Carbon Bonds: Setting long-term incentives for emission reductions

With the Copenhagen climate change convention coming up next month, many governments such as ours are looking for ways to demonstrate their commitment to long-term cuts in carbon emissions. Unfortunately, very few of these are anything more than worthless platitudes, and Ireland’s plans certainly fit within this category. Last week, the Joint Oireachtas Committee on Climate Change produced a report making a number of recommendations in advance of the Copenhagen convention. Chief amongst these is a recommendation that legally binding emissions targets be put in place, and that the Taoiseach be held legally responsible for sticking to these targets.

As well meaning as these recommendations are, they simply don’t address the reality of the situation. First off, there’s no constitutional mechanism for the Oireachtas to set such immutable targets. Any bill which the Oireachtas passes to restrict itself and the government in such a manner can simply be amended at a later point, making it an effectively worthless guarantee of future behavior, especially when the composition of the Dáil and cabinet may be radically different by the time the guarantee is meant to take effect. The question also arises of what exactly happens if these “legally binding” targets are exceeded? The state can hardly levy a fine upon itself. The further recommendation of making the Taoiseach legally responsible makes equally little sense. It’s simply unworkable to make a single individual, who may be in office for only a couple of years, legally responsible for the results of a decades-long program which involves the entire economy.

Of course, this begs the question of exactly how a government can make long-term commitments to reduced emissions levels. With the possibility of a new government being elected in a few years with completely different priorities, it’s hard to take seriously any long term plans of this kind. Furthermore, the credibility of the targets, and not just the targets themselves, are vitally important if we want to ensure long term reductions in emissions. This is because the sort of decisions businesses take to reduce emissions often have effects long into the future, even if those decisions can only be made on information available now.

As an example, consider a company that is building a factory, to be completed next year and with a 30 year lifespan. This company has two choices: build a high-emissions factory that’s cheaper to build initially and has lower running costs, or a low-emissions factory that is more expensive in both the short and long-run, but emits substantially less carbon dioxide. A carbon-trading scheme is in place, but because of political uncertainty, the company has no idea if the scheme is even still going to be in place by 2040, let alone how much carbon credits will cost. As a result, building the more expensive low-emissions factory would be a big risk for the company; if the cost of carbon is low or non-existant in the future, then the company simply wouldn’t be able to compete with others that built cheaper high-emissions factories. Hence, the risk-averse company will simply build the high-emissions factory; if there is a working carbon market in years to come, the company can just buy credits, bringing its operating costs to a similar level of those companies with low-emissions factories.

This is clearly a significant problem; without credible long-term commitments from governments today, companies aren’t going to make the sort of investments in low-carbon technologies that will be needed to keep emissions low in years to come. There are, however, two schemes which can be introduced to give companies like the one above a far greater degree of confidence about what the price of carbon will be in the next few decades: carbon futures markets and ‘carbon bonds’.

Note: I’m going to assume anyone reading this post understands the principles of a cap-and-trade system for carbon emissions, and why an auction-based system for allocating these carbon credits is the most efficient. I’m not going to try to fit such arguments in here, but I’d encourage anyone interested to read up on the countless articles, papers and blog posts to be found on the subject. Anyway, I’m going to frame the following discussion on the basis of such a system being in place.

The principles behind a carbon futures market are quite simple, and would work in exactly the same way futures markets work today for standard commodities. Effectively, in a carbon futures market, instead of companies trading this year’s emissions permits, they would enter into contracts to trade emissions permits for a specific future year at some specific price. This provides a form of insurance for companies, as they could enter into a futures contract to buy, say, permits for 100 tons of carbon emissions in 2020 at a specific price, which would allow them to plan with certainty regardless of the actual price of carbon credits at the time. Even without buying and selling on the market directly, companies (and governments) could use a carbon futures market as a predictor of what carbon prices will be in coming years, as the trading price in a futures market for emissions for a given year will be the market’s best estimate of what the emissions permits will actually cost that year.

Carbon futures markets have been advocated by economists for a number of years now, as they’re a vital tool to encourage companies to make long-term investments in low-carbon technologies. Unfortunately, these markets would have great difficulty properly functioning if set up tomorrow without any complementary policy measures. As futures markets work on the basis of predicting future prices, they work most effectively when the companies trading have reasonable information with which to estimate future supply and future demand, thereby predicting a price which would balance these. While companies may be able to come up with decent estimates of demand for emissions permits, estimates for the supply of these permits (ie how many permits will be auctioned off by the government in a given year) are going to vary wildly, as even the governments themselves seem to vary their own targets on a monthly basis, and changes of government may result in wholesale changes to climate change policies. As a result, prices on the futures market are going to be almost purely decided by traders’ predictions of the whims of future governments, turning the entire thing into more of a political betting exchange than a carbon futures market.

Clearly, making carbon futures markets work effectively involves giving the markets some kind of guarantee of how many emissions permits will be auctioned off in future years. As pointed out above in Ireland’s case, there’s very little that a government can do politically or legally on the issue of emissions targets that holds any real weight; such guarantees can be reneged upon as easily as they are given. However, while political or legal pressure may not bind future governments in suitable ways, it’s entirely possible that financial pressure can, and this is where carbon bonds come in.

When a government needs to borrow money, it typically does so by selling government bonds, which are to be paid back at a future date with interest that is either fixed upon the sale of the bond, or sometimes linked to inflation. What I propose is that any government which auctions carbon emissions permits would sell a new type of government bond, which I’ll refer to as a carbon bond. This carbon bond would neither have a fixed nor inflation-linked interest rate, but would instead have an interest rate that is linked to the number of carbon permits that the government auctions in future. Hence, before selling any 10-year carbon bonds, the government would have to set out a schedule of exactly how many carbon permits will be auctioned off in each of the next ten years. The interest that the government has to pay on the bonds will then increase if the government deviates from that schedule, and the greater the deviation, the greater the interest that will have to be paid.

These carbon bonds would then serve two purposes. The first, and most obvious, is that governments would have a clear financial incentive to set out a definite plan for future emissions levels and stick to it. This would give a reason for both the general populace, who are concerned about climate change, and businesses, who wish to make long term investments, to have confidence in government plans. Secondly, it would give businesses and traders of carbon futures an extra form of insurance for their decisions; by buying these carbon bonds, even if the government does renege on its emissions targets, the increased interest payments would mitigate the otherwise negative effects that this change in policy would have on a business. As a result, the existence of carbon bonds would allow a carbon futures market to function far more effectively, and hence provide a way for businesses to make long term investments in low emission technologies with confidence.

Edit (30/03/2010): This post was originally written using the term ‘green bonds’. I’ve since changed all references to ‘carbon bonds’ instead. This is to bring the terminology closer to that used by Michael Mainelli and Jan-Peter Onstwedder in a proposal made last year, where they used the term ‘index-linked carbon bonds’ to describe effectively the same thing. The change should also remove any confusion with other uses of the term ‘green bonds’.