Climate Bonds

A range of options exist for structuring bonds to suit the needs of climate change mitigation while delivering investor security. Different options will work in different contexts. Some examples being explored are:

• Index-linking bonds to inflation rates or carbon prices. For example, Climate Bonds could be issued with a low base rate of interest, but have bonus payments if carbon prices reach certain higher levels. This is on the basis that low-carbon projects funded by climate bonds would increase in profitability as carbon prices rise.

A twist on this approach, proposed by the London Accord’s Michael Mainelli, is a bond where the interest rate payable goes up if the carbon price does not meet stated targets. This allows renewable energy investors to hedge their bets by buying such bonds as insurance — if the carbon price targets they base their investment plans on are not met, they can claw some of the loss back by getting a higher rate of return on these bonds.

• Zero-coupon bonds that pay out a guaranteed rate upon maturity, whether 10, 20 or 30 years in the future. These do not pay any interest (no coupons) until the end of the bond period. These are most suitable when new technology needs to be developed, embryonic technology needs to be scaled up, or existing technology has to be invested in high-risk countries. An “enabling institution” converts high-risk projects into low risk investments for institutions by acting as incubators until companies and technologies become large enough or low risk enough to sell off.

Zero-coupon bonds can finance these outcomes because of the long-term time frame of debt, and by using qualified “enabling institutions” to diversify investments made with funds raised from bond sales. A key requirement is the support of government guarantees.

• Convertible bonds would allow investors to convert their bonds to equity stakes in an entity (in other words, become shareholders in a company), at agreed points in the development.
• Islamic bonds – Sharia-compliant bonds could attract investment from Islamic businesses within the UK and from across the Muslim world. These would have no interest payable (payments would be in other modes, such as fixed periodic payments, equivalent to a lease). Government guarantees would only apply in the context of projects benefiting from renewable energy feed in tariffs.

“Banks need more high-grade paper (sukuk) to place their money in, but there is hardly any.” – Farmida Bi, partner at Norton Rose in London[1]

“There is a lot of pent up demand (for sukuk)” – Mohammed Dawood, head of capital markets at HSBC Amanah, the bank’s Islamic arm[2]

• Regulated Covered Bonds. In this proposal, guaranteed revenue streams generated by energy generation projects that qualify for renewable energy feed-in tariffs are used as collateral for AAA bonds. This creates a deep and standardised Climate Bond market, modelled on Germany’s 300 year-old Pfandbrief “covered bond” property market.

Bond investors invest in AAA Covered Bonds issued by a financial intermediary. Bond investors receive 20 year annuity income. Bonds are secured at low leverage against the collateral of the renewable power generation infrastructure and its income stream, the latter guaranteed by a renewable energy feed-in tariff (such as the FiTs currently in place in Germany, Spain and Ontario).

Financial intermediaries access funds from financial markets and use their balance sheet and/or money markets to increase leverage.

To pay for renewable energy generation projects, project developers combine investor equity with money borrowed from banks acting for the bond-issuing intermediary.

This market would produce large amounts of standardised and long-dated, low-risk bond investments. This is just the category of investment product required by pension funds and other investors to balance their long-dated liabilities. It may be very useful for the fast-growing bulk annuities market.

[2] Ibid