has started many markets, e.g. freeing telecommunications companies and bandwidth to competition led to mobile telephony infrastructure today undreamt of twenty five years ago. As for helpful, public finance often displaces private finance, as a multiple, in areas such as research & development. Public finance has a bias for large-scale projects over networks of smaller projects, think large power stations, and high overheads, think PFI and PPP mega-projects that crowd out smaller projects.

Let’s home in on green investment estimates for the UK of £550 billion over the 10 years to 2020. Rhetoric quickly leads to calls for government support for investment using mechanisms ranging from pilot projects to tax incentives to special investment zones to capital allowances and accelerated depreciation. Some propose a new mechanism, a green investment bank. All of these mechanisms assume that, in some way, investors are making the wrong decisions and government distortion of markets can help investors make the correct decisions. Current rhetoric surrounding government-owned investment banks talks about their role in “de-risking” investment. That rhetoric implies that privately-owned investment banks assess risks incorrectly. The UK’s Green Investment Bank Commission admits that many public initiatives to kick-start private investment “can fall foul of the ‘rule of unintended consequences’: financiers stop investing while they wait for the rules of engagement to become clear”. Perhaps the real risk dare not speak its own name, government.

Clean-energy projects face virtually the same risks as traditional energy projects except for one thing; their competitiveness depends on government policy being enacted. Governments promise a combination of policies – planning rules, feed-in tariffs, carbon emission targets, grid access – that might lead to a favourable environment for clean-energy investments. But investors who believed governments were committed to biofuels, as governments claimed in the early 2000’s, got burned. Investors who believed governments would keep the Emission Trading Scheme (ETS) price of CO2 above €25/tonne, as governments claimed during ETS’ 2005 launch, got burned. Private sector investors are willing to put up money, but want to be sure that governments are equally aligned with risks and rewards. Investors want governments to have financial ‘skin in the game’, but that is not to claim that investors want governments to invest directly or to subsidise. Governments are strapped for cash and selling bonds furiously just to fund current expenditure on schools, roads and hospitals, so direct investment or subsidy for clean-energy could dry up at any time.

Governments meet financiers daily in traditional bond markets. Why new mechanisms when tweaking old ones might do? One simple, almost subversive, proposal on clean energy finance is index-linked carbon bonds. An index-linked carbon bond is a government issued bond where interest payments are linked to levels of feed-in tariffs for renewable energy, emission certificate prices or actual greenhouse gas emissions of the issuing country. An investor in an index linked carbon bond receives an excess return if the issuing country’s targets are not met, e.g. an extra percentage point of interest for each €1 that CO2 emission certificates are below target.

Investors can hedge projects or technologies that pay off in a low-carbon future because, if the low-carbon future fails to arrive, the issuing government winds up paying them higher interest rates on government debt. Index-linked carbon bonds eliminate the one risk that differentiates clean-energy projects from other energy projects, the uncertainty of government policy actually being directed at a low carbon future.

With so much planned debt issuance, governments will need ways to distinguish themselves in a crowded bond market. By issuing carbon bonds linked to independent, auditable indices, these ‘bond cuffs’ would directly address the primary concern of private sector investors, lack of confidence in governments’ commitments to preventing climate change. Funds would not be hypothecated to green projects, just as inflation-linked bonds are not hypothecated to anti-inflation measures. Given that failure to perform would cost, governments would have real incentives to meet their own emission targets.

Bonds could be created against other government risks. Imagine branching out from inflation and carbon targets to education, healthcare or crime. We’ll locate our corporate facilities in deprived areas (poor education rates, high murder or crime rates) governments claim they’re going to improve, and hedge the risks of non-performance with government debt (education quality bonds, crime-linked bonds). Investors want to “cuff” governments to their targets, not invest alongside them. Taken to its logical conclusion, the ultimate government bond might have an interest rate that goes down as government debt goes down.

[1020 words] Professor Michael Mainelli is Executive Chairman of Z/Yen Group, the City of London’s leading commercial think-tank.