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Financing climate-friendly energydevelopment through bondsJohn A Mathews a & Sean Kidney ba Eni Chair of Competitive Dynamics and Global Strategy , LUISSGuido Carli University , Rome , Italy , (concurrently Professor ofManagement, MGSM, Macquarie University, Sydney, Australia)b Climate Bonds Initiative , London , UKPublished online: 11 May 2012.

To cite this article: John A Mathews & Sean Kidney (2012) Financing climate-friendlyenergy development through bonds, Development Southern Africa, 29:2, 337-349, DOI:10.1080/0376835X.2012.675702

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Debate article

Financing climate-friendly energydevelopment through bonds

John A Mathews & Sean Kidney

In this paper we review the various instruments that have been proposed and implemented for

financing renewable energy and low-carbon technology projects, in both the developed and

developing world, with a focus on private sector involvement. We consider their common

features and compare their total impact so far with the scale of renewable energy funding likely

to be needed over the next several decades, as estimated by such bodies as the International

Energy Agency, which puts the amount at one trillion US dollars per year. An increase of this

magnitude in the required financing provides opportunities for developing new financing

instruments, based on what has been accomplished so far, and for regional development banks

to be involved in the process, subject to sound risk management principles.

Keywords: climate bonds; green finance; green bonds; global warming; low-carbon technology

1. Introduction

It is widely agreed that the energy systems currently used by both developed and developing

countries are creating problems. Countries that use fossil fuels (coal, oil and gas) face energy

shortages and economic insecurity (caused, for example, by the fluctuating prices of these

fuels), and the world as a whole faces severe environmental problems because of global

warming (Stern, 2006). Whatever stand one takes on these issues – and there is surely

scope for many opinions – it is undeniable that a shift to renewable energy and low-

carbon technologies would be prudent, for developing as much as for developed countries.

The important question is how such a shift is to be financed. In this paper we review the

financing mechanisms that have been used to date (tax credits, equity investments, bank

loans, green bonds) to see how they measure up to the level of investment considered

necessary by such agencies as the International Energy Agency (IEA) and the UK’s

Green Investment Bank Commission. The former cites a global investment

requirement of up to one trillion US dollars per year until 2050 (IEA, 2010), and the

latter a figure of 550 billion pounds sterling as the scale of UK investment required

between now and 2020 (GIBC, 2010).

Focusing on climate-friendly bonds as a critical component of any future financing

system capable of scaling up energy investments to this level, we discuss the likely

structural features of such bonds, arguing that they must be kept as plain, or ‘vanilla’,

as possible if they are to be widely adopted. We provide some hypothetical

illustrations of how such bonds are likely to work, grounded in the experience of

investment banks obtained to date, both with green bonds and earlier targeted bonds

such as Industrial Development Bonds in the US. We provide some examples of

Respectively, Eni Chair of Competitive Dynamics and Global Strategy, LUISS Guido CarliUniversity, Rome, Italy (concurrently Professor of Management, MGSM, Macquarie University,Sydney, Australia); and Chair and Co-founder, Climate Bonds Initiative, London, UK.Corresponding author: john.mathews@mgsm.edu.au

Development Southern Africa Vol. 29, No. 2, June 2012

ISSN 0376-835X print/ISSN 1470-3637 online/12/020337-13 # 2012 Development Bank of Southern Africahttp://dx.doi.org/10.1080/0376835X.2012.675702

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current renewable energy projects in South Africa, where some initial funding has been

provided under the World Bank’s Clean Technology Fund programme, and demonstrate

how the projects could be advanced (and others stimulated) through the climate bond

mechanisms we discuss. We conclude our argument by making the point that

development banks can play a leading role in issuing such climate-friendly bonds,

without running excessive risks for themselves and the investors they seek to attract.

We start by describing a swing in investment finance towards a range of ‘green’ issues.

This swing suggests that ‘climate bonds’ are beginning to be seen as an attractive

investment offering security in long-term sustainable energy futures. In this paper we

probe the advantages of using such bonds, while drawing attention to the risks that

such debt instruments involve (Sturzenegger & Zettelmeyer, 2007).

2. Green finance

Already there are several precedents as well as proposals for new kinds of private

financial instruments that are intended to help mitigate the negative effects of climate

change. Consider the following items of financial news.

. Clean Renewable Energy Bonds 2009, US Treasury. The US Treasury in its 2009

stimulus package authorised 2.4 billion US dollars’ worth of Green Bonds to

generate financing for renewable energy initiatives. These are known as Clean

Renewable Energy Bonds (CREBs) and the government undertakes to pay interest

in the form of a tax credit to bondholders in lieu of coupon interest payments.1 The

bonds are targeted at municipalities, municipal utilities, public power utilities and

rural cooperatives, which are authorised to issue bonds under the programme. The

funds generated by the sale of such bonds are to be used in a range of clean energy

investments approved by the Department of Energy, such as moves towards a

‘smart grid’ in the US, and wind, solar, geothermal and biomass projects. The same

stimulus package (the American Recovery and Reinvestment Act of 2009) has

provided a range of funding for renewable energy projects, including direct tax

credits, loan guarantees and federal cash grants. The CREBs are known as a form

of tax credit bonds, paying returns in the form of tax credits in place of coupon

interest (see Klein, 2009).

. Climate Awareness Bonds 2007 and 2009, European Investment Bank. The European

Investment Bank (EIB), established as the official banking arm of the European

Commission, has issued bonds as part of its climate awareness programme to a

value of E840 million. The first tranche was issued in the form of a E600 million

five-year bond, issued by the EIB through the services of the merchant bank

Dresdner Kleinwort. Its return was linked to the performance of the Financial

Times FTSE4Good Environmental Leaders Europe 40 Index (an index designed to

identify European companies building environmentally sustainable business

models). The EIB enjoys the highest credit rating possible, and has offered the

Climate Awareness Bond to a wide range of investors contacted by Dresdner

Kleinwort (a UK-based investment bank). It was fully subscribed, and the funds

raised were used in EIB renewable energy and energy efficiency projects. A second

tranche, also oversubscribed, was issued in 2009, denominated in Swedish kroner,

to a value of SEK 2.2 billion (about E240 million).

1All bonds are issued with a ‘coupon’ or designated interest rate payable, stated on the bondcertificate.

338 J A Mathews & S Kidney

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. Green Bonds, World Bank. After some initial small issues of green bonds, the World

Bank joined with the Scandinavian bank SEB (Skandinaviska Enskilda Banken) in

November 2008 to issue a Green Bond targeted at institutional investors. The first

tranche of the bond was denominated in Swedish kroner to a total value of SEK

2.325 billion (approximately E250 million), with a maturity of six years. Interest

payable on the bond was 0.25% above current Swedish government bond rates,

giving investors an estimated yield of 3.15% per annum. The investors are for the

most part institutional investors such as Swedish pension funds. Several subsequent

tranches have been issued, always appealing to institutional investors. The State of

California Teachers’ pension fund purchased US$300 million of the second issue,

again managed by SEB but denominated in US dollars, as a sign that California

wanted to contribute tangibly to climate solutions. As of late 2010, these World

Bank Green Bonds had been issued to a total value of approximately E1.5 billion,

with varying maturity dates of five, seven and even 10 years.2

. Breeze Bonds, Germany. The company CRC Breeze Finance has issued a series of

seven asset-backed bonds, secured against wind farms operating in Germany, up to

a total value of E900 million. The Breeze Bonds are structured so that revenues

from the wind farms are used to pay interest on the bonds as well as capital

repayments, thus using the bonds markets directly. These bonds are designed to

make use of reasonably certain revenues flowing from the wind farms under the

German feed-in tariff law. The bonds were lowered from B+ to B grade in 2009 by

the ratings agency Fitch, which indicates that these bonds are taken seriously by the

ratings agencies.

. Green Investment Bank proposal, UK. Shortly after its election the new coalition

government in Britain formed a Green Investment Bank Commission, with a remit

to produce a blueprint for the bank and for financial instruments that could be

issued under its authority, including Green Bonds. The Commission issued its first

report in June 2010, and at the time of writing a response from the government was

awaited (GIBC, 2010). The Commission identified an investment need of around 55

billion pounds sterling per year for the next decade to be channelled into renewable

energy and low-carbon technology projects, and compared this with global

spending on such projects in 2009 of around E90 billion.

. Green Bank Act of 2009 Congressional Bill, USA. In 2009 a bill was tabled in the US

Congress by Chris van Hollen (a Democrat representative from Maryland), calling for

the creation of a US Green Bank as an independent, tax-exempt, wholly owned

corporation of the US, with a mandate to provide financing for qualified renewable

energy and energy efficiency projects, and initial capitalisation of US$10 billion.

The bill lapsed for lack of support.

. Climate Investment Funds, World Bank and regional development banks. Under the

leadership of the World Bank, a number of multilateral lending banks, including the

African Development Bank, the Asian Development Bank and the Inter-American

Development Bank, have joined forces to create two major new funds to promote

renewable energy and low-carbon technology investments in developing countries.

These are known as the Clean Technology Fund (CTF) and the Strategic Climate

Fund (SCF). After meeting in Manila in March 2010, the Climate Investment Fund

(CIF) governing body issued a statement saying they envisaged attracting

2The World Bank maintains a webpage devoted to the Green Bonds, with the latest information:http://treasury.worldbank.org/cmd/htm/WorldBankGreenBonds.html

Financing climate-friendly energy development through bonds 339

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investments of up to US$40 billion, but they did not specify the measures needed to

attract such funding.3

These items carry a clear and distinct message, namely that the financial system is now

being enlisted as a player in this most demanding of challenges. They mirror discussion

in the wider press and in papers issued by such bodies as the OECD and the UNFCC.4

Yet these finance instruments (or in other words debt instruments) as issued so far clearly

go nowhere near the scale required, if estimates such as the GIBC’s E500 billion up to

2020 (GIBC, 2010) and the IEA’s even more ambitious one trillion US dollars per year

each year up to 2050 (IEA, 2010), mentioned above, are to be believed.5 In this paper we

explain what these financial instruments have in common and discuss how they can be

generalised and scaled up so as to meet the challenges of building new energy

systems around the world. This is both an energy challenge and a development

challenge, since the new low-carbon energy systems can be viewed as drivers of

industrial development. Following Mathews et al. (2010), we call this generalised

financial entity ‘climate bonds’, treating these as a new species in the rapid evolution

of financial forms.6

There are of course many ways of financing the development of infrastructure and in

particular the new infrastructure required by renewable energy and low-carbon

technologies. The simplest and most straightforward, as the pure forms of equity and

debt investment structures, are equity investments, by the project promoters or by

energy investment houses or both, and bank loans. In between are various kinds of

intermediate financing, mezzanine finance, tax credits and different kinds of subsidies,

as well as various forms of insurance to reduce the risks involved in investing in

novel energy projects.7 We see bonds as private and public sector financial

instruments that are uniquely suited to facilitating major infrastructure investment

projects, and this why we focus on them in this paper. In the following section we

offer some historical background, before going on to discuss the options for climate

bonds to be issued over the next decade.

3The estimated totals (CTF allocation plus co-financing) for the 13 currently endorsed CTFInvestment Plans (in US$ billions) were: Colombia (2.9), Egypt (1.9), Indonesia (3.1),Kazakhstan (1.3), Mexico (6.2), Morocco (1.9), the Philippines (2.8), South Africa (2.3),Thailand (4.3), Turkey (2.1), Ukraine (2.6), Vietnam (3.4) and the regional Middle East andNorth Africa concentrated solar power plan covering Algeria, Egypt, Jordan, Morocco andTunisia (5.6). For a discussion of how the various climate funds might work together, seeWorld Bank (2010).4See for example Doornbusch & Knight (2008), especially the discussion of climate bonds inparagraphs 71, 72 and 73, and UNFCC (2008); as well as calls for greater involvement by thefinancial system by Avato & Coony (2008), Doornbusch et al. (2008), Spratt (2009) and Wardet al. (2009).5The IEA further estimates that cumulative investment of $46 trillion between 2006 and 2050would halve carbon emission by mid-century (IEA, 2010).6Some other terms used are ‘green bonds’, ‘environment bonds’ and, in a similar vein,‘development bonds’ or in some specific instances, ‘rainforest bonds’. We consider ‘climatebonds’ the most suitable label for what promises to be a very broad category of financialinstrument.7Under the umbrella of the United Nations Environmental Program (UNEP), the GlobalEnvironment Facility and CarbonRe, an insurance consortium known as insurance4renewableshas been established, bringing together CarbonRe, RSA Insurance Group and Munich Re toprovide financial risk management for renewable energy projects around the world. The WorldBank Group also offers insurance on sovereign risk for development projects under theMultilateral Investment Guarantee Agency.

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3. Bonds as instruments of credit and development

Bonds issued by Renaissance Italian city states, such as the prestanze of Florence or the

Venetian prestiti, proved to be financial innovations of the first order, in that they created

debt securities that had the same status as traditional fixed property (Ferguson, 2008).

In time they came to be called ‘mobile property’ (as in the later French innovation of

credit mobilier). The issuer had to have either the power to compel uptake of the

bond (as in the first cases, specifically the Florence cases of prestanze, where the

bonds were a form of tax) or the sovereign status to inspire confidence that the fixed

interest of, say, 5% per annum for 20 years, would indeed be paid. Eventually the

bond market expanded to accommodate issues (known as debentures) from private

firms backed by the reputation and market strength of the leading merchant banks

(such as Barings in London, or Goldman Sachs in New York) which acted as their

underwriters.

The evolution of financial instruments has already moved through several major

innovations and adaptations, from the invention of giro banks and then credit-creating

banks to the securitisation of government debt via bonds and the subsequent

innovations involving shares (equity) and markets where such instruments can be

exchanged and liquidated. New institutions have been established in the past to meet

new financing needs – such as the Credit Agricole, an institution founded in 1860 to

channel credit towards the French agricultural industry, or the European Investment

Bank, founded in 1958 as part of the European project initiated by the founder

members of the European community. In Spain the ICO (Instituto de Credito Oficial)

was founded as a state-owned bank to help implement the Spanish Government’s

social and economic goals, including those linked to renewable energy. In Japan

‘long-term credit’ banks were established as a means of channelling savings into

targeted industries, where the banks attracted savings by issuing bonds and then

lending at favourable rates to small and medium-sized firms in selected industries.

The literature mentions many precedents for developing countries to issue specially

designated industrial development bonds to overcome some of the obstacles to the

issue of debt financing vehicles (see for example Zervos, 2004). In each case the

financial institution acts as an intermediary between the sources of the funds (the

lenders or investors) and the desired object of investment, with the bond acting as the

instrument of choice because it aggregates the funds available.

3.1 Industrial Development Bonds

There are already a number of important precedents for the kinds of targeted bonds now

envisaged for green-tech and clean-tech projects, and which provide experience in the

workings of such financial instruments – some devoted explicitly to promoting

industrial development.8 Industrial Development Bonds (IDBs), for example, have

been used as a vehicle to promote investment in new industries in non-traditional

industrial regions in the US, such as those in Florida or Alabama. Through the 1950s

and 1960s, under the stimulus of federal taxation exemptions, these states and the

municipalities within them issued IDBs that proved to be extremely effective as

means of advancing the industrial development of these regions. According to

Thompson (1968), the state of Alabama recorded 250 separate issues of IDBs in the

period 1958 to 1967, so that such vehicles accounted for nearly a quarter of all

8See sources such as Davis & Steil (2004) or Eckhart & Mullen (2005) for comprehensive reviews.

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investment in Alabama, creating 25 000 manufacturing jobs directly and another 35 000

to 50 000 jobs indirectly – against the strong competition for investment from

established states such as Massachusetts in the northeast or Michigan in the north-

central region. In Thompson’s words, ‘the industrial expansion induced with IDBs has

meant the difference between a vibrant, expanding economy and one in serious

distress’ (1968:101).

These IDBs flourished under the impetus of tax exemptions granted by federal

legislation. They have evolved to the point where they are now called ‘private activity

bonds’ and are a form of finance favoured not just by local governments but also by

small and medium-sized firms that are often reluctant or unable to access the

mainstream stock markets with all their formidable bureaucracy and the expenses

involved in any new stock issue. Recent reports by the Congressional Research

Service indicate that this continues to be a thriving form of developmental finance in

the US (Maguire, 2006; Maguire & Negley, 2007). According to Maguire & Negley

(2007), approx US$55 billion in new private activity bond volume was created

between the years 2001 and 2005 by states in the US, using federal tax exemption

arrangements. Most of these private activity bonds were what are called in the US

‘industrial development bonds’, i.e. municipal and corporate bonds that finance small-

scale local investment projects through aggregation, pooling multiple projects into a

bond financing package that can be taken to the large bond markets.

Note that these IDBs in the US are not concerned with climate-friendly investments

(except indirectly where such investments might be seen as attractive industrial

options). But we view the aggregation involved in packaging IDBs as working on the

same principle that we envisage for climate bonds, or bonds that can be used to

finance multiple climate-friendly development projects largely in developing

countries. The US state-level IDB laws (such as Florida’s Industrial Development

Bond Financing Act, analysed by Scholl & Jimenez, 1984) provide a precedent for the

kind of financing instrument we are discussing. These instruments gain their tax

exemption from US Congressional approval.

4. Common features of Green Bonds issued to date

Experience with green bonds issued to date (and with similarly targeted instruments such

as US Industrial Development Bonds) indicates that scaled-up financial instruments for

renewable energy development should have certain basic structural features.9 We take it

as a given that for a ‘climate bonds’ market to flourish all participants need to make a

return, and should meet levels of risk no greater than those of conventional

government and corporate bond markets. This means that assets backing the bond

issues, and government guarantees, must be carefully structured, and the payments

(whether coupon interest or tax credits) must be regular and founded on relatively

certain income streams deriving from the energy projects themselves. These are

fundamental and irreducible elements without which no financial instrument can be

expected to succeed.

Given this background, how do we see a climate bonds market developing? We consider

this question from the perspective of the bonds themselves (and their issuing

institutions), in other words in terms of the kind of intermediation that is feasible.

9See Veys (2010) for a useful overview of the experience of the UK bonds market and prospects forgreen bonds.

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First, the climate bonds are designed as an intermediary between wholesale

(institutional) investors and desirable low-carbon investment projects such as wind

farms, solar photovoltaic (PV) farms, biofuels projects and the firms that contribute to

these developments, such as wind turbine and PV solar panel manufacturers. The

point is that the institutional investors cannot be expected to know the profit potential

of a wide range of such investment outlets – so they need a financial aggregating

vehicle to provide the bridge. The climate bond is intended as just such a bridge, and

is designed to attract primarily institutional investors such as pension funds.10

Second, the bonds are intended to be ‘asset-backed’ to the extent that they channel funds

into real investment projects that generate real assets based on low-carbon industrial

activities. These activities are intended to generate the income stream required by the

bond-issuing institution to meet its coupon-payment obligations on the bond. But in

case of failure guarantees must be provided – by the government that stands behind

the issuing institution, or by multilateral institutions such as the Multilateral

Investment Guarantee Agency of the World Bank, or both.11

Third, the maturity of the climate bonds needs to be extended as far as is practicable, to

give the underlying renewable energy projects time to move from loss-making to making

better profits than fossil fuel energy projects. We note that World Bank Green Bonds

issued to date have maturity dates extending from five to seven and even 10 years.

UK government ‘gilts’ have maturities of up to 30 years, reflecting the reasonable

certainty that the British government will not default on its loans. There is an inherent

trade-off here: the longer the time to maturity, the more risk perceived by the

investor, but from the point of view of the energy project promoter, the longer the

time to maturity, the greater the prospects for revenues to overtake up-front costs.

Fourth, in a field as novel as renewable energy project financing, the debt instruments

need to be as closely modelled on existing ‘vanilla’ bonds as possible. Specific

innovations and assorted ‘bells and whistles’ (such as varying interest repayments)

need to be minimised, in the interests of appealing to as wide a class of institutional

investors as possible. Thus it would seem to be counterproductive to attempt to make

a link between climate bonds as A grade investment vehicles and carbon credits, to be

traded on existing or future carbon exchanges. The carbon credits market is one thing,

and attracts participants who wish to offset their carbon emissions; this is a very

different clientele from the institutional investors likely to be attracted to climate

bonds issued in large denominations.12

Given these four fundamentals, we envisage climate bonds as being issued in a variety of

forms. The UK Green Investment Bank Commission envisages three such forms in its

initial report: 1) single project bonds, which provide exposure to specified projects

that are aligned with a transition to a low-carbon economy (such as wind farms); 2)

bonds whose proceeds are invested directly in asset portfolios (such as onshore and

offshore wind farms); and 3) secondary project finance loans that are bought from

commercial banks and bundled by asset class into new bond issues (GIBC,

10The world’s largest 300 retirement funds grew 10.9% in 2010 to a record US$12.5 trillion,according to an annual survey conducted by Pensions & Investments and Towers Watson & Co(P&I/Towers-Watson, 2011). See a summary of the report online: www.pionline.com/specialreports/towers-watson-30011UNEP/SEF Alliance (2010) provides a discussion of the role of publicly-backed guarantees as ameans of promoting investment in clean energy projects.12IETA (2010) makes such a link between carbon credits and green bonds.

Financing climate-friendly energy development through bonds 343

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2010:20–1). Bonds issued by development banks from developing countries, probably in

association with leading investment banks in the developed countries, would also have to

be framed to assuage other concerns, for example by reducing the risk premium attached

to developing country investments.

The security that underpins the climate bond concept is provided by assured revenues

coming from investments in sound energy systems over the long term. This is the

fundamentally attractive feature of renewable energy investments – whether they be

investments in biofuel farms in Angola or Mozambique (linked to Brazilian know-

how) or concentrated solar power grids emanating from such regions as North Africa

as an extension of a smart grid encompassing Europe, or offshore wind farms in China.13

An unfortunate negative feature is that many such potential investments never go ahead,

for any number of plausible reasons. One of these is diseconomies of scale associated

with multiple small projects. Many renewable energy projects, such as local wind or

solar installations, are conceived as small-scale. While this small scale can encourage

experimentation and innovation, it retards implementation and system transformation

as a whole. The finance raised by climate bonds would enable an issuing institution or

government to aggregate many such initiatives and thereby equip them for

commercial scale operation much earlier than would be achieved without such

assistance. Many renewable energy projects are rendered uncompetitive not because

of technical inadequacies but because funding sources are limited to loans from very

conservative banks.

Climate bonds, as generalisations of green bonds issued to date, could help by

aggregating smaller projects into larger ones. We know this can be done because

private institutions already issue bonds designed to aggregate and standardise

economic activities such as provision of infrastructure. The Australian Macquarie

Bank devised such a scheme in which it aggregated infrastructure assets up to the

point where they could be used to underpin the issuance of a new fund that would

attract investments from private investors. This was done initially with toll roads, then

with airports, then with fast-growth forests, and so on.

So, given these considerations, how would climate bonds actually work? How would

they differ from existing government-backed securities?

5. How climate bonds are likely to work

Most climate bonds are likely to be issued by private sector players or supported by

commitments from private players. Their distinguishing feature would be backing by

governments or utilities in the form of contractual commitments to phase in renewable

energies rapidly. To take a hypothetical example from Brazil, let us say that the

Brazilian National Development Bank (BNDES) floats a one billion US dollar

‘climate bond’ on the NY and Tokyo bond markets, with backing from the Brazilian

Government.

When discussing ordinary government securities, such as treasury certificates, the

government backing the issue commits to repaying investors out of its revenue

13We refer here to the Desertec project, which envisages solar power generation facilities in NorthAfrica being linked via high-voltage direct current lines to the European electric grid, forming asingle transcontinental super-grid powered by renewable energy. For a discussion, see Battagliniet al. (2009).

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streams, usually taxation. In the case of a climate bond, a different kind of commitment

would be needed, in relation both to sources of revenue (e.g. from revenues accruing to

providers of renewable energies) and to specified actions to mitigate the negative effects

of climate change or help with adaptation to the change (e.g. ‘ring-fencing’ the funds

raised by the bond for climate-related activities). These commitments would have to

be clearly visible to investors and be backed by guarantees and audit reviews, to

ensure that the funds will actually be expended as advertised. After all, investors are

interested in a return commensurate with the risk they are prepared to take. ‘Ring-

fencing’ the investments to be made out of the proceeds raised by the bond would

provide investors with some degree of certainty that the funds would not be disbursed

on irrelevant projects that might not meet their environmental goals or match their

risk perceptions.

One way forward would be for the Brazilian Government to attach an agreement, or

contractual commitment, from an energy provider in Brazil, to the prospectus issued

in connection with the bond. Let us say that the agreement is with the state-owned oil

and biofuels company Petrobras, to raise the proportion of biofuels in its fuels mix by,

say, 5% over a period of 10 years. Such an agreement would require Petrobras to

make the necessary investments in growing, processing and purchasing biofuels in

addition to whatever other investments it was contemplating. The agreement with

Petrobras would make the climate bond issued by BNDES, with backing from the

Brazilian Government, credible to investors in the New York and Tokyo bond

markets. The funds raised by the bond could then be allocated by BNDES to Brazilian

companies that are in the biofuels value chain, to enable them to make the needed

investments, as well as to Petrobras itself. These funds would be made available by

BNDES at a level of interest at least comparable to that available for other

development investments, and probably at a better rate because of the aggregation

effects achieved by the bond itself. The on-lending interest rate should of course be

related to the cost of international borrowing, including the exchange rate risk, the

options to cover such risk, and other factors. Thus individual projects related to

raising the level of biofuels in the national fuels mix that might otherwise be rendered

unachievable through high interest charges would become feasible when financed out

of the proceeds of the bond.

As an alternative, the climate bond issued by BNDES with backing from the Brazilian

Government might be supported by an agreement with the country’s electricity

distributor, Eletrobras, where again there might be a commitment to enhance the

national electric power grid with further electrical supplies from renewable sources,

including hydro, wind and solar. (We recognise that Brazil already has substantial

hydroelectric resources used in generating electric power.) Again these commitments

from Eletrobras could be attached to the prospectus through which the bond is issued.

And again, Eletrobras would need to invest in renewable energy sources in order to

fulfil these commitments, and the funds raised by the bond could be used precisely to

make these investments, channelled to Eletrobras and renewable energy companies

and suppliers of equipment by the development bank BNDES. Yet again, this would

provide a means to overcome diseconomies of scale, allowing small projects to go

ahead (through aggregation), whereas they might be frustrated if pursued individually

through, say, ordinary bank loans or equity investments.

The same hypothetical scenario could be played out in Angola, or Mozambique, or South

Africa, as the following examples demonstrate.

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6. Potential for novel financing forms in South Africa and southern Africa

Under the Clean Technology Fund established by the multilateral development banks

(and coordinated by the World Bank) a number of clean technology projects have

been identified in South Africa that would be eligible for (limited) CTF funding in the

first instance, but where we could envisage more extensive funding based on climate-

bonds-style financial instruments. South Africa has an official goal of producing 4%

of the nation’s electricity from renewable sources by 2013 and improving energy

efficiency by 12% by 2015 (see IEA, 2011). So far, CTF funding to a level of $500

million has been approved for renewable energy projects encompassing grid-

connected solar thermal power, wind power and energy efficiency projects in both the

industrial and commercial sectors. It is envisaged that these initial funds would

leverage a further billion US dollars from bilateral and multilateral finance sources as

well as the private sector. The following are some projects that could benefit from

such financing.

. Concentrated Solar Power (CSP) facility. Eskom has proposed a 100-MW CSP

facility to be built at Upington, the first of its kind in sub-Saharan Africa. In April

2010 it was announced that the World Bank had provided development financing

for the CSP project, along with US$3.05 billion for the completion of a 4800-MW

coal-fired power station (making this World Bank financing decision a source of

much controversy).

. Utility-scale wind power project. At the same April meeting of the World Bank, a loan

of US$260 million to help with financing of a 100-MW wind power project was also

announced. This is Phase 1 of Eskom’s Western Cape Province Wind Energy facility.

The World Bank funding under the CTF umbrella is designed to give momentum to

wind energy projects and help create an industrial infrastructure for manufacturing

wind turbines in southern Africa.

. Solar water heaters programme. The South African Government has a target of

converting one million households from electric to solar water heating over the next

five years, and CTF funding is helping to realise half this goal by providing

assistance to municipalities and the private sector.

. Energy efficiency projects. CTF financing is also designed to catalyse the expansion of

bank lending to the commercial and industrial sectors and create lines of credit to

commercial banks, in association with energy service companies.

We view the demonstration potential of such CTF-financed projects as being highly

significant. Eskom estimates the potential of concentrated solar power in South Africa

alone as being close to 40 GW, and replication of this in Namibia and Botswana

could double the potential. Biofuel and bioenergy projects in tropical African

countries have enormous potential, particularly if supplied with capital and know-how

by Brazilian investors. It is unrealistic to see the CTF itself (or World Bank loans) as

meeting the financial needs of such projects, and therefore some instrument such as

the climate bond discussed in this paper will be needed to spur further involvement by

private investors. The CTF-funded projects in South Africa provide the test and

demonstration projects, to be followed by more conventional funding of both equity

and debt investment in further, more expansive projects. The generalised green bonds,

or climate bonds, can be expected to accelerate this process, by reducing risks and

aggregating smaller projects into a larger one, thus overcoming diseconomies of scale

and enhancing economic development itself.

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7. Concluding comments: The attractiveness of climate bonds

Financing initiatives designed to raise funds internationally for infrastructure projects in

developing countries (dams, railways, water works) have traditionally run into the

problem of the risk spread needed to attract investors. There have been so many risks

associated with lending to underdeveloped countries – uncertain rule of law, wild

currency fluctuations, illiquid securities markets, absence of insurance coverage,

corruption at various levels of government – that risk spreads sometimes become

prohibitive, without government guarantees and in particular multilateral guarantees.

But the basic problem is that the developing countries are soliciting funds to do things

that wealthy countries have already done for themselves – things for which

fundamental incentives are lacking.

When it comes to climate bonds, however, the situation is rather different. Now it is

investors in the developed world looking to find ways to invest in what are viewed as

‘safe’ and ‘sustainable’ energy projects. Long-term investors would rather see their

funds going to energy projects based on wind and sun rather than to increasingly

problematic sources such as coal, oil and gas. These fossil fuels are subject to too

many political risks (e.g. OPEC countries in the Gulf, unpredictable Latin American

regimes, Iran), too many economic risks (wildly fluctuating prices and projected

increases as fossil fuels reach the peak of their supply curves), and too many

environmental risks (particularly global warming from rising carbon dioxide levels).

They are thus becoming less attractive for long-term investment, while low-carbon

and renewable energy projects in the developing countries are becoming

correspondingly more attractive.

Under these circumstances, the developing countries actually have something to offer

that is not available in the developed world. Brazil, or southern Africa, for example,

have sunshine, rainfall and land on which biofuels can be grown, sufficient sunny and

windy locales where renewable energy may be generated, and an abundance of

farmers and businesses willing and able to put their land at the disposal of such

energy generating activities. This match between the demand for ‘safe’ investment

outlets from the developed world and the supply of renewable energy options in the

developing world provides the rationale for climate bonds.

We view climate bonds then as the financial instrument of choice in channelling funds

from the vast investment pool represented by institutional investors in the developed

world to the equally impressive array of attractive, low-carbon investment projects in

the developing world. In doing this, the bonds play the role that financial instruments

have always played – channelling funds from where they are pooled to the projects

where they are needed. The climate bonds proposal simply adapts and updates this old

idea to the new situation. The world is searching for climate-friendly and low-carbon

investment projects in the developing world, and development banks in emerging

markets want to play a positive role in the financial intermediation of such projects.

Before embarking on the course outlined here, and scaling up the financing needed for

renewable energy projects, developing countries will of course want to be sure they

know the risks as well as the benefits of issuing climate bonds. The bond markets, as

they have matured over hundreds of years, are buttressed by a range of provisions

designed to reduce investor risk, and which raise costs for the countries issuing the

bonds. But what investors fear most is default, and this is why countries that do fall

into default – such as Mexico in 1982 or Argentina in 2001 – are severely punished

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by the markets, and suffer from high ‘risk premiums’ for years thereafter. We do not wish

to see the Development Bank of Southern Africa, or any other development bank, falling

into such a trap. This is why any climate bond issued will need to be backed by solid

agreements with energy providers and distributors that will ensure a continuous flow

of revenues that can be used to meet the claims of investors, while leaving some

margin of profit for the energy firms involved in opening up the new energy options

and for the country’s energy consumers themselves.

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