Index Linked Policy Bonds

The Long Finance and London Accord community (over 50 financial institutions, thousands of people in finance and nearly 400 reports since 2005) has developed a simple, almost subversive, proposal for on climate change finance – index-linked carbon bonds. An index-linked carbon bond is a government issued bond where interest payments are linked levels to a carbon target - 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 certificate prices are below target. Or a one percent for every two percent that a government falls short of a 2020 30% renewables target.

Index Linked Policy Bonds - Carbon or Renewables
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 investors 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. If governments tell the truth, they get cheap money. If governments are not committed, they pay. This “Unburnable Carbon” report is perhaps the clearest about investors not believing government low carbon policies.

IMF estimates are for trillions of issued debt each year over the next few years, so scale is limited only by government deficits, not a big limitation these days. Any government (supra-national, national, state, province) could issue index linked carbon bonds without the need for a global initiative. Documentation would be simple. Most existing government treasury mandates already allow for these types of instrument.

With so much planned debt issuance, governments will need ways to distinguish themselves in a crowded bond market. Just as governments fought to issue inflation linked bonds when their inflationary risk dominated, they can now issue carbon bonds when government inaction risk dominates. 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. And no, the funds raised would not be hypothecated to green projects, just as inflation-linked bonds are not hypothecated to anti-inflation measures.

The idea was first formally presented by Dr Kevin Parker of Z/Yen at the World Bank Government Borrowers' Forum in Ljubljana in May 2009. Since 2009 we have been in discussion with four G10 national governments, central banks, debt offices, and a number of entrepreneurial national and state governments. Credit Agricole apparently drew up the idea for Sarkozy in 2009, but he then clearly realised France would probably have to pay more than on current debt. In wider discussions, UNEP FI are coming behind it, Nick Stern now supports it as a possible tool, Forum for the Future like it, Aldersgate Group see it as almost essential -, Green Alliance now support, discussed it with Charlie McCreevy, John Gummer likes it, Sam White, (Special Advisor to the Chancellor (Darling)) chatted with us before the election, Oliver Letwin & Zac Goldsmith this year, Al Gore spoke about it at the UN in January 2010, major pension funds are interested, four investment banks want to handle the bond issuance, blah, blah. The City of London also put forward the idea in its 2009 Copenhagen submission.

The idea is set out in the following articles as well (the last of which has the most numerical detail, the shortest of which is the third in Petroleum Review):

Index Linked Policy Bonds - Forestry
Turning briefly to forestry, the analogy with index linked carbon bonds is strong. Index linked forestry bonds would be issued by developing or developed countries with interest rates tied to forestation targets. As an example, Brazil: “In 1990 we had 520,027,000 hectares of forest. In 2005 we had 477,698,000, an 8% drop. Our target is to move back to 1990 levels over 16 years. The UK has volunteered to buy £X million of our bonds which pay an interest rate of twice our annualised gap”. In other words, if 16 years hence forestation is the same as today, the bonds are paying 16%. If forestation increases by 0.5% a year or more, then the bonds pay no interest.

Again, the funds raised would not be hypothecated to forestry projects, just as inflation-linked bonds are not hypothecated to anti-inflation measures. Surveillance could be done using basic satellite coverage. The bonds could only be used by countries with a reasonable capacity to issue debt – leaves out Haiti or Congo, but includes about 50 to 75 deserving countries. A developed country could aid a developing country by either guaranteeing to purchase such bonds initially. Later sale of the bonds would be bringing in private sector money, and the funds could be used for further bond purchases. A developed country might also aid by guaranteeing a portion of the bond. Such bonds might also facilitate REDD projects nationally by providing a ‘container’ for the overall national risk assessment.

Z/Yen and the Long Finance-London Accord group produced three relevant reports recently on global data requirements for markets:
Finance & Forestry: Where's the Data?, Z/Yen Group (2010)
Finance & Water: Where's the Data?, Z/Yen Group (2010)
Finance, Biodiversity and Managed Ecosystems: Where's the Data?, Z/Yen Group (2011)

The closest yet to writing up the analogy with index linked carbon bonds is on pages 13&14 of the forestry paper:

Some of the most forest-rich areas of the world are within developing economies where unstable currencies and fluctuating economic growth exacerbate the difficulties of addressing sovereign debt through the issuance of government bonds. There is considerable potential to use these countries’ forestry assets as the collateral on which to issue ‘forest bonds’. Given adequate metrics, the maintenance of tight control over sovereign land rights and the protection of the related forest stocks, a combination of the yield from sustainable management and the underlying value of the assets, both as produce sources and carbon stores, should allow for the creation of a bond with an attractive yield and significant potential for capital growth. The scientific community has a key role to play in providing the models and metrics to underpin valuation, while the City should be taking the lead in approaching the relevant governments to provide the financial advice, underwriting and distribution capacity to make the bonds a viable and liquid proposition.

Next Steps
Of course, rather like the carbon markets coming to the UK due to the UK’s thought leadership between post-Kyoto and 2003, so too could early promotion of index linked carbon bonds or index linked forestry bonds create a global centre awaiting to trade them in London. Please feel free to share, comment or question. Z/Yen see a sensible next step for either index linked carbon bonds or index linked forestry bonds as “market research”, which would actually be pre-marketing to talk with lenders about the best indices, terms & appetite, and with borrowers about awareness.

This note is designed to initiate conversation. Z/Yen is interested in exploring these issues further with all parties. Please contact Michael Mainelli, Director, Z/Yen Group Limited,

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