LondonAccord:Index-Linked Carbon Bonds
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.
Government inaction risk is perceived to be high. 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. The original idea of index-linked carbon bonds emerged in April 2009 from a number of London Accord participants.
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.
The idea was presented at the World Bank Government Borrowers' Forum in Ljubljana by Dr Kevin Parker in May 2009. The wider implications of the approach (it can be extended to many other sorts of government policy, forestry, education, health, crime) are touched on here;
Michael Mainelli, Gilding Government Debt: Government Innovation And Risk Management, Journal of Risk Finance, Volume 10, Number 5, Emerald Group Publishing (2009), pages 537-39.
Jan-Peter Onstwedder and Michael Mainelli, Living Up To Their Promises, Environmental Finance (February 2010).
Michael Mainelli and Jan-Peter Onstwedder, Over the Hedge: Index-Linked Carbon Bonds Petroleum Review, Energy Institute (November 2009).
Michael Mainelli, Jan-Peter Onstwedder, Kevin Parker, William Fischer, "Index-linked Carbon Bonds – Gilty Green Government", Z/Yen Group Limited (April 2009).
3 December 2009, Three G10 Governments 'mulling climate-linked bonds' on Environmental Finance.com
3 December 2009, Investor brains target "smart" climate finance on Forexyard.com
10 November 2009, Michael Mainelli spoke on the BBC World Service Business Daily Programme, addressing "Index-Linked Carbon Bonds" listen from 13.50
13 October 2009, the Financial Times positioned index linked carbon bonds as a key SRI tool to reduce government policy risk, "Special Report: SRI - Powering towards a low-carbon future".
3 September 2009, Professor Michael Mainelli, Principal Advisor to the London Accord, gave an interview to EurActiv detailing how investors' confidence in low-carbon projects would rise if bonds were issued to hedge government inaction risk - "London Brokers Turn Attention To Green Finance".
The City of London, Consilience Energy Advisory Group and London Accord have advocated index-linked carbon bonds in their co-written report entitled Delivering Copenhagen: the Role of the City's Financial Services Sector in Supporting Action on Climate Change, published November 2009.
Alex Evans, co-editor of Global Dashboard, wrote on 26 November 2009 how index-linked carbon bonds could be a great success Hey! Look! Climate policy that would actually work!
The Aldersgate Group commended index linked carbon bonds on 15 October 2009 as a way of governments demonstrating commitment to carbon policies, "Financing the Transtion: A Strategy to Deliver Carbon Targets" (see page 9).
Green Alliance sees pros and cons in index linked carbon bonds, "What Is A Green Bond?"