If good intentions put money in the bank, financing the additional generation from wind and other green energy sources needed in the transition to a low-carbon economy would be a straightforward task. A survey of 100 institutional investors conducted by Deutsche Bank Climate Change and research firm New Energy Finance in the midst of the financial crisis earlier this year showed that more than 75% planned to increase clean energy investments by 2012. In September, a group of 181 global institutional investors managing more than $13 trillion in assets released a policy statement calling for a tough post-2012 agreement at next month's Copenhagen climate summit to help mobilise investments in low-carbon technologies and reduce investment risks associated with climate change, indicating that they, too, would like to invest more in clean energy.
Yet, even if a strong carbon-emissions reduction target and serious measures to encourage renewable energy were to be agreed in Copenhagen, there are still obstacles to securing the necessary investment. One of these is a lack of investor confidence that governments will actually follow through on climate policy pledges. "People have got repeatedly burned from believing in government rhetoric," says Michael Mainelli, a founding director of London-based risk management firm Z/Yen. "The UK has come out with more climate-change papers than anyone and consistently blows its target."
Hedging against inaction
Mainelli believes an "eminently simple" solution to this problem would be to issue index-linked bonds allowing investors to hedge against the risk of government inaction. Pension funds and other institutional players would invest directly in wind farms and other clean energy projects, while at the same time acquiring bonds to hedge against the risk that the government would not fulfil its policy pledges. The bonds would be indexed to carbon prices or government-mandated power-purchase prices, for example, and would be analogous to the inflation-linked bonds the UK and other governments began issuing in the 1980s when investor confidence that inflation would be kept under control was at a low. Since it was first proposed in April, Mainelli says the idea has gained ground on the basis of its sheer simplicity.
Mainelli provides an example of how this index-linked bond might work: "Say we have a wind plant that's producing at EUR80/MWh and I, the government, have told you: 'Trust me, trust me, I'm going to have a EUR110/MWh feed-in tariff.' Let's say you, the investor, get 1% in interest for every euro below 110. If there is no feed-in tariff, you the investor are making 30%." The investor is consoled by the compensatory bond income being earned on the wind farm.
Governments, of course, may be reluctant to back up rhetoric with their chequebooks. "It's a somewhat subversive idea," says Mainelli. On the other hand, governments would also have a strong incentive to meet targets and be encouraged to funnel more resources into low-carbon technology. It would also represent an innovative way of attracting investors to bonds. "The UK, under its own figures, is going to do £230 billion in bonds next year," Mainelli adds. "What if it did, say, £50 billion of these against carbon figures?"
The trillion-dollar issue
While the risk of government inaction is one factor that could drive a market for green bonds, another is the enormity of global demand for finance to pay for clean energy and other low-carbon technology. Sean Kidney, Europe manager for Climate Risk Ltd, says roughly $1 trillion in additional low-carbon investment will be needed each year over the next decade to prevent rises in global temperature going beyond tipping points at which runaway changes to the natural environment occur. The company's research has found that business as usual is clearly not an option. "The quantitative modelling shows that, unless all sectors of the low-carbon economy are growing at a 25-30% per annum rate, we won't be able to avoid the tipping points," he says. "For example, wind energy needs to grow at about 30% each year globally. The growth rates we are seeing in low-carbon economies are clearly not enough. We need to unblock large amounts of capital."
Kidney is also the co-chair of the climate-change working group at the Network for Sustainable Financial Markets in London, which has taken a close look at how needed capital could be released. Its proposals for climate bonds include the index-linked bond supported by Mainelli, who is a member of the network, and zero-coupon bonds, which are bought at less than their face value and then repaid at face value upon maturity. Also on the list are other, more mundane, debt instruments which, despite relatively uncomplicated structures, would still exclusively fund low-carbon initiatives. "If I'm buying a bond, I want to know that it's being used for wind farms in East Anglia, for example, rather than just for general (government) revenues," says Kidney.
In another proposal, the government would finance mandated purchase prices for power generated by renewable energy sources with bonds rather than taxes. "The reason to do this is because of resistance to feed-in tariffs," says Kidney. "It could make them more politically palatable, particularly in a place like the US."
Important to the concept of both bond-financed tariffs and other bond proposals is the idea that large-scale investments will make renewable energy profitable without outside support, and in a relatively short time. Climate Risk believes economies of scale among all renewable energy sources will make them cheaper than fossil fuels over the period 2020-2050. Investments with higher front-end costs but lower long-term costs are typical candidates for bond financing. Given the enormity of the financing requirements, governments are seen as crucial for allowing the climate bond market to get started. But bonds could also theoretically be issued by large corporations such as utilities. Kidney says an example of indirect government involvement could include bonds being offered by a private-public partnership in which a government owns a minority stake.
Kidney says these bonds could help tap built-up demand from institutional investors, particularly pension funds. "We know that pension funds are (under-represented) in infrastructure projects, but what they are saying is that there are not the deal flows and (suitable) projects," he says. "Big investors need large-scale investments."
Dan Bakal, director of electric power programmes for Ceres, a Boston-based coalition of investment funds and environmental organisations, agrees that inventive financing mechanisms are needed to take clean energy forward. "We think that there do need to be a number of different investment vehicles in different asset classes and there aren't many in the fixed-income category, which includes bonds," he says. Ceres was among the 181 signatories to the statement on carbon-reduction investment, which declared: "It will only be possible to raise large sums if the risk-return characteristics of such climate bonds are competitive with those of normal bonds." This is precisely the idea behind most bond proposals. The notion that pension funds should be investing in climate change out of some sense of obligation is without basis, says Kidney. "I don't want my pension fund putting money in areas that are bad investments. I want good investment decisions and to save the world at the same time."
World Bank tests the waters
The World Bank has also made a foray. In late 2008, it launched a green-bonds offering denominated in Swedish kronor with total value of SEK 2.85 billion (EUR276.8 million) and placed with Scandinavian institutional investors. The proceeds from the bond issue will be used to support climate-change mitigation and adaptation projects in developing countries. This was the first time the World Bank had offered bonds to raise funds for a specific programme.
Swedish bank SEB was the sole lead manager on both this issue - whose annually payable interest rate at the time of issuance was 0.25% above Swedish government bond rates - as well as a dollar-denominated, $300 million green-bond issue earlier this year placed privately with the state of California.
Kidney estimates the various sectors of the worldwide low-carbon economy together account for 3-4% of global GDP, at most. By 2050, that figure is likely to rise as high as 16%, he forecasts, presenting big opportunities. While investors' portfolios do not currently reflect that, there will be a shift, he says. "But we need to give them investment opportunities to allow them to shift."