Forget Kyoto – climate bonds will drive the green revolution



If no-one argues against the proposition that it was capitalism that created the global warming problem, then no one can argue that it must therefore be capitalism that will solve the problem. But how can capitalism solve the problem of global warming? The answer: by financing the transition to a clean energy economy. This is the biggest challenge of all.

The Kyoto Protocol process framed the issue as a public problem that called for government solution and public financing (that is, tax-based financing). The process fell apart at the Copenhagen conference in December 2009 – and there has been nothing of note to replace it. Even the limp gesture of a Green Climate Fund amounting to $100 billion (a sum which falls far short of the investments in clean technology required) has not been honoured.

Yet the investments in clean energy needed to really address climate change – the renewal of the entire energy system over the course of the next three to four decades – will dwarf these sums. The International Energy Agency has talked of sums like $20 trillion to be invested up to the year 2030 – less than 20 years away. The Green Climate Fund, even if it ever got off the ground, would raise just 1/200th of the sums needed.

In retrospect, then, one of the greatest failings of the Kyoto process was that it never got to grips with this most critical of issues. And by keeping it off the agenda, it delayed any serious engagement with global warming by a decade.

So where are the funds going to come from?

The answer is that they will have to come from the bond markets – the real engines of capitalism. The scale of these markets is awesome. The Bank for International Settlements states that the total size of the global debt securities market (domestic and international securities) was about $100 trillion as of June 2011.


Almost all of those funds are invested ultimately in projects that uphold the fossil fuel economy – drilling new oil wells, building coal-fired power stations, pipelines and all the rest of it.

Yet the institutional investors (pension and superannuation funds, insurance funds, sovereign wealth funds) – the dominant players in these markets – are deeply unhappy about making such carbon-exposed investments with all their uncertainties, such as possible exposure to rising carbon taxes, or future punitive actions. The security of their investments in fossil-fuelled projects is increasingly in doubt.

But funds are not flowing to alternative eco-investments – as yet. In fact, compared to the level needed, the scale of financing of green energy so far is puny. Bloomberg New Energy Finance estimates that there are $243 billion outstanding fixed-interest securities that meet their definition of green finance, up from $186 billion in 2009. It sounds impressive until you realize that investments in a clean energy economy will call for trillions.

Now there is a group of financial markets activists based in London that are trying to do something about this. They are called the Climate Bonds Initiative. So far, the Initiative has issued a standard to be used to certify bonds issued as “climate bonds” with the emphasis on certifying that funds really are directed at low-carbon projects.

Think for a moment what a difference an active “climate bonds” market would make. Governments would no longer be able to spout green rhetoric that they would reach, say, a 10% reduction in emissions by some target date. With climate bonds, they would be held to account, and would be forced to invest the sums raised in projects that would really reduce emissions. If they failed to do so, the bonds would lose value, and the government would face a Greek-like crisis.

But there are some caveats. You might think that the whole international finance system is so dodgy that climate change action should have nothing to do with it. That was the Kyoto approach. But in reality, institutional investors would stabilise the financial system by being able to invest in green projects that carry authentication and certification. By tying investment to real carbon emissions reduction processes, the scope for engaging in byzantine financial schemes such as collateralised debt obligations (CDOs) would be drastically reduced.

Projects financed by climate bonds would be expected to carry lower interest charges than those for conventional infrastructure projects – because their prospects improve over time – and so the projects that they designate stand a far greater chance of being implemented. Climate bonds would enable banks to aggregate multiple small projects into large, investment-grade funding opportunities.

Some questions obviously present themselves. If climate bonds and green finance are so good, why are institutional investors not already crowding into this space? The answer is that the potential bonds targeted at eco-investment are not yet being offered at scale or in sufficiently attractive form to attract major investors. Sean Kidney, head of the CBI, was at Davos last month talking up the issue, and laying out a framework for accelerating the entry by institutional fund managers into eco or green investment.

Some of the points he made: the projects offered need to have scale; they need to be structured simply and transparently; and they need to come certified as being able to guarantee that funds raised will indeed be invested in the projects designated.

Secondly, are governments the only agents who could offer, and underwrite, climate bond issues? Certainly not. Indeed, the whole idea is that development banks should get in on the act as a means of accelerating the uptake of green projects around the world. Development banks operating in Brazil, India or southern Africa would be prime candidates to issue such bonds, particularly if they have insurance backing from the World Bank’s Multilateral Insurance Guarantee Agency (MIGA). Already the World Bank – in partnership with the Scandinavian Private Bank (SEB) – have tested the market, issuing small-scale green bonds, and found a positive response.

Third, the bond markets with their colossal scale represent one option for green finance but not the only one. There are also the equity markets, where stocks and shares in corporations are traded. Globally they amount to around $55 trillion, as opposed to $100 trillion for bonds. But institutional investors were badly burned through their investments in equity markets during the 2008/09 global financial crisis, and they are not rushing back to these markets. Bonds are the way to go.

These approaches to financing the emergent clean energy economy need to be sharply distinguished from “carbon finance”.

It is a beguiling idea that carbon markets – the trading of certificates that represent carbon pollution in some form (whether saved or emitted) – will provide a means to mitigate emissions. Behind the long-running debate over cap and trade schemes for dealing with carbon emissions, there stands this ultimate rationale for such approaches, namely the operation of markets for carbon credits (or pollution credits) of various kinds. They are difficult enough to regulate in a national setting, but international carbon markets constitute a financial bubble waiting to happen. The world will not solve its carbon emissions problem by inflating carbon balloons. But of course the “carbon markets” would make a lot of City and Wall Street investment banks and their clients a lot of money – which is why they are promoted so assiduously.

The next great transformation of capitalism needs to be focused with laser-like precision on changing the energy markets (from fossil fuels to renewables), the resource and commodity markets (from resource intensity and waste disposal to circular economy resource-linkage), and above all the finance markets to drive the transformation. Until the bond markets are seriously involved, at the scale of tens of trillions of dollars, the transition cannot be said to be seriously under way.

If Australia would like to be viewed as a leader in promoting the clean economy, then here is an obvious way forward.