"Why, sometimes I’ve believed as many as 6 impossible things before breakfast…"

Two weeks ago we sent you a note about the release of an International Emissions Trading Association (IETA) discussion paper proposing a new international scheme of asset-linked green bonds tied to carbon credits. We welcomed that contribution to the debate.

Below for your interest is a comment on that paper from Climate Bonds Advisory Panel member Prof. John Mathews. John is Eni Chair in Competitive Dynamics and Global Strategy at LUISS Guido Carli University, Rome.

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"Thanks for this invitation to comment. In the interests of clarifying issues, let me take this IETA paper and show where I think it would take the climate bonds initiative in the wrong direction. I mean no disrespect at all to the IETA itself."

Prof. John Mathews,

Why, sometimes I’ve believed as many as six impossible things before breakfast…The IETA paper on ‘Green sectoral bonds’ is welcome as a means of furthering discussion on green bonds and how they might be used to accelerate investment in renewable energies (REs) and energy efficiency (EE) to reduce greenhouse gas emissions from continued use of fossil fuels.

But it betrays much of the top-down thinking that poisoned the Kyoto process and that has made the Clean Development Mechanism almost useless as a means of reducing real carbon emissions on any scale (a point on which the IETA itself surely agrees) – even if some individuals and organizations have managed to make money out of it. But along the way, the IETA proposes financing mechanisms – to be used by emerging industrial giants like China, India and Brazil – that would involve these countries agreeing to subordinate their efforts to:

• Approval of the bond by an international body;

• Compliance by the bond with standards issued by the international body covering monitoring, reporting and verification (MRV) processes;

• Issuing of green bonds to be circumscribed by an over-arching Guaranteed Carbon Collateral Units (GCCUs) (issued by someone) that set a ceiling on the range and volume of climate bonds to be issued; and

• Investors such as pension funds being expected to accept carbon credits as means of payment in addition to equity or interest payments.

Frankly, these are four impossible conditions that would strangle the climate bonds initiative at birth.

Let me take these conditions in reverse order. On the final point, the whole purpose of climate bonds, as conceived by members of the Climate Bonds Initiative, is to break with the clumsy and bureaucratic mechanisms of the CDM, and instead allow funding agencies to build new financing vehicles based directly on the long-run revenue potential of REs and EE investments. The financing vehicles would be attractive to institutional investors if they can be structured to deliver a return for a given amount of risk, reducing over time as the returns from the REs and EE investments bear fruit. To complicate this clear picture by offering ‘carbon credits’ as part of the return would be to irretrievably confuse the issue.

Carbon credits can indeed be made part of investment projects in REs and EE; they could be included in underlying agreements such as energy off-take agreements that a wind energy provider might negotiate with an electricity distributor, say, over a 20-year period. To make such an agreement interesting, a national body might designate ‘renewable energy certificates’ or carbon credits to be generated by the wind power as well as the electricity itself, and these could be counted as assets by the electricity distributor (and be traded on international carbon markets).

With such an agreement in place, a national government or development bank could approach the bond markets with a bond proposal, backed by this agreement between the wind company and the electricity company. But the carbon credits generated would be used to cement the underlying agreement; they would not be used as part of any bond structure itself nor offered as part-payment to potential investors. What would CALPERS as a large institutional investor do with carbon credits, and how would it fulfil its fiduciary obligations by accepting payment in carbon credits?

On the third point, the proposed GCCUs are designed to limit the range and frequency of national governments resorting to financing mechanisms called ‘green bonds’.

They resemble caps as discussed in cap and trade systems, and derive apparently from Kyoto-style emissions caps to be committed to by governments over time. Countries are envisaged as having a GCCU ‘inventory’ which they can replenish from time to time as emissions are accomplished and verified. Surely this is Kyoto all over again.

Again, there is no reason why such emissions caps should be part of the bond – and indeed their inclusion would kill off any possibility of getting such bonds to the point of lift-off. Rather, in the Climate Bonds Initiative discussions we have seen the market in climate bonds already issued as providing the needed discipline on governments that might be tempted to ‘game the system’ and issue green bonds beyond the scale warranted by their real GHG reductions.

To see their issued green bonds losing value on the international markets (i.e. watching their yields rise, indicating rising risk levels associated with them) would be a salutary lesson for any such government. You don’t need GCCUs (whatever they are) for that.

On the second and first points, the Climate Bonds Initiative discussions so far have certainly envisaged an international body emerging, and one that has critical certification powers to establish whether a green bond really is ‘green’ or not, and whether claimed GHG reductions really are taking place or likely to take place.

But in the Climate Bonds Initiative discussion paper, such an international body is seen as emerging as banks looking to issue climate bonds view it as a necessary market discipline.

It might be four or five years before a group of issuing banks designate their offerings as ‘meeting the standards of X International’ where they themselves would probably have created ‘X International’, in response to the perceived need.

Such a body might then be endorsed by an international grouping of countries, such as Annex 1 countries, to impose some discipline on the mitigation efforts of Annex II countries, or rather to clarify which initiatives could be included in bond prospectuses and which could not. But to impose such a body as having powers to veto a bond issued by China, India or Brazil at this stage is to invite a hostile response.

These comments are offered constructively as a means to clarify the issues. I do appreciate the efforts made by IETA to define what they mean by Green climate bonds, and to invite responses from members of the Climate Bonds group.

-----------------A Climate Bonds meeting to further IETA and related ideas will be held In London at lunchtime, Friday 18 June 2010. Leave a Reply below if you'd like to come along.