Economist: Index-linked carbon bonds to kickstart lending


Bonds providing a hedge against the risk of governments missing their climate commitments could give investors the necessary confidence to invest in low-carbon projects, Professor Michael Mainelli from Z/Yen, a City of London-based risk management firm, told EURACTIV in an interview.

Professor Michael Mainelli is founding director of Z/Yen, a City of London-based risk management firm.

To read a shortened version of this interview, please click here.

What do you see as the biggest obstacle to investment in low-carbon projects?

I don’t think anybody genuinely has the confidence they need in government policy being enacted. That’s the big problem.

As you go round all the various conferences, everybody nods their heads and mutters ‘yes, something ought to be done’. And government ministers come in and make pledges about money and commitment, Copenhagen and Kyoto. 

But people look at the reality. They say, ‘well, everybody agreed we needed carbon prices about €25-€30 a tonne,’ and the carbon price is nowhere near that. The politicians said they really meant it, but the carbon markets crashed in 2007 because they issued too many permits.

Things are getting better. I’m not trying to claim it’s all horrible, but there’s a big difference between €30 per tonne and the current price of about €14.

So basically investors have no guarantees at present that carbon prices are going be high enough to make investment in low-carbon projects profitable?

Yes. And they depend on government policy. It’s not even just the carbon price, if you look at other policies like Germany, and the feed-in tariff rates, and things like that. Investors in Germany do actually have a lot of confidence in the German government keeping those feed-in tariff rates up. By and large, that’s the sign of it being good.

What they need is confidence that the governments are going to do what they say they are going to do.

You promote the idea of index-linked carbon bonds to build that confidence. What distinguishes your idea?

There are a lot of other bonds proposals out there.

There’s some very complicated ones. People are claiming [that] what we need is the World Bank and the UN to issue bonds that the IMF guarantees; that the credit ratings agencies are involved in; that can only be invested in things that are done in a way that the carbon offset is put through REDD.

All these bond proposals at that level are complicated. One of the great things in finance is you’ve got to keep it simple. 

In Britain, James Cameron of Climate Change Capital is recommending that we have “carbon war bonds” so that you invest in carbon and lose a lot of money, but you feel good about it.

That’s what a lot of these things are: you invest money, feel good about it, take lower returns. Or invest money in it, and after ten years, if it makes a profit, we’ll take the profits for you and reinvest them, which is another way of saying lose money.

You promote index-linked bonds as a solution. What is the principle behind these?

The basic idea here is that governments would pay interest on their own debt, and they would pay more interest if they failed to meet their carbon targets.

Their carbon targets can be a variety of things. They can be their emissions – in the UK, we have this climate change commission that is supposed to set out how much Britain is going to emit. 

It could be the price of carbon, where the governments are going to pay if the price of carbon isn’t above a certain price. Pick whatever price you like.

You could do it on the feed-in tariff, where the government guarantees that anybody who is in a clean-tech project, wind or wave or whatever, will always have a feed-in rate of €100/MWh. Or the government will pay if the fossil fuel price is too low.

So these would all be reasonable targets that governments could set. Then they would issue their debt and they would pay no interest on the debt if they met their targets. But if they failed to meet their targets, they would pay more interest.

Could you give an example of how they would work?

Imagine that you are someone who wants to build a wind farm and I am an investor. Imagine that the current price of energy is, say about €85/MWh.

So you come to see me and say: I want you to put €500 million into my wind farm. As an investor, I’m probably an institutional investor, so I’m a very large pension fund or something like that.

I say that the current price of electricity is €85/MWh, but your wind farm only produces at €90/MWh. So this is what we in finance call ‘stupid’.

So let’s say governments then go and do issue these bonds. And let’s say one of them is priced on the feed-in tariff.

So they’re issuing a bond in France that says ‘we will pay nothing if the feed-in tariff in France is €110 or more but we will pay a percentage point for every euro below that’.

So now you come back to the investor to ask for €500 million investment and tell me that the French government is guaranteeing that it will pay if it fails to make €110. Your plant produces at €90/MWh, therefore we will both be making €20/MWh.

So as an investor, I’ll give you €500 million, but I’m a large pension fund and I’ve got a lot of other things I could do and I equally go and buy €500 million of other bonds. This is a simple case but I’m simplifying.

Now what happens is that the French government was telling the truth: it actually keeps the feed-in tariff at €110. And you were correct and could produce at €90. So the French government gets free money; it’s not paying any interest. You meanwhile are making me €20. So I’m happy, the climate’s happy, the French government’s happy, and all it did was do what it said it was going to do.

So this is basically a government guarantee to return the money in case it fails to deliver on its climate goals?

Correct. Let me go through the second example, which is that the French government lies.

The feed-in tariff is, let’s say only €100. You tell me that you’re only making €10/MWh. But that’s OK because I’m making €10 on the French government.

And if the French government is completely lying through its teeth and the feed-in tariff is €80, I’m shutting you down but I’m not actually hurting because I’m still making €30 off the French government.

Would each government be able to issue these bonds on its own, or would you need some sort of international agreement?

They can do it completely on their own, there is nothing stopping them. What makes us really subversive, one of the things I find interesting as we’ve been chatting to governments, is that they begin to realise that they’ve got to put their money where their mouth is.

If you look across the top 10 of the OECD countries, we are looking at issuing $9 trillion of debt in the next three years. That’s the conservative estimate by the IMF. There’s only about $18 trillion of debt out there.

It took us 40 years after the war to get to $18 trillion. And in the next three years, we are going to be issuing $9 trillion due to the financial crisis. 

Governments are pumping up debt. In the UK, we were issuing virtually nothing in debt. This year alone, the estimate is well over 200 billion, next year’s estimate is we’re hitting 250 billion, a fifth of GDP. So governments are going to issue a lot of debt.

The closest example of this – and it’s actually a very close one – is what happened with inflation linked bonds. Prior to 1980, nobody issued inflation linked bonds. 

The British government was in a terrible situation, and Britain in 1981 issued the first inflation linked bonds. 

Why? Because it had to. Its back was against the wall, nobody trusted the British government, which was coming out of hyper-inflation – Margaret Thatcher had just come into power – to control its economy or its inflation.

That was followed later by the Swedes, then the Canadians and Australians. In each case, the governments had to issue these bonds on their own when people lost confidence.

So it’s very analogous.

Is this something you are trying to get into the debates for the new climate treaty due to be agreed in Copenhagen in December?

It’s actually now in those debates. When we started in April we were trying to get it into the debates, but now it’s very firmly there.

Lord Stern has put it into his paper. It’s being treated quite seriously.

But governments really don’t like this idea.

Are there any exceptions?

Some of the smaller governments: Canadians, I’ve had discussions with Barbados, the Isle of Man, some of the Germans. It’s definitely been picked up by a number of people.

But of course the uncomfortable truth is that they just don’t like it because if they fail to make their targets, then they’ll have to pay a lot of interest.

Another thing is that they are going to have to do something anyway because it’s worse than what happened in 1981 just to the British government: $9 trillion in debt going out. 

The British government is already having problems funding its bond auctions. They are going to have to come up with new ways of selling that debt. So it’s like any supply and demand situation: supply is going through the roof but demand is dropping. And the suppliers, the governments, are going to have to come up with interesting ways of selling their debt. And this is one of them.


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