As the current round of UNFCCC talks continue this week in Bonn, albeit with little real chance of an immediate or even medium term breakthrough, progressive industry groups are picking up the pieces left behind after Copenhagen and seeking ways to move the debate forward. One particular challenge is to find a substantive mechanism to drive investment into developing countries, given the Copenhagen Accord pledge to channel $100 billion per annum in that direction by 2020. The reality of a post-recession developed world is debt, less government spending and general belt tightening all around which means that such funding is unlikely to come from the public purse. Although the Clean Development Mechanism will have issued some 1.8 billion CERs by the end of 2012, which in turn equates to about $25 billion in carbon income and probably more in overall project investment, the finance flow is naturally limited by the project by project approach of the CDM and the uncertainty related to CER issuance.
Recently the International Emissions Trading Association (IETA) floated a concept paper that addresses this issue head on. The paper scopes out the design of a sectoral Green Bond, which delivers financing to developing countries through the sale of bonds that return both interest payments and a flow of carbon credits. Although the interest payment is relatively low, the bond becomes attractive thanks to the potential value of the credits. One of the important design elements is a mechanism within the overall structure that limits total bond issuance by a given economy, effectively capping the flow of credits and therefore ensuring their value in the longer term. An international organisation such as the UNFCCC or World Bank would be charged with overall management of the approach, particularly given the need for sectoral benchmarking, issuance approval and monitoring, reporting and verification(MRV).
The Green Bond is sectoral based, or potentially linked to a NAMA (Nationally Appropriate Mitigation Action). Should the green sectoral bond’s underlying sector fail to deliver an agreed-upon level of reductions, carbon credits would not be issued to bondholders; as a result, the interest rate payable by the host country would increase. If reductions failed to materialize for a pre-defined number of subsequent years – post-issuance of the sectoral bond – the host country would be obligated to make an early pay-back of the bond. In the case of default by the host country, the guarantor(s) would stand behind the issued sectoral bond and repay investors accordingly, either on pre-determined higher interest rates or principal payments. These guarantee mechanisms supporting the bond will facilitate the financing of projects.
But at the core of the bond is the carbon credit. The Green Bond relies on there being demand for these, which in turn means cap-and-trade systems running in developed countries. Although there are other approaches that may also create demand for credits, sustainable demand is only likely to come from these systems. Therein lies the challenge – recently we have seen the demise of the CPRS in Australia and a broadly based cap-and-trade approach in the USA is looking unlikely, although still not impossible. If the latter happens, then the potential for instruments such as Green Bonds becomes huge, particularly as other countries follow the US lead and move back to cap-and-trade (e.g. Canada). Widespread uptake of cap-and-trade in tandem with a revised target in the EU-ETS could lead to demand for bond-linked credits of some 5+ billion by 2020 (on a cumulative basis). That means some $100-150 billion in carbon income and perhaps as much as $500 billion to 1 trillion in project investment during the period (NB: much of that investment will see its income generated in the period 2020-2030). This means that the bond mechanism can operate on a scale that is commensurate with the finance pledges made and the potential demand for credits.