Over The Hedge: Index Linked Carbon Bonds

By Professor Michael Mainelli and Jan-Peter Onstwedder
Published by Petroleum Review, Energy Institute (November 2009), page 16.

Uncertainties surrounding government commitments to de-carbonising the economy create three key risks – missed carbon emission targets, low fossil fuel prices and low carbon prices. Such risks reduce the attractiveness of clean tech projects. But can governments themselves help hedge these risks?

What’s So Special About Clean Tech?

All energy projects share similar risks. Universal risks include energy prices, construction costs, operating costs, efficiency, waste and decommissioning. But there is one qualitative difference between traditional fossil fuel energy projects and clean tech energy projects, the risk of failed government policy. Government policy is core to most clean tech profitability. If governments stick to declared targets for reduces greenhouse gas emissions, renewable energy, or carbon prices, many clean tech projects make investment sense. If governments are blowing so much hot air, clean tech projects are highly risky. Call this the risk of government inaction.

Government inaction risk is perceived to be high. At some £10M to date, the London Accord (www.london-accord.co.uk)is the world’s largest cooperative investment research programme into climate change and other environmental, social and governance issues. Encompassing over 30 concerned investment firms and banks, the City of London Corporation, Gresham College and BP, as well as nearly 2,000 individual members, the community constitutes a good sample of investment sentiment. The London Accord community’s confidence in government commitment to renewable energy, carbon prices and carbon emission targets is low, rendering clean tech energy investments less attractive.

Yet, what can governments do other than exhort people to invest in clean tech? One intriguing proposal emerged from the London Accord itself earlier this year, that government should put its own money where its mouth is. London Accord members proposed that governments issue index-linked carbon bonds which investors could use to hedge government inaction risk. This proposal debuted in Ecosystem Marketplace. A longer paper was presented by at the World Bank Government Borrowers’ Forum in Ljubljana in May 2009 to an audience of senior debt issuers from around the world. Tomorrow’s Company and UKSIF are promoting the idea for serious consideration by policy-makers both for its simplicity and its directness. One major pension fund has praised the idea and governments in Europe, North America and the Caribbean have discussed its feasibility with The London Accord team.

Index-Linked Carbon Bonds

Index-linked carbon bonds are a simple, and somewhat subversive, idea that yet might form the foundation for long-term carbon and clean tech financial markets. 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 enables the same investor to invest more confidently in projects or technologies that pay off in a low-carbon future because if the low-carbon future fails to arrive the government too bears direct costs of having to pay higher interest rates on government debt. Index-linked carbon bonds eliminate the one risk that differentiates clean tech projects from other energy projects, the uncertainty of government policy actually being directed at a low carbon future. Examples of potential indices that address this unique risk are:

  • levels of greenhouse gas emissions;
  • levels of feed-in tariffs for renewable energy or 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.

Eventually, if the bonds are actively traded, simple derivatives would allow potential investors in low carbon projects or technologies to obtain a hedge against government risk without having to physically purchase the government bond itself. Derivatives would broaden the appeal to investors prohibited from buying government debt, for example those whose investment mandate stipulates they must invest in low carbon projects only. More complex versions are possible. A developed country could issue the bond but use an index of a group of developing countries weighted average feed-in tariffs for clean energy, for example, so transferring the risk of those governments’ policies from a private sector investor to the develop country’s government.

A Surgical Strike On Government Inaction

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. 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, they get cheaper debt. Moreover due to the credit crunch the IMF estimates that G10 governments are likely to issue about US$9 trillion in bonds over the next three years. So the scale of issues is limited only by government deficits, not a big limitation these days. Governments will need ways to distinguish themselves in a crowded bond market. By issuing carbon bonds linked to independent, auditable index metrics such as emission targets, renewable energy levels, future carbon prices or the price of fossil fuel, governments would remove private investors’ objections that their biggest uncertainty is government commitment.

Likewise, given that failure to perform will cost, governments would have a real incentive to meet their emission targets. Index-linked carbon bonds provide genuine government commitment, a form of ‘bond cuffs’ that directly address the primary concern of private sector investors, lack of confidence in government commitment to preventing climate change.

About the authors

Professor Michael Mainelli PhD FCCA FSI MEI created the upstream energy Mundocart and Geodat cartography databases, followed by seven years as a partner in a large international accountancy practice and a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency. Michael is Chairman of Z/Yen Group, the City of London’s leading commercial think-tank, Emeritus Professor of Commerce at Gresham College and a Visiting Professor at the London School of Economics & Political Science.

Jan-Peter Onstwedder was Project Director for The London Accord from 2006 to 2008, and is now Head of Risk & Portfolio at 3i. From 2001 to 2006 he was Head of Risk Management for the Integrated Supply & Trading division of BP plc, responsible for market, credit and operational risk. Prior to 2001 Jan-Peter was Head of Group Market Risk for The Royal Bank of Scotland. He was actively involved in the banking industry’s consultation with the Basel Committee for the market risk amendment and the initial phases of Basel II. Jan-Peter has an MBA from Kellogg, Northwestern University, Chicago and an MSc in mechanical engineering from Delft University of Technology in The Netherlands.

[An edited version of this article appeared as “Over The Hedge” Petroleum Review , (November 2009).]