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Policy performance bonds are a climate action “game changer”

Author: ICAEW Insights

Published: 03 Nov 2021

A financial instruments expert has urged the UK government to issue bonds linked to its climate targets as a means to show commitment to its sustainability objectives, as their use across the corporate sector continues to ramp up.

Professor Michael Mainelli, Chairman of commercial think-tank and venture firm Z/Yen, says linking public debt to carbon dioxide emissions could give governments a strong incentive to deliver on climate change action. Governments should tap into growing interest across the investor community in green investments by offering policy performance bonds that link to governments’ sustainability objectives, he says.

Use of sovereign policy performance bonds – the equivalent corporate bonds are also known as positive incentive bonds or sustainability linked bonds – could be used to encourage governments to deliver on their sustainability policies, particularly relating to climate change, Mainelli argues 

In the case of carbon emissions reduction targets, for example, a policy performance bond is a government issued bond where interest payments are linked to the actual greenhouse gas emissions of the issuing country against published targets. 

“An investor in a policy performance bond receives an excess return if the issuing country’s emissions are above the government’s published target,” Mainelli explains. “A policy performance bond thus provides a hedge against the issuing country’s government not delivering on its commitments or targets.”

In an article published in the Sustainable Policy Institute’s journal, Mainelli and economist Djellil Bouzidi explain how a UK government bond tied to ‘net zero 2050’ implies a 3.6% annual reduction over the next 28 years. If by 2025 emissions are at today’s levels, rather than the 89.2% policy target for 2025, such a bond would pay 10.8% interest in 2025. If by 2025 emissions are below 89.2% then it is an interest-free loan to the government.

Policy performance bonds can be issued against carbon emissions reduction targets as well as any other area where policy risk is significant. Mainelli explains. “In the case of index-linked carbon bonds, the ability to hedge enables the same investor to invest more confidently in projects or technologies that pay off in a low-carbon future because if the low-carbon future fails to arrive the government too bears direct costs of having to pay higher interest rates on government debt.”

In 2017, Danone and Louis Vuitton started issuing policy performance bonds followed by Italian energy company ENEL. French consultancy Terra Nova believes that policy performance bonds will represent around a third of the corporate green bond market by value this year. The corporate bond market is moving swiftly from ‘use of proceeds’ to ‘outcome based’ performance bonds.

In January this year the first policy performance bond appeared in the UK – a £500m revolving credit facility (RCF) issued by renewables infrastructure group TRIG, where the interest charged is linked to the Company’s ESG performance. TRIG will incur a premium or reduction to its margin and commitment fee based on performance against defined sustainability targets including an increase in the number of homes powered by clean energy from TRIG’s portfolio.

Policy performance bonds aren’t a new concept; government inflation-linked bonds are long-standing examples of policy performance bonds whereby a government issues the bond for a specific inflation target, say 2%, and pays interest above that based on inflation. 

Mainelli says governments should follow in the private sector’s footsteps to show their commitment to the sustainability and climate risk promises being made. “Talk is cheap. Performance bonds mean governments putting their money where their mouth is,” Mainelli says. “If you want us in industry to make 25-year investments against your energy policies and plans, why aren’t you also financially committed? This would be a real game changer to emulate what the corporates are doing.”

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