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Analysis
The case for sovereign climate bonds

The case for sovereign climate bonds

Combating climate change with fiscal policy

by Abdeldjellil Bouzidi in Paris

Tue 10 Jan 2017

Investment in a low-carbon future is a key priority for many governments across the developed and developing world, and also for central banks looking to diversify their investment portfolios. One proposal for turning this priority into action is through the creation of climate policy performance bonds – calling them ‘sovereign climate bonds’. This could be one of the significant investment themes for 2017 and beyond.

The interest rates on these bonds would be linked to carbon dioxide reduction targets. Governments could set a rate of return on their bonds that pays investors more when the proportion of renewable energy over a year drops below a target percentage. Alternatively, the more a government reduces carbon dioxide emissions, the less interest it pays.

Governments are well-placed to take the initiative and have the political and moral incentive to do so. Climate change threatens the lives of billions of people. If the global temperature rises by 1.5 degrees Celsius, 150m children’s lives are threatened, while if it rises by four degrees this figure increases to 1.5bn. The World Bank estimates that air pollution causes one in every 10 deaths worldwide, killing four times as many people as HIV and six times as many as malaria.

There is an urgent need to take action. But the collapse in carbon dioxide prices is weakening incentives for investment. Nationally determined contributions towards cutting greenhouse gas emissions are high-level blueprints, not action plans or investments. These need to be ordered so their impact is measurable. They could then be transformed quickly into investments, especially as low oil prices and the election of Donald Trump are threatening temperature rises.

More importantly, governments have the financial means and incentives to enact change. Since 2007, public sector debt has grown by $62tn, around 9% per year. Fixed rate bonds (which includes so-called ‘green bonds’) are growing across the corporate sector. The government bond sector is a different story. There is a huge opportunity to re-orientate traditional government debt to help achieve carbon dioxide emission reductions. Governments could use debt to add credibility to their commitment of holding on to their policies.

Issuing a sovereign climate bond is a simple and effective way for governments to enhance their funding, provided they engage in reducing their own carbon dioxide emissions or increase renewable energy generation. Contrary to traditional ‘green bonds’ with a fixed coupon, there is a clear incentive for the issuer to reduce carbon dioxide by whatever means are available, especially through ‘costless’ measures such as adhering to reduction policies. The pay-off formula ensures that the proceeds of such bonds will be appropriately invested rather than resulting in under- or over-investment in green projects.

Imagine if Barack Obama’s outgoing administration had issued sovereign climate bonds following the adoption of the 2015 Paris climate agreement. The buyers of this debt would have been institutional or renewable investors hedging their risk of policy change. President-elect Trump would probably have considered an environmental policy change more carefully, as this would have resulted in billions of additional dollars to be paid to investors.

Many investors know they are overexposed to climate change risks and underexposed to the opportunities. Sovereign climate bonds could allow long-term investors, such as insurance or pension funds, to hedge their climate risk and eventually profit from opportunities linked to low-carbon markets.

Long-term investors, such as public pension funds or university endowments, have faced public pressure to divest from fossil fuels and invest in green products. However, they also have a duty to provide returns. Sovereign climate bonds would allow them to decarbonise their portfolios while supporting public policy and hedging against changing government policies.

The first sovereign bonds were issued by the Bank of England in 1694 to finance Britain’s war against France. Now, more than 300 years later, we urgently need to issue a new form of sovereign bond to win the war against climate change and turn the promises of Paris into substantive action.

Abdeldjellil Bouzidi is a Board Member of The Bridge Tank, a Paris-based think tank focusing on emerging markets, and Founder of Emena Advisory, a Paris-based strategy and market finance consulting firm.

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