Government

John Mathews and Sean Kidney introduce a powerful new weapon against climate change and ask: could Australia lead the way?

While the talks in Copenhagen have been holding everyone’s attention, one aspect of mitigation of climate change appears to be oddly absent from the discussion. 

It’s one thing to say that taking steps now will cost less than taking steps later, of the order of 1 or 2 percent of global GDP. But how are those steps to be financed? What are the respective roles of public and private finance?

In Copenhagen developing nations argued that ‘developed’ countries will have to transfer billions, if not trillions of dollars, to countries where mitigation and adaptation efforts are most needed. Various developed nation government and UN officials happily said that public funds will not be enough to do what’s required -- but say little more than that. 

Yet the role of private finance in effecting the transition to a low-carbon economy -- what will be the biggest economic transformation in history and estimated in one recent report to be more than three times the size of the whole industrial revolution -- is the crux of the issue.

Putting the emphasis on private financing allows a different perspective. In place of always talking about the ‘costs’ of climate change mitigation, we can talk instead about investment opportunities. 

For example, a large part of mitigation effort involves building and renovating energy infrastructure, whether at a grid level or at a household level. The International Energy Agency has said that global investment to shift to clean energy over the 20 years from 2010 to 2030, over and above business as usual investment, is likely to be of the order of US$10 trillion. 

At the Copenhagen Conference numerous meetings discussed how to mobilise that scale of investment from the private sector. What is needed is a range of financial instruments that can bridge the gap between ‘expenditure now’ and ‘returns later’ – a familiar bridging gap that finance has always addressed in any major new infrastructure project. 

How was the vast interstate highway system in the US built and financed? How were the sewer systems of London, Paris and Berlin built and financed in the 19th centuries? 

The answer is – by specially designated bonds, offered to the investing public. The bonds were earmarked for financing of the infrastructure, and offered a guaranteed rate of return over a designated time span, 20 years or longer.

Even World War II was largely financed by bonds; the UK paid out its last 60 year War Bond only in 2005.

Governments issuing infrastructure bonds promise regular returns based on the revenues that are certain to flow as the infrastructure starts to exert its effect. These would normally be collected by governments in the form of new taxes, paid in return for new services, or from tolls or utility charges. The bonds would be issued by public authorities, but would be underwritten by the private finance system, and would appeal largely to institutional investors.

In the case of climate change mitigation, bonds provide an ideal financing mechanism since projects typically involve large upfront costs and long payback periods. In fact energy infrastructure and some renewable energy technologies, with major capital costs but minimal operation effort and thus relatively secure operating margins, are particularly suited to fixed interest debt funding.

Globally, there is no shortage of capital. There is some $128 trillion being managed globally just by institutional investors, for example.

In the wash-up of the Great Financial Crisis, fund managers the world over are re-weighting their portfolios towards fixed interest debt. Even with huge government bond issues in the US and the EU, money is flowing, and will continue to flow for some time, into bonds. But the problem is that most of the bonds on offer lock institutional investors into the carbon-intensive economy. 

Recent research with institutional investors such as pension funds has found a large appetite for bond investments related to low-carbon and climate mitigation projects – as long as they first meet accepted risk ratings and rates of return. Many of the large funds face twin pressures from their stakeholder groups - governments, public servants, etc – to both deliver solid returns over the long term and to help address climate change with their investments. 

Some investors, such as the Danish public service pension fund, have set up special climate change investment funds; others, such as Australia’s Aria and Holland’s APG, have chosen to look at climate change risks as part of their overall portfolio management.

The London-based Climate Bonds Initiative (disclosure: we are members of the Initiative) is working on mechanisms and models that will facilitate institutional investments in mitigation and adaptation financing measures.

Any government concerned about climate change could take the initiative and issue Climate bonds – including the Australian government. To take such an initiative would not depend on other governments acting in concert – merely on some government taking the lead. And there will be much kudos for the government that issues the world’s first ‘Climate Bond’.

How Climate Bonds could work

Climate bonds could be structured financially in any number of ways designed to make them attractive to institutional investors looking for guaranteed investments. A bond could be designed as an instrument that pays an annual interest at a competitive rate, or that includes a bonus payment if carbon prices rise or Certified Emission Reductions are gained. The World Bank, for example, has issued both in the past 18 months . 

Or it could be a ‘zero coupon’ instrument that pays no annual return but at maturity guarantees the repayment of principal plus some agreed amount (such as an amount that is, say, 1% in excess of growth in underlying GDP in the country concerned – like the zero-coupon bond issued by the European Investment Bank through Dresdner Kleinwort in 2007). 

If the issuer itself is a government that is undertaking to reduce carbon emissions and build renewable energy industries, then the cumulative positive outcome is reinforced – the issuer has every incentive to make the circumstances of the issue come true. 

The debt created need not be new debt; rather than expanding overall debt, we aim to redirect investment flows away from carbon-intensive infrastructure to low-carbon activities.

In the simplest form a government — national or State - would issue a $5 billion ‘Climate bond’ paying returns of, to pick a figure out of the air, 5% per year over 30 years. It would be tied to a portfolio of climate change relevant investments, in the same way funds raised by recent World Bank green bonds were allocated to environment programs funded by the Bank. 

In Australia the bond would take its place beside existing Treasury Bonds, Treasury Indexed Bonds and other notes issued by government in order to raise finance needed for public expenditure. (For the last five years there have been just under A$50 billion of Treasury Bonds on issue, rising to $78.4 billion in 2009 because of the stimulus package.) 

A government would nominate a bank as the issuer, and specify that the Climate Bond is to be floated on the NY, Tokyo and Sydney bond markets, backed by a commitment from the federal government to raise the proportion of renewable energies (non-carbon technologies) in the Australian national energy matrix by, say, 5% over ten years. This would result in substantial reductions in carbon emissions, which could be quantified in the commitment and its documentation. 

This government commitment (which constitutes the security for the bond) could be backed by even more specific commitments from an energy company, say AGL, to switch to renewable resources at an agreed timescale, say by 5% over 10 years. AGL might commit to raising the level of renewable energy sources in its power mix and introduce specified elements of a smart grid to its distribution operations. The proceeds from the bond issue could then be used by the issuing bank to channel investments to AGL at favourable rates to enable it to fulfil these pledges, and change its energy mix. 

Everyone gains by this arrangement. The NY, Japanese and Australian investors gain by receiving a favourable rate of return on a relatively safe investment in the energy future of Australia (a rate superior to ordinary government bonds). The Australian government gains by having a credible commitment to reducing carbon emissions that it can take to international climate negotiations. AGL gains by securing loans at favourable rates from the issuing bank to migrate its energy portfolios to renewables, in a way that does not disadvantage it financially. The energy company provides the mitigation effort, but the funds are provided by international (probably institutional) investors. The world benefits from the switch to renewables achieved through this financial intermediation achieved by the floating of the Climate Bond.

For countries that face serious energy security issues, such as Pacific Island states threatened by rising diesel fuel prices, there are special opportunities. By developing long-term – say 30 year - energy purchase contracts with renewable energy developers, they provide those suppliers with a long-enough guarantee of revenue that they could raise their own Climate Bonds (for example through the Asian Development Bank) to make the upfront investments required. By doing this they go green while removing their economic exposure to volatile oil and gas prices.

In the corporate arena, asset backed-bonds, for example secured against renewable energy projects, would provide an important mechanism for carbon-industry companies, like Shell, to shift their portfolio of work to low-carbon projects. The strength of this model would depend on the credibility of third party verification of mitigation claims; this is one of the areas of work being pursued by the Climate Bonds Initiative.

Why specific Climate Bonds?

Institutional investors are looking for ways of achieving secure, long-term returns plus supporting climate mitigation efforts. This isn’t just because of government and community pressure over climate change; it is also because they understand that the macroeconomy in which they invest is fundamentally threatened by climate issues, and that investment in energy alternatives is a prudent way forward.

Climate Bonds are simply bonds with competitive returns that also provide an assurance that the investments funded contribute to climate mitigation. Some form of credible international standardization and verification will eventually be needed to guarantee the integrity of Climate Bonds, in particular to support corporate bonds.

If Climate Bonds are such a good idea, why are they not being issued already? Well, in a sense they are. The US Treasury in its stimulus package of 2009 issued Green Bonds to a value of US$2.2 billion to generate financing for renewable energy initiatives. These are known as ‘Clean Renewable Energy Bonds’ and the government will pay interest in the form of a tax credit to bondholders. The European Investment Bank has issued two lots of “Climate Awareness Bonds” and the World Bank is on to its 6th or 7th green bond raising.

Climate bonds would shift the emphasis of the debate over global warming and its mitigation – away from costs and instead towards investments in cleaner energy. Investments in some kind of energy have to be made anyway – so better to ensure that they are made in clean energy activities, through specially designated financing vehicles, and subject to audit to ensure that the claimed reductions in greenhouse gas levels are actually achieved. 

The more such bonds are issued by a government, the more the government has credible commitments to take to international negotiations – and the investing public is thereby given the chance to demonstrate their commitment as well, through making safe investments. In this way, Climate bonds create a fresh way of thinking about a topic that is growing mired in political gamesmanship. 

John Mathews is the Eni Chair of Competitive Dynamics and Global Strategy at LUISS Guido Carli university, in Rome, on leave from the Macquarie Graduate School of Management.

Sean Kidney is the London representative of the consultancy ClimateRisk, and the coordinator of the London-based Climate Bonds Initiative.