The C-bond
The way a Green Bond works is the following:
1. A company (or government) says it wants to borrow money to do something ‘Green’. This could be a wind farm, a coconut plantation or something less exotic.
2. The International Capital Markets Association lists 4 broad criteria that need to be followed. These are quite general and can be found here.
3. The company engages a bank or broker to issue the bond. They would advise that the bond be certified ‘green’ by the Climate Bond Initiative group which stipulates a more stringent set of verification procedures.
4. The company issues the bond in some currency, the bond prices at an attractive spread which is lower than the company’s other debt securities and then goes about its business. The market takes it on good faith that the bond proceeds will be used for the green project described in the prospectus.[1]
I wrote about Carbon a few weeks ago in this blog where I noted that the market for Carbon is fragmented and complex to the extent that it is holding back progress on climate change. Green bonds are potentially powerful in being able to influence climactic forces. But the simple process of lending money to do something green leaves me a little vacant. A good chunk of investors distrust the core claim that the money will actually reduce Carbon in the atmosphere. There is a veiled threat that the company will be ostracised from the market if they use the proceeds for non-green purposes. But is this strong enough? How close is the link between the objective and the financing vehicle? Is the accreditation process believable?
There are many examples in corporate finance where viable investment projects do not receive funding because the lenders don’t trust the borrowers[2]. The solution to this inherent distrust is to make the debt security depend on the core value proposition of the project itself. Rather than buy unsecured debt from a company, the loan contract carves out the cash flows that all parties agree will make a profit and funds that.
This principle can be applied to the Green Bond market. Reducing CO2 emissions is the Green goal and extracting Carbon from the atmosphere is the way to do this. Therefore, it strikes me that the natural way for lenders to force green performance is to lend money to the company and demand Carbon in return. If the Carbon price is $20 per tonne and a green project generates 1m tonnes of carbon over 5 years then it can borrow $20m today and deliver the carbon to investors. If more than 1m tonnes of Carbon is produced then the company makes a profit in Carbon terms, if less than 1m tonnes then it is in default. The company is on the hook to deliver Carbon either through extracting it directly or being forced to buy it in the open market to avoid default. Meanwhile, the investors can store or sell the Carbon as they see fit – or even burn it if they want to!
One advantage of this ‘Carbon Bond’ is that the vague opinions of accreditation specialists is supplanted by the factual requirement to deliver Carbon itself. Rather than a bunch of experts estimating the Carbon impact of a project to qualify as green or not, the proof is in the Carbon that is actually generated. In practice, Carbon-credits would be the conduit for payment and the loan contract could specify all manner of credits as valid for delivery. For instance, the project may earn carbon-credits issued by the European Union but the contract could specify Indonesian forest credits as an acceptable Carbon payment or just Carbon-credits generally as sufficient. Where EU credits trade at $70 and Indonesian at $7 then the natural trade is to earn EU and buy 10-times as much Indonesian carbon to then pay to the bondholders. This price differential would disappear quite quickly. This would go a long way toward standardising and arbitraging the carbon-credits markets tagged with differing provenance.
Starting a new market for Carbon bonds is complex and a guinea pig is needed to sacrifice in the name of Financial science. The key requirement to support a bond like this would be the development of a Carbon payments system,
- Find a project that generates carbon-credits
- Find a ‘carbon custodian’ that can inventory the credits earned and distribute to investors along the lines of the contract (I know what you are thinking…Blockchain!)
- Model a lending contract on similar commodity based bonds that lend dollar in return for payments in a commodity. Include in this the forms of acceptable forms of carbon that can satisfy the contract – eg Official credits, voluntary credits from issuer A, B, C etc (I know what you are thinking…SmartContract!)
- Price the bond using some measure of the ‘term structure for Carbon’. This aspect of the exercise could be interesting in itself.
Readers, no doubt, have thoughts of their own to extend this list of features. The Carbon bond could revolutionise the Green Bond market. The Carbon payments system could also streamline the Carbon market as well. All that we need is a guinea pig.
[1] Of course, charlatans and thieves are attracted to markets that appear to offer free money. Green bonds have their share of false claims that mislead investors. Last week, for instance, Total priced a ‘carbon neutral cargo of natural gas’ where the arranger had bought carbon credits to the amount of the emission from the ship only as opposed to the gas it was carrying.
[2] The classic examples are the ‘Underinvestment problem’ and the ‘Asset Substitution’ problem.
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