Using Climate Bonds to fund a Feed-In Tariff

Electricity generation is responsible for 41% of global energy-related CO2 emissions. As the International Energy Authority (IEA) has said[1], decarbonising electricity generation is critical to meeting emission reduction goals. The IEA has called for mechanisms “ambitious new policies to push for a more efficient use of electricity”. We propose such an ambitious policy that would borrow against future economic benefits for the investment needed to reap those benefits.

A common feature of new technologies is that their cost of application tends to drop with rollout and time. This has certainly been the case with renewable energy technologies such as wind and solar thermal. Photovoltaic technologies started their journey with a higher cost base than many other renewables, but have been dropping in cost at a faster rate — for example, the cost of manufacturing photovoltaic cells in China is reported to have dropped by half in the past year.

Philip Wolfe, former Director General of the Renewable Energy Association, explains that some technologies that still seem too high on the price curve have exceptional cost reduction potential. Photovoltaic cells, for example, are basically semiconductor components, he says, and should mirror computer chips in dramatically reducing costs as volumes build.

That falling cost curve means that electricity generated from renewable sources will eventually be cost-competitive with conventional fossil fuel sources – a cross-over point termed ‘grid parity’. When is it likely to occur? In the case of solar photovoltaic systems, there are many estimates available in the open literature. It might come as early as four to five years in the case of solar PV installations[2], and 10 years in the case of wind, and in any case by the 2020s at the latest. The cross-over will occur at different times in different countries due the prevailing market prices and renewable resource levels.

There are many sources of evidence for such an assertion. Researchers from McKinsey (Lorenz, Pinner et al. 2008) estimate that even without subsidies, solar energy could become cost-competitive with conventional electricity in parts of the United States (California and the Southwest) and in Italy, Japan, Spain and Australia within the next three to seven years. As shown in Figure 3, the cost curves of solar PV cross the retail electricity price curve as early as around 2008; and are largely competitive by 2020; even in the most unfavourable scenario the two cross around the year 2032.

The idea of using Climate Bonds to fund a Feed-In Tariff exploits the idea that the cost of renewable energy generation is continuing to drop, and will become cheaper than fossil fuel energy generation. Critically, it requires (or contracts) a constant, government-regulated energy price per kilowatt hour, paid by energy consumers to the utility company providing them with energy services and then “borrows” against future savings in renewable energy costs to pay for a premium energy tariff in the present.

For example, the government could fix electricity prices paid by electricity consumers for the next 30 years at the average inflation-adjusted electricity price of the past five years. This fixed price reflects the energy costs characteristic of today’s electricity supply, which is mostly composed of fossil and nuclear energy.

Initially, the costs to a power producer of building and operating renewable energy power plants will be higher, on average, than the costs of building and operating fossil-fuelled power plants (absent a significant carbon emissions charge).

By issuing Climate Bonds to raise money for building and operating renewable energy capacity, an investment fund buying power from renewable energy providers (at a price premium over fossil power, in the near term) nevertheless achieves a positive return on investment, by effectively “borrowing” against future savings in energy generation costs. (The investment fund will profit from the difference between the lower cost of power produced from renewable energy infrastructure compared to the higher price of power produced from fossil fuels, in a future time when renewable power is consistently cheaper than fossil power). These future higher net revenues pay for a premium energy tariff in the present.

The intervention is also important since this cost reduction curve would be sharpened given an increased scale of investments, sufficient to provide rapidly escalating economies of scale. Renewable Energy Feed-in Tariffs and carbon prices can deliver increased investment.

The model could work either as a simple government bond whose revenue funds the Feed-in Tariff, or as a public-private partnership that does the same.

  • An Energy Investment Fund, let’s call it “EnerFund”, enters into a long-term contract to supply renewable energy to the grid. The Government guarantees that a fixed (inflation-adjusted) price per kWh will be paid to EnerFund for any renewable electricity it supplies for 30 years.  This price is inline with the regulators expectation for energy prices – not higher and not lower.
  • EnerFund raises money, secured by the purchase contract, by issuing Climate Bonds to spend on a defined amount of Feed-in Tariff subsidies to support new renewable energy capacity designed to accelerate economies of scale. This is borrowing money to build generation now.

A variation on the Energy Investment Fund model is that Govt would be involved in setting up the Fund or as a cornerstone investor (with the govt guarantees implied).

  • EnerFund commissions a large solar thermal plant next year and arranges a contract with a local utility to take and supply the power under the contract it has with government.
  • In the short term the power from the solar plant is more expensive than payment received from the utility via the governments contract.  So the renewable power producer must be paid a higher rate per kWh than the price paid by power consumers (this is how a Renewable Energy Feed-in Tariff works).
  • EnerFund absorbs these operating losses (the net cost of the Feed-in Tariff) until cost-convergence is achieved.
  • The renewable energy cost reduction curve would be sharpened given the increased scale of investments, sufficient to provide rapidly escalating economies of scale.
  • EnerFund is building many such projects around the world under similar contract and each time the costs go down.  Fifteen years later it goes back and builds a new solar thermal plant next to its first, and this time the plant produces energy at considerably lower costs, so much so that it can earn a substantial profit from its government power contract.  With these and subsequent projects it is able to repay the climate bonds used to fund the initial losses plus interest.
  • Governments provide other forms of guarantees for specific renewable energy projects. For example, the World Bank currently agrees to take first the 20% hit on any losses on some selected developing nation projects; national governments could do the same with, for example, a big wave-power project that was seen as more risky but important to the development of the country’s capabilities. This approach is unpopular in rich nations because it’s seen as “picking winners” (and this is more traditionally done through targeted tax-break schemes), but it is common in developing nations, notably with big hydro schemes. Big hydro is now becoming unattractive; the model could switch to, say, big solar thermal in Rajasthan.

This approach requires a constant, government-regulated contracted energy price per kilowatt hour, paid by energy consumers to the utility company providing them with energy services. It then “borrows” against future savings in renewable energy costs to pay for a premium energy tariff in the present.

Scale, aggregation and ubiquity

An obstacle to the raising of conventional funds is the relatively small-scale of many energy projects. While this small scale can encourage experimentation and innovation, it retards implementation and system transformation.

A Climate Bond can be used as a financial instrument that enables an issuing institution or government to aggregate many such initiatives and thereby equip them for commercial scale operation much earlier than would be achieved without such assistance.  It can also be used as easily in developing countries as developed countries which again increase market and scale up.

For example, many renewable energy projects are rendered uncompetitive not because of technical inadequacies but because they are forced to pay higher interest rates for loans from very conservative banks.

A Climate Bond might raise funds that could then be disbursed as low-interest loans to renewable energy providers. The issuer of the Bond would need to be regulated in the same way as other financial institutions, to ensure probity and transparency, as well as compliance with climate bond procedures and standards.

We know this can be done because private institutions already issue bonds designed to aggregate and standardize aspects of economic activity such as provision of infrastructure. The Australian institution Macquarie Bank Ltd devised such a scheme in the way that it aggregated infrastructure assets up to the point where they could be used to underpin the issuance of a new fund which would attract investments from private investors; this was done initially with toll-roads, and then with airports; and then with fast-growth forests, and so on. Exactly the same thinking and principles would inform the issuance of Climate Bonds.

Climate bonds for feed-in tariffs could be structured financially in any number of ways. The bond could be designed as an instrument that pays an annual interest (coupon) at a competitive rate – like the World Bank ‘Green Bond 2009’. 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 EIB zero-coupon bond issued through Dresdner Kleinwort in 2007). Such an arrangement (where any excess accumulated by the issuing institution is redistributed to the bond holders on maturity) would be designed with a view to making it attractive to institutional investors who are required by fiduciary obligations to seek out such guaranteed investments. 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.


[2] PV installations on homes and offices compete with the delivered price of energy which is considerably higher that the ex-power station price..