Professor Michael Mainelli & Djellil Bouzidi
Published by Official Monetary And Financial Institutions Forum (OMFIF) Sustainable Policy Institute (September 2020), pages 12-13.
[An edited version of this article first appeared as "How Government Policy Performance Bonds Could Save The Planet”, Michael Mainelli & Djellil Bouzidi, Official Monetary And Financial Institutions Forum (OMFIF) Sustainable Policy Institute (September 2020), pages 12-13.]
Sovereign Sustainability-Linked Bonds: The Missing Asset Class?
A world with rising temperatures due to climate change needs new financial tools to turn the economic thermostat down. One such tool, sustainability-linked bonds (also called environmental policy performance bonds or environmental impact bonds), can help ensure that, once ‘dialled down’, the new lower thermostat setting sticks.
A policy performance bond is a fixed income instrument that represents a loan made by an investor to a borrower where the interest rate is tied to a policy outcome. Government inflation-linked or inflation-indexed bonds are long-standing examples of policy performance bonds. A government issues the bond for a specific inflation target, say 2%, and pays interest above that based on inflation. If inflation is 5%, the bond might pay 3%. The first known inflation-linked bond was issued by the Massachusetts Bay Company in 1780. Modern inflation-linked bonds emerged anew in the UK in 1981, followed by Australia in 1985, then Canada in 1992 and Sweden in 1994.
We first proposed the use of several such bonds for environmental, social, and governance (ESG) purposes as part of the Long Finance initiative in journal articles from 2009, such as "Index-linked Carbon Bonds: Gilty Green Government", and other publications, and in some detail in 2017 with the publication of the book, “L’Innovation Financière Au Service Du Climat: Les Obligations à Impact Environnemental”. In addition to these publications, the paper "Environmental Policy Performance Bonds" published in 2015 (https://www.strategie.gouv.fr/sites/strategie.gouv.fr/files/atoms/files/contrib_bouzidi.05.11.pdf) set the scene for the issuance of the first significant sovereign green bond in France fiveyears later. We think that linking public debt to C02 emissions is urgent as it will give governments a strong incentive to deliver on climate change actions.
A series of ESG bond 'flavours' seem to be emerging, in increasing order of sophistication:
Policy performance bonds are different from green or ESG bonds. They are ‘linked’, i.e. the issuer is putting its money where its mouth is on guaranteeing outcomes. Unlike green bonds, policy performance bonds are relatively agnostic about how the funds raised are applied, but care enormously about achieving targeted outcomes. These instruments are less expensive to administer and harder-hitting on underperformance than un-hypothecated green bonds. Terminology is still evolving with policy performance bonds also known as ‘positive incentive’ or ‘sustainability-linked’ loans.
Starting in 2018, policy performance bonds have emerged strongly from the green bond movement background, issued by firms such as Danone, Luis Vuitton, Enel, MásMóvil, Wilmar, Bunge, and COFCO. A good example might be BNP Paribas raising a US$1,200 million, four year, syndicated revolving credit facility for WSPwith terms of up to four years tied to (a) reduction in market-based greenhouse emissions across global operations; (b) increased percentage of “Green” revenues from services having a positive impact on environment; and (c) increase in the percentage of management positions held by women. This last target shows the full ESG potential for such bonds. Any policy with clear goals can set an interest rate, percentage of renewable energy generation, carbon prices, forestation, or educational attainment levels.
A major step was taken recently by the European Central Bank (ECB) who decided to accept such instruments as collateral for credit operations even if they are quite new and issued by few private players. Commenting on the ECB decision, Christine Lagarde declared: “Climate change is everybody’s responsibility. As I have said before, I want to explore every avenue available in order to combat climate change, and this is another step in the right direction”.
Climate Cuffs – How Government Policy Performance Bonds Could Save The Planet
On climate change, governments have a huge opportunity to issue policy performance bonds with interest payments linked to actual greenhouse gas emissions of the issuing country. Investors in such bonds would receive excess returns if the issuing country’s emissions are above the government’s published target; nothing other than their capital back if the country meets its goals. We could imagine different structures, depending on the issuer and investors preferences but the general idea here is to "pay-for-failure". For example, a UK government bond tied to ‘net zero 2050’ implies a 3.3% annual reduction over the next 30 years. If by 2025 emissions are at today’s levels, rather than the 83.5% policy target for 2025, such a bond would pay 16.5% interest in 2025. If by 2025 emissions are below 83.5% then it is an interest-free loan to the government.
Benefits are myriad. Investors in green projects, or portfolio managers such as insurers, can hedge government policy risk across political cycles. Countries can be compared internationally on the scale and certainty of their commitments by examining the quantity of bonds issued (as a percentage of debt and/or GDP) alongside market prices. Against a background of discussion on trade and ‘border carbon adjustment mechanisms’, tariff rates could be set in line with outcomes based on market prices, thus avoiding the need for interference in ‘how’ countries achieve ‘net zero 2050’.
If governments did issue adequate amounts of bonds linked to carbon targets, then the global carbon price would converge appropriately, clean-up costs would be borne locally, and there would be little need for carbon tariffs. Sovereign policy performance bonds linked to sustainability targets are ‘bond cuffs’ that would inspire more confidence in binding government targets than a government’s commitment to a ‘legally binding’ slap of its own wrist three decades hence.
Perhaps a positive incentive to announce at COP 26?