texto 2 concept note workshop-1

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ESTE TEXTO NÃO REFLETE UMA POSIÇÃO DA SECRETARIA DE ASSUNTOS ESTRATÉGICOS

A monetary based financial device to trigger

a low carbon transition and a sustainable

economic recovery

Zero order draft of a study funded by the Caisse des Dépôts et Consignations, Entreprises pour

l’Environnement under the umbrella of Entreprises pour l’Environnement

This draft has been written by Jean Charles Hourcade, Michel Aglietta (Cepii) and Baptiste Perissin-

Fabert, with important inputs from Ruben Bibas, Christophe Cassen and Franck Lecocq (Cired), Igor

Shishlov, Camille Ferron, Romain Morel, Ian Cochran (CDC Climat Research)

Work in progress and under review: not to be quoted

Workshop "Innovative solutions for climate finance, the energy

transition and a EU narrative"

Co-organized by Centre CIRED and IASS Potsdam

July 8th and 9th, 2014

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Title: A monetary based financial device to trigger a low carbon transition and a

sustainable economic recovery

Introduction: Carbon Finance and the ‘paradigm shift’ in Climate Negotiations 1. Climate policies in an adverse context: turning the question upside-down

1.1. About the nature of the ‘funding gap’

1.1.1. Assessing the orders of magnitude: incremental vs redirected investments 1.1.2. The nature of the tensions, their heterogeneity and context dependency 1.1.3. Tensions not specific to the 450 ppm scenario 1.1.4. Tensions symptomatic of a deeper re-direction problem

1.2. The rationale for a climate architecture using a financial-monetary device

1.3. Basic principles in a nutshell

2. Components and design of a financial architecture aligning climate and development

objectives

2.1. The Value of Avoided Emissions : a trajectory of notional prices

2.2. Voluntary commitments and pledges; creating a “pull-back” force

2.3. Transforming the carbon based liquidity into real wealth

2.4. Using a diversity of canals to redirect savings

2.5. Supporting the Namas, the specific contribution of the Green Climate Fund

3. A virtuous circle between environmental, economical and macro-financial integrity

3.1. Drivers of the leverage effect on low carbon investments

3.1.1. Risk-adjusted profitability of one LCI: a non-linear mechanism 3.1.2. Pools of low-carbon investments 3.1.3. LCI backed by carbon assets and firm’s value: back to the Capital Asset Pricing

model

3.2. A contribution to sustainable economic globalization

3.2.1. The macro-financial interest of a stable benchmark 3.2.2. Clearing up a foggy business environment and getting the world out of the

doldrums 3.3.3 Climate policies and reduction of structural imbalances in the world economy

Conclusion

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Introduction: Carbon Finance and the ‘paradigm shift’ in Climate Negotiations

In the succession of Conferences of the Parties since 1995, the Cancun conference (COP-16)

marked, a turning point. It called for ‘‘…a paradigm shift towards building a low-carbon

society that offers substantial opportunities and ensures continued high growth and

sustainable development’’ (paragraph 10). It introduced a notion of ‘equitable access to

sustainable development1 (EASD) “in the context of “shared vision for long-term cooperative

action” and ‘global peaking of GHG emissions”.

This perspective being an shifts the negotiations away from adversarial competitive game

among nations for deciding who shall be allocated “how much” of the remainder of the

emissions budget? It calls for a cooperative exercise linking climate policies to other global

and national development issues in a diversity of political, social and economic agendas.

To serve this new paradigm, it establishes a Green Climate Fund (GCF) devoted in part to

funding low-carbon development projects (LCPs) in non-Annex 1 countries, their adaptation

and capacity build up. This GCF is meant to support ‘‘one or more market-based mechanisms

to enhance the cost effectiveness of, and to promote, mitigation actions’’ (paragraph 80).

The establishment of the GCF is a political pre-requisite for overcoming the distrust

cumulated overtime in climate negotiations. Despite its contribution, the Clean

Development Mechanisms (CDM) did not suffice in satisfying the requests of non–annex 1

countries because its revenues were suspected to remain low given the uncertainty about

the deployment of a world carbon trading system, the will of the EU to limit carbon trading

through concrete ceilings and the fact that the only provision of the Kyoto Protocol ‘Article

12(8)) to cover administrative expenses and the costs of adaptation was the payment of a

share of the proceeds of the CDM2 and not of the carbon trading amongst rich countries.

However the GCF is at risk of becoming a new source of misunderstanding. First, pressures

on public budgets in Annex 1 countries after the financial crisis cast doubts about the

amount of funds it will mobilize. Second, given their orders of magnitude at stake, the

financial flows for a transition towards the 2°C objective cannot be provided by the GCF

alone. Third, the context of ‘depression economics’ (Krugman 2009) and of world re-

equilibrium of economic force relationships undermines the political acceptability of large

North/South transfers. Fourth, in this context, many Annex 1 countries will be reluctant to

really engage their own transition, both because of a social resistance to explicit or implicit

carbon pricing, of concerns about competitiveness and employment and of a priority given

to the debt problem and the stability of the banking systems.

1UNFCCC Decision 1/CP.16, para. 1.6, http://unfccc.int/resource/docs/2010/cop16/eng/07a01.pdf#page=2 (Accessed on

November 22, 2013) 2 The Brazilian proposal of a compliance fund was not retained and the perspective of a restoration fund to

unlock the discussions came too late at COP6

http://unfccc.int/resource/docs/2010/cop16/eng/07a01.pdf#page=2

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Waiting for the re-establishment of a stable growth regime would mean the end of climate

policies because of the uncertainty about the date of a re-establishment credible enough to

create a political ambiance conducive to climate policies. Without an early redirection of

their investments dynamics, emerging economies will soon be locked into carbon-intensive

development patterns. The evidence of this lock-in will then be an argument used in

developed countries for not engaging a fast refurbishment of their existing capital stock.

This study starts from the intuition that the only way out to solve the contradiction between

the urgency of climate action and the fact that it cannot be on the top of real political

agendas, it is logical to examine it through the lens of the climate agnostic policy-makers.

Through this lens, climate action will be worth undertaking, beyond symbolic gesticulations,

only if it helps to respond to short term concerns like poverty alleviation, the stability of

financial systems and the world economic recovery. This does not come to push climate

change into the background. This comes, on line with the UNFCCC political agreement, to

tackle it in the perspective of sustainable development and of the repeated calls for Green

Marshall plans or Green Growth since the nineties.

In a first section we show why, given the deep transformations required by the 2°C targets,

climate finance cannot remain a marginal department of global finance. In second one we

sketch the components and the design of a climate-friendly financial architecture and we

examine, in a third section, the conditions under which it can trigger a virtuous circle between

environmental, economical and macro-financial integrity over our century.

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I

Climate policies in an adverse context? turning the question

upside-down

1.1. About the nature of the ‘funding gap’

1.1.1 Assessing the orders of magnitude: incremental vs redirected investments

An indicator of the problem to be solved is the gap between the US$ 100 billion a year by

2020 to which 2020 Annex 1 countries committed to at Copenhagen and the $15 billion per

year envisaged by the EU member states in a first step. Applying the same share of the GDP

(0.082%) to all Annex I countries would lead to $31 billion transfers to non-Annex 1 countries.

Although representing only about one third of the commitments, they would increase by one

third pre-2008 overseas development assistance, hence the temptation of simply

greenwashing existing transfers.

This is all the more embarrassing that the real ‘funding gap’ at stake is significantly higher.

The US $140–$175 billion a year by 2030 appraised by the World Development Report

(World Bank 2009) actually correspond to US $264–$563 billion upfront financing needs, 1,9

3,2 . The former figure assesses the payments due over the duration of the projects to cover

capital and operation costs, including the interest to be paid to a patient lender; the latter,

between 1,9 and 3,2 higher is the cash necessary to cover the cost of the equipments before

they enter into operation. Hence, the funding gap would not be 66% of the needs but

between 82 and 89% of the needs.

Moreover, the incremental investment costs are only the tip of the ‘financial iceberg’. Its

hidden part is the redirection of investments flows. If the capital cost of a given quantity of

‘clean’ electricity is say 30% higher than this of a coal plant, the real amount of investment

to be redirected is 130%. Moreover, higher energy efficiency and lower consumption of end-

use energy will not be achieved without redirecting investments in infrastructure, material

transformation and manufacturing sectors. This reassessment of the orders of magnitude at

stake does not necessarily mean that the challenge is impossible to meet. It means that

changing the climate policy paradigms calls for changing its economic framing.

To understand why and how, we conducted, with the IMACLIM-R model and in collaboration

with the team of the IEA in charge of the World Energy Outlook, numerical experiments for

twelve countries and world regions: USA, Canada, European Union, Rest of the OECD, Russia,

Middle-East, Africa, Brazil, China, India, Rest of Asia and Rest of Latin America. The results

are for 2035 assuming policies starting in 2010. Thus, they should be interpreted as

meaningful over a t+25 time period rather than for a precise date.

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1.1.2 The nature of the tensions, their heterogeneity and context dependency

In this exercise, thanks to the hybrid nature of IMACLIM, we can impose the technical

structure of the energy system projected by the three WEM scenarios (technical coefficients,

fuel mixes, energy intensity, energy costs, capital costs) to four macroeconomic contexts

(see Table 1). The WEM scenarios are a CPS scenario taken here as a baseline, a NPS scenario

corresponding to efforts to internalize environmental concerns and security issues and a 450

ppm scenario. The four macroeconomic contexts retain the same overall productivity trends

as WEM but are characterized by different assumptions about:

1. The savings rates: a) savings rates derived from World Bank (2013) and exogenously

imposed to the model b) savings rates endogenously calculated by the model to provide the

investments required to fulfill expected final demand

,

2. The international flows of capital: a) a “balanced capital flows” scenario which

assumes the reduction to zero of net capital flows of all regions in 2020 and b) an

“imbalanced capital flows” scenario with a linear reduction of imbalances by 2100 ( ⅔ of the

original imbalances persist in 2035)

Exogenous saving rates Endogenous saving rates

Balanced capital flows Exo – B End – B

Imbalanced capital flows Exo – I End – I

Table 1 – Macroeconomic context

The four macroeconomic contexts logically result in different growth rates for each the

world region (see Annex 1). What might be of surprise is that, at the world level, the

aggregate GDP growth rate in the 450 ppm scenario is slightly higher than in the CPS

baseline in whatever macroeconomic context. This little gain should not be over-interpreted

but it means that comparing 450 ppm scenarios to non-optimal baselines changes the

assessment of the interplay between climate policies and growth.

Setting aside the case of oil & gas exporting regions3, the small gain registered in the energy

importing countries, is driven by three major mechanisms a) the recycling of the revenues of

carbon prices into lower household’s taxes b) the postponement of tensions on oil and gas

which leads to lower costs of fossil energies and lower volatility of their prices and

c) optimistic assumptions on energy efficiency which comes to inject of a higher productivity

of the energy production factor.

3 Logically, the 450 ppm scenarios leads to lower GDP growth rates for these regions except in scenarios with endogenous

savings where lower revenues from oil and gas exports are compensated by high energy efficiency gains, a higher share the

GDP invested in non-energy industry and a higher domestic demand for non-energy products. This can be interpreted as the

end of the resource curse syndrome.

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One reason why this reassuring picture should not be over-interpreted is that this type of

modeling experiment does not capture the possibility of funding shortages: the energy

supply and demand of the WEM scenarios are imposed, triggering the required investments.

The judgment on the plausibility of a frictionless deployment of these scenarios can thus be

formed, ex-post, through the analysis of some macroeconomic indicators.

At the World level, the needs of energy related investment are lower, in 2035, in the

450ppm scenario than in the CPS baseline. This is not as paradoxical as it seems since a far

lower energy demand leads to lower energy supply (-40%). But this result is very unevenly

distributed with drastic falls of energy investments in the O&G exporting regions due to

lower necessity to invest for the expansion of export oriented oil and gas capacities. In these

regions the share of the energy investments over the GDP passes from between [36% -

47.4%] in the CPS scenarios to [27.7% - 35.5%] depending on the macroeconomic context.

In the other regions, the incremental investment costs to achieve a 450 ppm target in are

significant. They are between [14G$ - 42G$] in the US, [35G$ - 65G$] in the EU, [90G$ -

155G$] in China and [45G$ - 58G$] in India and [??G$ - ??G$] for Brazil4. The increase goes

along with a structural change of these investment with a share of the demand-side

investments multiplied by 2.6 on average between the CPS and the 450ppm scenario:

multiplication by 3.25 for the EU, 2.9 for China and India, 2.3 for the US (which can conduct a

higher share of their decarbonisation through gas).

One first vision of the macroeconomic implications of these figures can be derived from the

evolution of the share of energy investments on GDP between the CPS and the 450 ppm

scenarios in different macroeconomic contexts. This evolution represents a modest drain on

GDP of [0.1% - 0.13%] for the US, [0.6% - 0.11%] for the EU, [0.21% – 0.34%] for China and

[0,57% - 0,86%] for India5. This does not means that the transition will be easy; the GDP is

not a ‘jelly’ easy to manipulate and even a transfer lower than 1% might be difficult to

achieve. This means that a low carbon transition does not require a huge pressure on the

consumption levels of current generations and is not primarily a problem of trade-off

between current and future generations.

A good indicator of potential tensions is the variation of the share of the energy

investments in total investments. The ratio between the maximum and the minimum values

of this indicator in our scenarios is 1, 25 for the US, 1,38 for the EU and 1,63 for China for

example; these orders of magnitude are far from being marginal: the higher this ratio, the

higher the tensions on real interest rates and the lower is the probability to get the energy

4 Given the level of aggregation of IMACLIM-R we do not provide results for the non-energy exporting countries of Africa

and of the rest of Oecd, Latin America and Asia. However, the range [??G$ - ??G$] for these three major economies is consistent with the US $264–$563 billion upfront given by the WB (2009) for the totality of the developing world 5 The drain is higher in emerging economies because of a higher energy intensity of their GDP and because they are in a

‘catch-up’ phase with a high dependence upon energy intensive sectors (cement, steel, glass, non ferrous).

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investments funded or, in case of strong political will imposing their funding, the higher the

risks of crowding out other investments.

1.1.3 Tensions not specific to the 450 ppm scenario

Analyzing the share of energy investments on total investments shows an intriguing result.

The dispersion of this indicator is lower comparing the three WEM scenarios for the same

macroeconomic context than comparing the same WEM scenarios in the four contexts. For

the world, it reaches 34.8% and 28.6% for the NPS and 450 scenarios respectively, whereas

the dispersion drops to 16.2% to 22.0% if we compare each energy scenario for each of the

four macroeconomic contexts.

The consequence is that, if we classify the scenarios in descending order of the share of

energy investment on total investments displayed in table 4, we find, for example for the

USA, a classification with two 450 ppm cases on the top but followed by two CPS scenarios

and one 450 ppm scenario in the bottom third of the list. The ranking is:

450/450/CPS/CPS/NPS/NPS/450/CPS/450/NPS/CPS/NPS. Therefore the 450 ppm scenarios

do not always appear as the most strained. The CPS scenario itself, in certain contexts, can

trigger financial tensions and this casts doubts about its frictionless deployment. The 450

ppm scenarios even provide a hedge against macroeconomic uncertainties with, in almost all

regions, a lower dispersion of its share of energy investments in total investments.

This changes the way of addressing the funding of the low carbon transition since it might be

that the baseline will not materialize in the real world. Comparing the CPS and 450 ppm

scenarios without considering the uncertainty about their deployment becomes misleading

and the very notion of incremental costs, analytically useful, a fragile decision criterion. The

question is rather whether the policies supporting the 450 ppm scenario can contribute

overcoming the financial barriers to the expansion of energy systems and redirect to the

energy sector part of the available savings which currently go ‘elsewhere’. More precisely, if

they lead to a slightly higher share of the GDP invested in production, then the low carbon

transition could be conducted without crowding out investments on other economic sectors.

1.1.4. Tensions symptomatic of a deeper re-direction problem

Passing from framing the transition towards a low carbon economy in terms of ‘how to fund

incremental investments’ to ‘how to redirect investments’ is all the more important that the

demand-side of this redirection concerns sectors like building, transport, material

transformation, and a part of manufacturing industry. These sectors represent 41% of the

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world gross capital formation (see www.EUKLEM.net). A back of the envelop calculation 6

shows that accounting for the induced investment in these sectors augments by 20% the

incremental investments of the low carbon transition and, more importantly, leads to

redirected investments7 eight times higher the incremental investments.

Here lies the reason why, unless the UNFCCC objectives are de facto abandoned, the climate

policies cannot be isolated from the overall macroeconomic and industrial policies. This

diagnosis opens paradoxically an opportunity to change the current intellectual atmosphere

vis-à-vis climate policies. These imply indeed a redirection of investments within the energy

sector, but the deployment of the energy sector itself, independently from climate policies

confront a problem of redirection of investments within the production sectors, and the

development of these sectors in turn confront a problem of redirection of savings.

It climate policies are part of a larger problem of redirection of savings and investments, it is

thus logical to examine them through the lens of the climate agnostics primarily concerned

by the stability of financial systems and of the world economic recovery after the 2008 crisis.

Their concerns are legitimate because the symptoms that led to unstable financial

dynamics are still prevalent:

- The ultra-low interest rate policy of the central banks in advanced countries has

exacerbated the search for yield higher than ‘public bonds’ by holders of cash (financial

departments of multinational companies, institutional investors like mutual funds or pension

funds). Those holders have moved in and out of capital assets because they are very

sensitive to tiny changes in the communication of central banks that might hint to future

changes in interest rates. In wholesale short term money market, prior to 2008 these volatile

capital flows were channeled through wholesale funding instruments (ABS and CDOs) issued

by shadow banks (broker-dealers, conduits and SIVs8). These instruments have disappeared

but the mistrust in the banking system has motivated continuous build-up of institutional

cash pools. The high demand for safe short-term instruments provoked an increase of the

value of bonds and driven to zero their interest rate. The shortfall of such instruments was

aggravated because foreign central banks buy them for reserve keeping. Ultimately there a

mass of liquidity higher than bonds that can be backed on public assets.

6 We assume that, in 2020: a) 25% of the investments of the households, business and financial intermediaries in

residential and non residential infrastructures is redirected towards low carbon options with an extra unit cost of

5% b) 10% of the investment of the transportation sector (a low percent because of the low substitutability

between rail based and road bases transport) with an extra unit cost of 10% c) 33% of the electricity and gas

investment with an extra unitary up-front investment of 20% d) a decrease by 10% of the investment in mining

and carrying d) 20 % of the investments in machines 7 If, for example, the investment on a ULCOs technology for steel industry is 30% higher than in the basic

oxygen steelmaking with coke and blackfurnace, this is 100% of the investment which has to be redirected 8ABS stands for Asset-backed securities

CDOs stands for Collateralized Debt Obligation

SIV stands for Special Investment Vehicle

LOLR stands for Lender-of-last-resort

http://www.euklem.net/

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- The way governments and central banks have dealt with casualties due to excessive

risk- taking did not succeed to combat the too-big-to-fail syndrome and the imposition of a

higher equity capital on total assets to hedge against ratios the risk of losing control remains

an unachieved business. Therefore existing cash pools are largely outside banks because of

widespread distrust. They have been estimated by the IMF (Polszar, 2011) at $3400bns in

2010 against $3800bns in 2007 and $100bns in 1990)9.

- Firms operating in a business environment which prioritizes, since the eighties, the

shareholder value against the maximization of the long-term growth typical of a ‘managerial

economy’ (Roe 1994). This a main cause of the obsession for liquidity. The profusion of cash

in large companies fuelled bursts in dividend distribution and share buyback to boost equity

prices. It contributes to exacerbating unqualities of income distribution. Investment rates

have thus declined with lack of effective demand and flagging credit demand by SMEs is met

with bank reluctance to lend. Investors face a kind of ‘‘Buridan’s donkey dilemma10, the

donkey which died of hunger and thirst because it hesitated too long between eating oats or

drinking water: they do not know in what long term investments the money should go.

Viewed through this lens, the financing problem posed by the low carbon transition does

not come from a lack of fund. It comes from the inability of the present system of financial

intermediation to fund productive investments. Higher and more stable growth would be

possible by resorbing excess liquidity via heavy taxes which is highly unlikely, or by matching

Treasury bill issuance and the volume of cash pools which is not recommendable in time of

consolidation of public debts or by expanding the umbrella of the LOLR4 to non-banks which

is not a palatable option either. The only viable solution is creating intermediaries able to

bridge long-term assets and short-term cash balances, the preferred support of saving, so

that they are invested productively, without incurring the risks of excess leverage, maturity

mismatch and interconnectedness (illiquid long-term assets financed by short-term,

unsecured liabilities of money market funds) that have fostered the systemic crisis.

The question though is whether climate finance can provide the opportunity to create such

an intermediation. If it can lower the investment risks of low carbon projects and redirect

savings towards productive activities, it will reduce the magnitude of the cash-pools and fuel

the world growth engine by shortening the trickling down of current savings to productive

investments.

9 They are held by 1) global non-financial corporations and institutional investors outside the banking system 2)

mutual funds and hedge funds (managed liquidity and cash collateral associated with securities lending) 3) the

overlay of derivatives linked to derivatives-based investment 4) wealthy individuals and endowments. 10

This legend is a caricature of Jean Buridan, a theologian at the Sorbonne in the 14th

century, who argued that a

wise conduct is to postpone decisions up to the availability of the necessary information. The legend counts the

sad story of a donkey whodies hesitating between oats and the pail of water placed at equal distance from him. A

non-directed inflow of money comes to add more oats and water in front of it without breaking its hypnosis.

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This would be all the more timely that the globalization pattern is changing. What the OECD

development department calls “shifting wealth” is indeed taking a new course. Export-led

growth and reserve accumulation in emerging economies fuelled by excess credit growth in

a host of OECD countries is being replaced by more inward-focused growth with the

widening middle class in emerging economies, pressures for higher wages and services and a

huge investment demand driven by urbanization and environmental concerns.

This mutation also concerns international financial intermediation. European banks have

retrenched on their home borders since the Euro zone crisis and no longer borrow dollars via

their US subsidiaries to relend worldwide. Faced with this vacuum Asian development banks

and sovereign wealth funds are stepping up their ventures. A financial model emerges,

based on long-term bilateral financial contracts at agreed upon prices backed by

government guarantees and on Bond issuance substituting national currencies to dollar.

1.2. The rationale for a climate architecture using a financial-monetary device

The diplomatic momentum that led to the Kyoto Protocol was not a result of an ex ante fully

fledged vision of a global climate architecture, although it was on line with views early

developed by, for example, Grubb (1990) or Agarwal & Narain (1991). It was, rather, the

outcome of a succession of diplomatic fait accompli (Bodansky, 2001): inter alia the principle

of common but differentiated responsibilities (Article 3.1, UNFCCC, 1992), a quantity-based

approach to settle countries’ commitments that exempted developing countries from such

commitments prior to 2012 (Berlin COP 1, 1995), and the possibilities, under Articles 17 and

12 of the Kyoto Protocol, of carbon trading between countries and of a project-based Clean

Development Mechanism (CDM) between developed and developing countries. This

architecture was meant to organize North–South transfers large enough to spur the South to

make significant quantitative commitments post-2012.

In the immediate aftermath of the Kyoto conference11, the Kyoto Protocol was often presented as

implying a world carbon market generating the same carbon price imposed on all the carbon

emitters. This mental map was validated by the fact that most modeling exercises assume carbon

markets as mechanisms connecting ‘technical abatement cost curves’ all over the world as if

decarbonization was operated by “GHGs abatement factories” selected in a descending merit

order12. This mental map is misleading because the abatement factory metaphor:

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The KP actually follows stricto sensu a subsidiarity principle: a) emissions allowances are allocated to nation states b)

countries select domestic policies to meet their emissions caps given their national development objectives, and c) an

international carbon market instituted amongst governments facilitate them to meet their commitments cost-effectively.

This inter-countries market would generate a world carbon price, but domestic carbon prices could differ. A country

meeting its GHGs emissions targets without carbon prices but through traffic regulation (e.g. speed limit), housing programs

or subsidies to low carbon electricity could nevertheless participate in international carbon trading.

12Many sources of the wedges between technical, social and macroeconomic cost curves have been underlined as early as

the IPCC SAR (1996, chapter 8), and encompasses a rich array of literature about the double dividend hypothesis which assumes that fiscal reforms can lower the social cost of environmental policies and can even turn into a gain. For a short

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- It implies as though an Indian peasant was selling permits to the French tourist flying to the

Seychelles. But the transaction is not that simple. First, say 50€/t, carbon price directly impacts the

fuel for irrigation, with a possible direct non-linear negative effect on the earnings of the Indian

peasant. Second this peasant will be affected by the propagation of higher energy prices throughout

the entire Indian economy. Finally, many intermediaries might divert the money flows before it

reaches peasant’s pocket.

- It ignores the wedge between technical costs, GDP variations and welfare variations caused

by: i) incomplete and fragmented markets (not only energy markets but also other markets, e.g. real

estate markets or a dual economy in perpetual restructuring), ii) structural unemployment, iii)

absence of compensation mechanisms for the adverse distributional effects of policies, iv) distorting

fiscal systems, v) weak policy regimes, vi)under-protected property rights, and vii) investments risks

in unpredictable business environment13. This is the place where domestic policies14 addressing these

wedges are critical for breaking the mechanical link between “burden sharing” and “target setting”.

It assumes that micro decisions are made in function of levelized costs which is a misrepresentation

of the rationale of firms’ decisions in a business environment very sensitive to the ups and downs of

the shareholder value. In such a context, options are not selected by firms in descending merit order.

They are selected in function of their impact on the value of the firm. Risk adjusted costs are critical

for this impact and are dependent upon the magnitude of the upfront costs, upon the time profiles

of the difference between revenues and operational costs and upon the risks associated with each of

these three parameters.

The first of these reasons questions the capacity of monetary compensations to mitigate the

heterogeneity of adverse effects of higher energy prices; the second questions the interplays

between climate policies and other public policies; the third questions the capacity of carbon

price only policies to redirect investments and calls for examining financial instruments.

We are not in the idealized world pictured in Figure 1, where economic agents “see” the

entire trajectory of carbon prices equal to the SCC along the optimal least-cost pathway to

achieve a given climate objective. In this world, decisions are made today on long-lived

investments as a function of, say 200$/tCO2 in 2080 even though the current prices are

10$/tCO2. In the real world, economic agents do not ‘see’ the 200$/tCO2 because long term

synthesis see Ghersi and Hourcade (2009). The fourth assessment report of the IPCC placed a useful caveat on the vision

described by modeling exercises which assume long term balanced growth pathways and “use a global least cost approach

to mitigation portfolios and with universal emissions trading, assuming transparent markets, no transaction cost, and thus

perfect implementation of mitigation measures throughout the 21st century” (IPCC AR4 WGIII SPM Box 3, 2007).

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Here lays the fundamental reason why a carbon-price-only framework hardly offers an acceptable deal for

emerging and developing countries.This should not be a surprise for economists who, a very long time ago,

warned that recommendations – here a carbon price- valid in a 1st best world are not necessarily valid in a 2nd

best one (Lipsey and Landcaster, 1956; Guesnerie, 1980). 14

+ include Weitzman 2014 Can Negotiating a Uniform Carbon Price Help to Internalize the Global Warming Externality? Political economy argument in favor of the carbon tax : the proceeds of the tax remains into the country, there is no transfer from one to another country. Governments can decide domestically how to recycle the proceeds.

http://scholar.harvard.edu/weitzman/publications/can-harmonized-national-carbon-taxes-internalize-global-warming-externality



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markets are missing, because carbon price signals in infrastructure sectors (energy,

transportation, building) are swamped by many other distorted signals (like the prices of real

estates) and because of regulatory uncertainty which cast doubts about the permanence of

price signals.

Fig. 1: The expectation gap. Agents today consider the carbon price a, and do not anticipate its evolution beyond t1. In case of full confidence in public policies and clear perception of carbon price signals they see the entire trajectory O. If carbon prices are blurred by other imperfect signals (including low confidence in public policies), a carbon price c >b has to be launched. It leads to the L curve in the case of endogenous technical change.

Actually there are two major arguments for articulating carbon prices signals and carbon

finance:

- The first is to bridge very quickly the ‘expectation gap’ in view of avoiding emerging

economies to be locked into carbon intensive development patterns. Doing so only by

means of the carbon prices would imply very high prices in the short term to cover the

Carbon Price

Time t

1

Optimal trajectory assuming « perfect expectations »

(O)

Optimal trajectory assuming « limited expectations »

(L)

a

c

b

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“noise” of other signals (figure 1) and these very high prices will exacerbate transition costs.

The role of domestic policies mobilizing a broader set of economic signals (real estate and

land prices, labor markets, reforms of regulatory regimes of infrastructure sectors) is

important to lower these noises together. But, there is an irreducible level of regulatory

uncertainty, and no political power can make credible commitments about the future carbon

prices during several decades. Carbon finance is a credible way of making such commitments

- The second is that carbon prices hurt installed capital stock whereas commitments to

issue carbon assets aim at redirecting new capital stock. Then necessity of carbon finance

can thus be advocated through a political economy argument, the fact that it will raising a

lesser mobilization of vested interests. But there is another argument, more ethical in

nature. Behaviors enabled by this capital stock (mobility, housing modes, location of human

settlements) result from an implicit social contract, cheap energy and environmental

innocuousness of fossil energies. That climate policies question this social contract is a real

obstacle to their deployment and the role of carbon finance is to facilitate the renegotiation

of this contract because it does not penalize populations trapped in the consequences of the

past contract.

But the consideration of the existing capital stocks and vested interest is at risk of resulting

into lobbying games for subsidies and exemptions which, in addition to important economic

inefficiencies and political arbitrariness of climate policies. This is why a device is needed

which does not hit existing capital but sends the same carbon price signal to new

investments. Organizing carbon finance around an agreed upon and agreed upon price of

carbon is then first pre-requisite for making a new low-carbon social deal happen while

guaranteeing economic efficiency.

A second pre-requisite is to avoid additional burdens on tax payers or on public budgets

deficits. The only leeway, technically, is then a monetary based mechanism and this makes

sense, if, as stated in section 1 the core issue is to creates the perspective of safe productive

investment avenues to attract savings out of speculative investments and to reduce the

vulnerability of the financial systems.

1.3. Basic principles in a nutshell

In this context, options to prime the funding pump of the low-carbon transition despite

limited carbon markets are many. However, given the tensions on public budgets and on the

banking systems, there is no other margin of freedom than internalizing the “social value” of

avoided carbon emissions into the economy by means of a carbon-based monetary

instrument. For the climate agnostics, compared with the “unconventional monetary

policies” implemented to restore confidence on the monetary and financial systems after

15


2008, this value is of interest only if it is used in a system helping the banks to develop their

credit activities towards productive investments.

The basic wrinkle consists in injecting central bank liquidities into the economy, provided

that they are used to fund low-carbon investments. Governments would provide a public

guarantee on a new carbon asset, which allows the central bank to provide new credit lines

refundable with effective CO2 emissions abatement. This targeted credit facility makes it

possible to expand credit to LCPs as it offsets LCPs' financial risk perceived by the banks and

investors relatively to BAU projects and would make these projects more attractive.

However, such monetary device may follow the four basic principles pictured in figure 1.

(I) The international community recognizes that avoided GHGs emissions is “something

of value” measured by the « social cost of carbon » (SCC). Governments commit, on a

voluntary basis, but within a framework agreed upon by the UNFCCC, to back a new class of

eligible « carbon assets » recognized by the central bank of their monetary zone. These

carbon assets are a quantity of carbon abatement (to be specified later) valued at the SCC.

(II) Building on this guarantee, Central Banks of participating countries (of Annex 1 in a

first step) open « credit lines » to commercial and development banks provided that the

money is used to issue ‘carbon certificates’ ‘CC) and back low rate loans to LCIs in the issuing

country or in any country participating to the system. The Central Banks announce that they

will accept the CC as repayment after due verification of the reality of the investments

reduction. These CC are then converted into carbon assets while entering central bank’s

balance sheet. This comes to a money issuance based on the guarantee that “something of

value” has been created in the form of low-carbon equipments.

(III) The CC are delivered by an independent international Supervisory Body, established

under the UNFCCC, like the CDM Executive Board, to secure the environmental integrity of

the mechanism (rules for the attribution of CC, monitoring of the completion of LCIs) and its

developmental effectiveness. The latter is guaranteed by the consistency of the funded

investment with a list of NAMAS selected by the participating countries to secure the

alignment of mitigation actions with development objectives.

(IV) Banks or specialized climate funds use the carbon-based monetary facility to back

highly rated climate-friendly financial products, such as “AAA” climate bonds, in order to

attract long-term saving. Institutional investors could be interested in safe and sustainable

bonds instead of speculative financial products for both ethical and regulatory purposes. Part

16


of the CC are used to scale up the Green Climate Fund in order to secure multilateral

cooperation around climate policies and the funding of NAMAS without crowding out

overseas assistance by each individual country.

Figure 1: The key elements of a climate-friendly financial architecture

17


II

Components and design of a financial architecture aligning climate

and development objectives

This proposal rests on four essential features that we explore more in depth in this section:

An agreement on the « social cost of carbon » amongst countries participating to the system including both countries accepting to issue carbon assets and countries accepting the preconditions to receive funding for their NAMAS through this channel,

Rules for the emission of ‘carbon based liquidity’ and for the ‘drawing’ on these liquidity so as creating a ‘pull-back’ force guiding the participating countries towards emissions trajectories consistent with the 2°C objective

A mechanism transforming the carbon based liquidity into real wealth and carbon assets and supporting climate-friendly financial instruments apt to attract long term saving

The establishment of an independent international Supervisory Body in charge of controlling the effectiveness of emission reductions and rewarding LCPs with CC.

2.1. The Value of Avoided Emissions : a trajectory of notional prices

The last COP has confirmed the long term objective of preventing a temperature increase

greater than 2°C above pre-industrial levels. Admittedly, this is close to acknowledge a social

cost of the carbon externality (SCC) or a social value of the avoided emission of carbon.

In theoretical economic models, this SCC is the value which equates the marginal damage

caused by one additional emission of CO2 and the marginal cost of avoiding this emission

along an optimized trajectory. The value of the SCC is highly controversial in the literature

(Tol 2008; Dumas et al 2010) since it depends on a large set of parameters amongst which

not only the pure time preference which crystalizes the dispute amongst economists, but

also the costs of carbon-free techniques, the beliefs about the climate change damages and

about the rate of arrival of new information about these damages. The polemic about the

Stern report shows that no agreement there might be a long way before agreeing on a

workable range of values, even in case of agreement on a low pure time preference as

suggested by the last IPCC report.

Things differ if one starts from the political deal made by the international community

around a 2°C temperature target. In this case, it is possible to calculate the trajectory of

costs for meeting this target under various scenario assumptions. Uncertainty is still

important but results from about 900 modeling exercises synthesized in graph 1 by the last

IPCC report (chapter 3) show ranges of carbon prices which are still large but provide a

18


corridor within which a political deal can be made: shows a maximum likelihood space of

carbon prices ranging from 28$/tC02 to 50$/tCO2 in 2020 and between 110$/tCO2 and

190$/tCO2 in 2050. Ultimately an agreement around a notional value of avoided carbon

emissions (VAE) 15 will be political in nature translating the willingness of governments to

pay for mitigating climate change.

Fixing this VAE implies an agreement on an initial price of carbon increasing over time for at

a pre-determined rate. This is important to launch a credible signal on the long term and to

compensate the penalizing role of discount rate against infrastructure investment. To

reconcile the credibility of the economic signal and the necessity to revise initial choices in

function of new information the VAE can be revised every five year time period but without

changing the VAE incorporated in the past contracts.

One major advantage of fixing this VAE worldwide is that it will secure the overall economic

efficiency of the Green Climate Fund and of any other bilateral climate initiatives, prevent

the risks of fragmentation of these initiatives16 and to send a comprehensive signal to

investors and, upstream, to R&D, city planning and infrastructure managers.

A political agreement on a SVE should be easier than on a carbon tax or national emissions

cap because it serves as a notional price paying for avoided CO2 emissions entailed in low-

carbon investments. Contrary to a carbon tax, that must be paid for each unit of carbon

15 This is the meaning of social cost of carbon integrated as a notional value by the US ($42), the UK ($60) and Frace ($130) for 2030 in the analysis of public investment decisions 16

See the Paris Declaration on Aid Effectiveness

19


emissions, it does not impose a direct short term extra costs on neither the public budget, or

firms and consumers. It is a signal for future investments which does not hurt existing

capital, entails less direct distributive impacts and therefore less risk of blocking coalition

from the owners of carbon-intensive capital.

A political agreement on a VAE should be easier than on a carbon tax or national emissions

cap because contrary to a carbon tax, that must be paid for each unit of carbon emissions, it

does not impose a direct short term extra costs on neither the public budget, or firms and

consumers. It is a signal for future investments which does not hurt existing capital, entails

less direct distributive impacts and therefore less risk of blocking coalition from the owners

of carbon-intensive capital. Moreover, each government will value the avoided carbon

emissions it in function of its own perception of the domestic co-benefits of climate

mitigation (air pollution, benefits of the recycling of the revenues of carbon pricing, energy

security). Hence countries might agree the same VAE for various reasons and it is

questionable that gains in development benefits through a differentiation of the VAE are

worth the risk of endless controversies about the rules for this differentiation.

More important is to hedge against the vagaries of market exchange rates. The VAE value

would be nominally similar to the 35$ per ounce of gold under the Bretton Woods regime.

But, since the exchange rates are the relative values of the VAE in national currencies will

thus differ from one country to another and will be submitted to variations large enough to

generate time inconsistencies of investment projects funded in several countries overtime.

This is why the world SVC should be the weighted average, in purchasing power parity (PPP),

of national prices. The internal returns of investment projects, would then all be implicitly

computed in PPP price system (reviewed every five years) which would minimize the

inefficiencies caused by the volatility of exchange rates.

2.2. Voluntary commitments and pledges; creating a ‘pull-back’ force

The voluntary adhesion to the system should be based on commitments to issues carbon

assets. Given the political constraints of the current negotiation process and the experience

of the failure of the Kyoto Protocol, this system should follow five principles: a) keep an

allocation of targets and timetables per countries with a controlled degree of “when” and

“where’” flexibility (COP3, 1997), b) leave all latitude to Parties to select the NAMAS apt to

align their climate and development policies so that there is no misgiving about

environmental colonialism (Agarwal and Narain, 1990), c) follow principle of “common but

differentiated responsibilities (CBDR)” in accordance with the article 3.1 of the UNFCCC, d)

secure that renegotiations every five years will not generate instable signals for economic

agents (Hourcade et al., 1993) and d) motivate countries to respect announced emissions

pledges and to narrow the gap between these pledges and an emissions trajectory

compatible with the 2°C target e) deprive a defaulter country of the benefits of the system

20


like in Carraro and Siniscalco’s approach (1998) of technological cooperation or in Victor’s

proposal of a club of voluntary countries (Victor, 2011).

A mechanism can be organized around carbon based assets could meet these principles

through a pull-back force anchored around two pillars. The first pillar rests on allocating to

each participating country part of the global emissions budget17. The agreement on an

allocation rule is ridden with controversies. However, what makes a compromise18 easier

than in the case of a cap and trade system is that the latter triggers immediate adverse

impacts for households and industry of countries with tighter carbon constraints and

possible high drains on GDP for importers of carbon allowances. The second pillar rests on

emissions pledges and commitments to issue carbon assets as means of motivating

countries each country to announce emissions reductions every five year time period and to

keep their announcements. Let us glance through the panels A, B, C how countries can be

guided towards their convergence trajectory:

- Pull-back force for Annex 1 countries and all countries over their convergence

trajectory. The panel A describes the situation in 2015 of two developed countries C1 and C2

characterized by the same gap (200 GtCO2) between their GHG emissions in 2015 and their

convergence trajectory in 2020. These countries have accepted to issue a quantity of carbon

assets representing half of this gap. Consequently, in 2015, their central banks open credit

lines for 100GtCo2 each at a VAC of 50$. But country C2 proves less virtuous than country C1

and conducts less domestic abatement efforts. It then uses only 1000$ of the credit lines to

support these efforts and let 4000$ available for projects abroad against 2000$ only for

country C1.

As described in panel B country C2 is ‘penalized’ in 2020 by a larger gap between its

emissions and its convergence trajectory (500 GtCO2 instead of 300 GtCO2). If the VAC is

now 60$/tCO2 it is obliged to open 15000$ credit lines (instead of 9000$ for country C1). It is

thus confronted to the risk of an increasing drift of outflows of capital. Here lies the pull-

back force to incentivize it to make more domestic efforts and use domestically a higher

share of its carbon assets. Between 2020 and 2025 it uses domestically two thirds of the

credit lines emitted by its Central Bank, which leaves 5000$ for funding LCI abroad. It is thus

achieved in Panel C by a reduced gap with its convergence trajectory (400 GtCO2) and then is

rewarded by a lower obligation of issue carbon assets.

17

We do not enter here in the discussion of the normative allocation. To avoid endless controversies, it should be

clear from the beginning that it will be a mix of two criteria (convergence of emissions per capital and

convergence of emissions per GDP).

18

A lot of mixed formula incorporating per capita convergence in a broader system based on historical trends

have been put forward (Agarwal and Narain, 1991; Jacoby et al., 1999; Colombier, 1998; Frankel, 2007,Bossetti

and Frankel, 2011)

21


- Pull-back force for the developing countries: In panel A, developing countries

D1 and D2 share the same gap of 300 GtCO2 below their respective convergence trajectory.

Because they are not at the same phase of their development, this trajectory increases from

900 GtCO2 to 1200 GtCO2 for country D1 between 2015 and 2025 whereas the trajectory of

D2 reaches a pick of 1200 GtCO2 in 2025.

In 2015, the behavior of the two countries differs in terms of ambition of pledges for 2020.

Country D1 announces 200 GtCO2 below its normative trajectory whereas as country D2

announces 100 GtCO2. Then, country D1 will have a drawing right on 2/3 of the available

amount of credit lines issued by developed countries. Here lies the pull-back force for these

countries: the more ambitious are their pledges (measured by the gap with their

convergence rule) the more they will be beneficiaries of capital inflows. To prevent false

announcements it will suffice to discount the theoretical drawing rights in t by the gap

between the emissions registered in t and the pledges announced in t-1. Note that, beyond

2030, country D2 overshoots its normative peak and then becomes an issuer of carbon

assets.

Panel A (2015) Country C1 Country C2 Country D1 Country D2

GHG emissions (2015) (GtC02) 1000 1300 600 1000

Convergence Trajectory (2020) (GtC02) 800 1100 900 1300

Carbon Asset Issuance ($*GtC02) 50*100=5000$ 50*100=5000$

Outflows (2015->2020) -2000$ -4000$

Inflows (2015->2020) 4000$ 2000$

Pledge (2020) 900 1200 700 1200

Panel B (2020) Country C1 Country C2 Country D1 Country D2



Carbon Asset Issuance ($*GtC02) 60*150=9000$

60*250=15000$

Outflows (2020->2025) -4000$ -5000$

Inflows (2020->2025) 4500$ 4500$

Pledge (2025) (GtC02) 700 900 1000 1100

22


Panel C (2025) Country C1 Country C2 Country D1 Country D2



Carbon Asset Issuance ($*GtC02) 70*100=7000$ 70*100=14000$ 0$

Outflows (2025-2030) -4000$ -7000$ 0$

Inflows (2025-2030) 11000$

Pledge (2030) (GtC02) 500 700 1200 1100

Actually over time all countries will be discouraged to announce lax emissions pledges. The

rationale of the expected virtuous behavior is as follows: the development benefit of the

mechanism will be tangible to those issuing and receiving countries which will make the

system increasingly attractive for all countries which might create a movement of expanding

climate coalition. In this system, the net capital flows will go from the North to the South.

The total investments in the energy transition over 2010-2035 are of the same order of

magnitude in the OECD countries [5950 G$ - 6300g$) and in the Developing Countries (OPEC

excluded) [6040 G$ - 6500 G$) and there will be a higher share of cost-effective

opportunities in the latter. It is also interesting to note that, one or two decades ahead,

emerging economies like China, Mexico and Brazil will overshoot their convergence budget

and contribute to the system as net issuer of carbon assets.

For this system to work, a global body has to be set up under the UNFCCC or any other UN

organization to manage the MRT system, register the issuance of emissions of carbon assets

and their use, like in a form of clearinghouse. This is critical to create a credible information

basis to facilitate the renegotiations of the pledges every five years.

2.3. Transforming the carbon based liquidity into real wealth

The key is to secure that the carbon based liquidity really supports the creation of ‘real

wealth’ and is not a pure ‘greening’ of the perverse commerce of promises which provoked

the 2008 crisis. The basic principle is that Central Banks accept carbon certificates as

repayment of their credit instead of cash and enhance the risk-adjusted profitability of low

carbon investments, before transforming the initial credit lines into carbon assets.

There are many possible circuits through which this transformation can be operated because

there are many types of financial intermediaries and many types of enterprises which must

23


be mobilized. Before commenting upon this diversity, and for clarity sake, let us however

describe the ‘banking canal’ which will likely be the most important.

2.3.1. From the credit lines of the Central Banks to carbon assets: the circuit of balance

sheets

Building on the political agreement on the SCC, a new class of carbon assets is created by the Central Bank. Their value is the agreed value of the SCC and their quantity is determined by an overall volume of emission reduction.

The attribution by the central bank of a conventional value to this carbon asset in the same fashion as gold under the Bretton Woods regime for instance, does not infringe on its independence. It is justified by an upstream political agreement on the SCC and backed upon the existence of effective emission reductions.

We list in Table 1 the components of central bank's balance sheet. Gold, special drawing rights, securities are part of the asset side while currency in circulation and bank’s deposits appear on the liability side.

Table 1: Central bank’s balance sheet

In accordance with government’s willingness to value emission reduction, the central bank announces that it will provide commercial banks with new liquidities to fund low-carbon projects. It also announces that it will accept as repayment “carbon certificates” (CC) which would testify effective carbon emission reduction. The value of the CC will be given by the politically negotiated SCC.

Tables 1, 2, 3, and 4 offer a numerical example of the balance sheet consequences for the

central bank and a commercial bank of a 1000 loan to a low-carbon entrepreneur expected

to realize 10 units of CO2 emission reduction. The SCC is set at 10, which values the expected

emission reduction at 100.

Table 2 indicates that the loan to the entrepreneur is divided into two credit lines. On the

first line, the commercial bank borrows 900 deposits at rate rd and lends 900 at rate rl. The

second line refers to the 100 liquidities equivalent to the value of expected emission

reduction lent by the central bank to the commercial bank that can be paid back with

24


certified emission reduction. Prudential rule about minimum capital requirement only

applies to the first credit line (900 rl), as a zero coefficient risk is applied to the line coming

from the carbon-based liquidities. Then net worth increase of the bank should only be

+0.08*900rl instead of 0.08*1000rl as in the BAU case, that is the funding of a conventional

project.

The central bank owns a new 100 claim on the commercial bank. Thanks to the 1000 loan,

the entrepreneur launches a project with expected returns RLC which makes the total

expected revenues amounting to 1000 RLC. Two lines appear in the liability side of the

entrepreneur’s balance sheet corresponding to two types of debt: 900 will be paid back with

the monetary revenues of the projects and at the interest rate rl, and 100 paid back with

effective emission reduction19.

Table 1: Balance sheets at the opening date of the low-carbon loan

During the payback period of the loan, the entrepreneur gradually reimburses the loan with

monetary revenues of the project as suggested by table 3. As the project realizes emission

reductions, the entrepreneur receives carbon certificates.

19 In this example, we assume the project realizes the 5 units of expected emission reductions.

25


Table 2: Balance sheets at mid-maturity of the low-carbon loan

At the end of loan maturity, table 4 indicates that the entrepreneur has paid back the entire 900 debt with the monetary revenues of the project and has gotten 10 CC for the emission reduction her project has achieved. Capital constraint for the commercial bank gets null and only the second credit line remains unchanged in the balance sheets.

Table 3: Balance sheets at the end of the payback period of the low-carbon loan before the asset swap

The last step of this process is an asset swap performed by the central bank who accepts the

10 CC as repayment of its 100 financial claims. This results in cancelling out the second credit

line corresponding to the “carbon debt” of the low-carbon project. Total amount of carbon-

based liquidities that the central bank can issue is reduced by 100.

26


Table 4: Balance sheets after the carbon asset swap

For commercial banks in a process of deleveraging, this new credit facility will encourage

them to expand their lending activity, instead of accumulating liquid reserves. An additional

regulatory incentive for the banks might be that a high share of LCPs in their loan book

would make their balance sheet less risky, since this share of their assets would benefit from

a public guarantee. One could even imagine that they keep part of the carbon assets. Banks

would then be rewarded with a reduction of the cost of their prudential capital constraint.

They could be indeed allowed to apply a zero risk coefficient – in the same fashion as for

sovereign bonds – to the fraction of the loan that comes from central bank liquidities backed

upon the value of emission reduction. Along the same line, it could be envisaged that

enterprises keep the carbon assets in their balance sheet to improve their value in terms of

Capital Asset Pricing Model.

2.3.2. Using a diversity of canals to redirect savings

In addition to inciting the banking system to better support low-carbon transition, the

virtuous cycle between climate policies, economic growth and a sounder financial order will

depend of the efficacy of the system to redirect of private saving toward LCP&P. In addition

to banks and sovereign Wealth Funds most of the financial intermediaries could be

mobilized: public private and corporate pension funds, insurance companies, endowments

and investment management companies.

The basic principle to build up is that the financial institutions could use the carbon-based

monetary facility to back highly rated climate-friendly financial products attractive for

households and institutional investors because the offer AAA-rated ‘‘climate colored’’ bonds

(like the green bonds of the World Bank) instead of speculative financial products for both

ethical and regulatory purposes.

27


Figure 2: Climate finance as a means to redirect long term saving toward low-carbon investments

2.3.3. Supporting the Namas, the specific contribution of the Green Climate Fund

This monetary based system is not likely to crowd out conventional overseas assistance since

it relies on totally different channels. However the suspicion of imposing a carbon

conditionally to funding at risks of threatening other development priorities is still pervading

the discussions. This is why it matters to selects eligible projects within the NAMAs proposed

by the national authorities of the recipient country which define those of the mitigation

measures which are on line with their development objectives. This consistency check will be

one of the most important role of the Supervisory Body of the system, under the UNFCCC, in

addition to determining the expected “avoided emissions” and confirming ex-post the

emission reductions achieved based on verification reports by accredited independent

entities. This process is similar to the manner in which the funds of the Marshall Plan where

managed post World War II (Schelling 1997).

However, both to clear up any suspicion of political deals in bilateral initiatives and to

reinforce the overall efficacy of mitigation actions it matters to reinforce the role of the

Green Climate Fund. Despite still unresolved debates, this fund will receive budgetary

contributions and small taxes on financial transactions, international shipping or

international aviation, but there is a risk that its funding capacity will remain limited, in

absolute terms and by comparison with the flows generates by bilateral initiatives.

The architecture designed above supports bilateral initiatives between the issuers and the

beneficiaries of the carbon assets. It is meant to attract private funds but does not respond

the legitimate claims of a strong multilateral system. The judgment about the right balance

between bilateral and multilateral systems is political in nature but there is no contradiction

between both. Indeed, since the proposed system links the issuance of carbon assets to past

responsibility of Annex 1 countries, a share of these assets could contribute to provide

28


capital outlay of the Green Climate Fund in order to increase its potential leverage effect of

this multilateral tool.

3.2. Securing LCPs environmental and developmental quality of the LCI

The reliability of this architecture rests on its capacity to certify that LCIs make a real

contribution to development and emission reductions. Thanks to the CDM, an important

experience has been accumulated in project assessment. But the problem to be solved for

triggering a wave of LCI is no longer to guarantee the additionally of each project on a case-

by-case basis from a counterfactual and controversial baseline but a statistical additional, so

that the pool of projects supported by the system yields a total of carbon abatement higher

than what would have otherwise occurred.

Three cases may appear:

(i) projects pay for themselves, the carbon certificates system would thus have

only helped to bridge a credibility gap inhibiting their adoption so far;

(ii) projects are able to pay back their loan if a cost of carbon appears in whatever

form, hopefully higher that the ex-ed SCC;

(iii) projects are in default payment because of mismanagement, technical failure,

or because they actually had little chance of success.

The challenge is thus to trigger a wave of investments in a situation of ignorance of the

precise outcome of each individual project and to reach a portfolio of LCIs both

economically viable and environmentally efficient. Focus on very high accuracy in the

allocation of carbon certificates would end up freezing investments while laxity would lead

to subsidizing projects that would have been funded anyway. The trade-off between these

two risks will ultimately result from learning process through which an independent

committee would progressively refine the assessments in function of experience and local

circumstances but with no retroactivity on past allocations). It can be secured in three steps:

(i) define a taxonomy of LCIs (size, technology, time horizon) and determine the

potential abatement (volume and time profile) to be expected from projects fitting within

each category of this taxonomy (for example a unitary capacity of hydropower). This

potential abatement will be used for every project of deployed in the country during the

considered time period. It will conventional in nature but its determination can rely on

modeling exercises providing orders of magnitude of the avoided carbon emissions

associated, for various growth scenarios, to main types of LCIs (hydro-power, solar or wind

power plants, transport infrastructure, building insulation, etc.). These values can be

reasonably bound by systematic model comparison and sensitivity analysis, through an

international expertise committee.

29


(ii) calculate the expected present value of avoided emission: let A(t) be the CO2

abatement yielded by the project at each point in time, t0 the date of the launching of the

project, N the project life-time and i the discount rate, the present value of the CO2

abatements can be computed as follows 0

0

( ). ( )

(1 )

t N

tt

A t VAE tNPV

i

. and the number of

allocated carbon certificates will be 0

.t

NPV

VAE

(ii) determine the amount of carbon certificates allocated to each kind of LCI by dividing

the present value of projects by the VAE at the date of project launching and, to secure the

0

.t

NPV

VAE

In the same spirit, the monitoring of projects (and possible invalidation of part of the carbon

certificates) has to rely on simple observable criteria to assess the degree of effectiveness of

the project in comparison with its ex-ante objectives (in terms of carbon emissions when this

is possible, in terms of indicators of physical achievement for transportation or building

infrastructure).

To set up such a process with a minimum degree of credibility would certainly have been

risky two decades ago. But we can now benefit from the experience of the Clean

Development Mechanism (CDM) which is to date the largest carbon offset mechanism in the

world – with over 7,000 projects.

This experience show first the importance of upfront transaction costs as a major barrier

for the implementation of projects. They include Project Design Document (PDD)

development, validation costs (internal and auditing), UNFCCC registration fees and the cost

of installing the monitoring system. They vary drastically depending on the type of project

and technologies and on the concerned sectors, ranging from EUR 37,000 for small-hydro

projects to EUR 434,000 for very large adipic acid N2O projects. They are also submitted to

scale effects (Figure 1) which indicates the necessity of specific procedures so as to avoid the

crowding out of small scales projects which might be the projects yielding the most of

development benefits in some countries and regions.

30


Figure 1 – MRV costs in the CDM

Source: CDC Climat Research based on Warnecke et al. (2013), Bellassen and Stephan

(forthcoming

Building upon (Shishlov and Bellassen 2012), to strike a right balance between lowering

transaction costs and the incentive to operate low carbon investments it is possible to define

criteria for a MRV process aiming at statistical environment additionally of the system.

a) standardization of the baseline setting: necessary to demonstrate the

additionally of the project represents half of upfront transaction costs in the CDM (Guigon,

Bellassen, and Ambrosi 2009). Abandoning project-by-project assessment will result in a

significant reduction of transaction costs without undermining the environmental integrity

of the system because, given the accumulated CDM experience, it is possible to set up

acceptable ‘counterfactuals’ like those developed by the Program of Actions (PoA)

framework as well as in the new sectorial crediting mechanisms. Based on discussions about

country-wide standardized baselines for different sectors in COP11 (Montreal), COP16 in

Cancun provided the possibility for host countries to submit standardized baselines

concerning all or part of the country (UNFCCC 2011). This will overcome the problem of

information asymmetry between the project developers and the regulator. But the problem

of the regulator will be the level of the stringency of the baseline and/or of the share of CC

31


allocated for an expected deviation from the baseline not to discourage the supply of

projects without compromising the environmental integrity of the program (Millard-Ball

2013).

b) positive lists: those already implemented within the CDM can be used as a first

basis for further standardization. Certain types of projects that meet minimum criteria can

be assigned a standardized, conservative amount of credits per operation period with

conservative discount in proportion of the uncertainty about their environmental

performance. The current list of projects automatically deemed additional include small

scale off-grid and grid-connected renewable energy, rural electrification project activities

using renewable energy sources in countries with rural electrification rate is less than 20%,

mass transit and bus lane in Least Developed Countries (LDCs), etc. This list can be

progressively extended to minimize both the “false positives” generating windfall profits

and the “false negatives” of lost opportunities (Trexler et al 2006). In this search for avoiding

free riding without high transaction costs it makes sense to have more stringent screenings

on projects with best leverage ratios than in projects (sectors, regions) with insufficient

financing adopted where the list of eligible project types expands over time in line with MRV

complexity and cost.

c) monitoring: the CDM project developers already devise a monitoring plan that

provides for “the collection and archiving of all relevant data necessary for estimating or

measuring anthropogenic emissions by sources of greenhouse gases occurring within the

project boundary during the crediting period”. The CDM Project Standard further specifies

that variables that continuously affect the amount of GHG emissions (reductions) - such as

the quantity of fuel input or the amount of gas captured – must be measured constantly.

Variables that remain largely unchanged, e.g. emissions factors, must be measured or

calculated once a year. The MRV system for a non-project based system may provide a

certain degree of flexibility to developers in order not to impede projects in sectors where

high level of monitoring are unachievable or too costly, e.g. transportation or forestry. This

may be done through discounting the amount of carbon certificates in proportion to the

overall monitoring uncertainty. Project developers can thus be encouraged to save on

monitoring costs at the expense of less carbon certificates awarded.

d) Verification: the use of accredited auditors for verification is necessary to reduce

the moral hazard to overestimate emission reductions. They key is the consistency check, by

an accredited auditor, between project description and implementation of the project. A

similar verification approach is applied in most carbon accounting systems, be it national

GHG inventories or an ETS. Since the third party tends to be paid directly by the verified

entity, a potential conflict of interest arises. However, the risk of losing the accreditation is

typically a much stronger incentive and keeps auditors from being complacent with their

client (Cormier and Bellassen 2012). Another option is to levy a share of the proceeds on the

32


system to pay directly the auditors. In order to keep verification costs at a reasonable level,

the stringency of verification is adapted to the importance of information. Auditors should

be encouraged to focus on larger sources of potential overestimations while small sources of

errors may be ignored. The threshold of “materiality” depends on the size of the project.

Typically in the CDM it ranges from 10% of total emissions reductions for micro-scale

projects (renewable energy projects of up to 5 MW and energy efficiency projects of up to

20 GWh of energy savings per year) to 0.5% for large scale projects that reduce more than

500,000 tons of carbon dioxide equivalent per year. Another potential approach that may be

considered is the “fire alarm”, i.e. the auditor conducts random spot-checks and focuses on

“suspicious” numbers.

d) Transparency: transparency improves the credibility of the system and allows

“learning-by-doing” among participants. However, there is a trade-off between transparency

and confidentiality especially when sensitive financial information is concerned. In the CDM

all the documents related to the project – project design, names of project participants,

methodology, validation and verification reports etc. – must be made public. The complete

transparency of the mechanism enables constructive criticism to emerge from a great

variety of stakeholders: project developers, e.g. through the International Emissions Trading

Association (IETA), auditors, e.g. through the Designated Operational Entities and

Independent Entities Association (DIA) and NGOs such as Carbon Market Watch or Sandbag.

The general tendency is to put little confidentiality on the reported data. This transparency,

however, may be used to obtain commercially sensitive information on the reporting

companies. This is why, for example, reported data is confidential in the Shenzhen ETS

where the problem is particularly acute as companies are asked to report their added value

as well as their emissions.

e) Timing the issuance of CC: by comparison with the current CDM, one advantage of

a system based on CC, is that the ‘cash’ is available immediately for the project developer in

exchanged of the commitment to reimburse this cash in the form of certified CC. However, it

still matter for the investors to have a precise information about the pace at which these CC

will be swapped into carbon assets because this determines the risk of being forced to

reimburse the loan in cash in case of non-certification. This information will be key for the

assessment of the debt servicing and mitigating the “MRV risk”. This is why it might be

reasonable to have part of the ‘asset swap’ carried out for example in three steps: one third

after the completion of the equipment and certification that they are conformed with the

initial plan, one third at the half of a conventional date of economic completion of the

project (lower than its technical and economic lifetime) and one third at this date.

33


III

A virtuous circle between environmental, economic and macro-

financial integrity

Figure 4 pictures three legitimate concerns aroused by the type of mechanism outlined

above: (i) risk of lax monetary creation under the pretext of carbon savings, (ii) risk of

‘‘carbon bubbles’’ (iii) risk of low-quality LCPs, both in terms of development and carbon

abatement.

Figure 4. Advantages and risks associated with the issuance of carbon assets.

To assess the first ‘inflationary’ risk it matters to remind that both the quantity and the price

of carbon assets are fixed over a given period. To give the orders of magnitude at stake let us

come back to the scenarios provided in the first section this note and let us assume that:

- the real trajectory followed by the OECD countries in 2035 is the CPS scenario

(which is a pessimistic view because, if we assume that the system works after 2015, the

OECD will follow another baseline)

- the VAC is 200$ per ton of CO2equivalent, which is the upper bound of the

likelihood space of prices of carbon given by the last IPCC report for this time horizon

- half of the gap between the CPS baseline and the 450 ppm is retained for calculating

the issuance of ‘credit lines’ leading ultimately to the creation of carbon assets

34


Under these hypotheses, the issuance of carbon assets in 2035 would represent 1% of the

GDP. But this is with no leverage of private savings and private loans. Assuming a 10%

leverage, then the issuance would be 0,1% of the GDP. This is the real upper bound of the

possible values; assuming 100$ and a 20% lower baseline would give 0,04% of the GDP. The

‘inflationary’ risk is all the more low that the LCI produce the collateral of this money and

that it is always possible to change the share of the gap between GHGs emissions and the

convergence trajectory which determines the volume of carbon assets.

The inflationary risk due to a possible ‘carbon bubble’ is also low because even though there

will be a secondary market of CC or bonds backed on carbon assets, their price will be

constrained by the fact that, ultimately the CC will be reimbursed at their face value.

More serious is the moral hazard problem which arises for both banks and project

developers faced with the incentive to fund low environmental quality LCIs or on assets with

high level quality but speculative in nature (real estates). The banks should indeed be

interested in funding LCIs because carbon certificates increase their legal reserves, and the

project developers cannot but be interested in overestimating the mitigation contribution of

their project. The only possible response lies in the quality of the MRT process described in

the previous section and which incorporates, in addition of criteria of environmental quality,

a procedure to secure the consistency of the projects with explicit NAMAS.

But, this risk has to be weighed against the benefits of the system both to trigger a wave of

LCIs and to contribute to sustainable development pathways.

3.1. Drivers of the leverage effect on low-carbon investments

Three mechanisms determine the leverage effect [of the mechanism described in Sections 1

and 3] on low-carbon projects. First, the availability of carbon-asset backed loans backed

carbon-assets reduce the cash-flow risk associated with (large) initial investments for project

developers, since their borrowing capacity is increased. Second, holding carbon assets – the

value of which is stable over time – increases firms’ total value. Third, pooling LCPs provides

for additional leverage. We discuss each of these three mechanisms in turn.

3.1.1. Risk-adjusted profitability of one LCI: a non-linear mechanism

In most economic models, technologies are selected based on net present value

maximization, i.e., on the maximization of the discounted sum of project benefits minus

capital expenditures minus O&M costs. This framework is both simple and easily tractable by

modelers.

35


But a sum over time is also a limited metric for assessing projects. In particular, it does not

fully account for differences in time profiles across projects. For example, two projects with

the same net present value might have very different time profile of net costs: one might

have large investment costs upfront, compensated by even larger benefits over time, while

the other may have much smaller investment cost upfront and much smaller benefits down

the road.

Such difference would not matter under unlimited financing capacity. But in the real world,

project developers have limited capacity to finance projects (be it via debt, equity, or self-

finance). Beyond that point, either their margins become too low, or the dividends they serve

their shareholders become too limited. Either way, the value of the firm is impacted, with,

e.g., risk of bankruptcy or of hostile takeover. The key point is that the “true” cost of an

investment for a firm is highly non-linear. In a first approximation, it is as if there was a line

(defined e.g. in terms of in debt to equity ratio or minimal level of profits distributed to

shareholders, etc.) project developers will stay clear off. In other words, they will not consider

projects in which upfront costs might lead them to cross that line.

As investment costs are in general uncertain—and it is worth remembering that

underestimating investment costs by 20% is standard in large infrastructure projects—project

developers will be even more conservative.20

Figure XX illustrates this behavior. It compares the time profile of net benefits of two

investment alternatives. Investment A is assumed to having a higher net present value than B.

A should thus be preferred to B to maximize the long run value of the firm. But A also implies

higher upfront costs--the probability density of which is represented on the left hand-side of

the Figure. The “danger line” is figured in b1.

The risk of crossing the line is highly nonlinear and here lays one major advantage of the

carbon certificates. In fact, allowing project developers to reimburse part of their loans in CCs

instead of cash amounts to displacing the “danger line” downwards (say from b1 to b2) as

commercial banks can lend the same amount in return for money plus some amount in return

for carbon certificates.

It is graphically easy to show out, comparing the black and dashed surfaces in the curve p

which gives the probability distribution of costs, that the impact of CC on the perceived risks

of A might be very non-linear.

20

The time profile of net costs matters all the more if the project developer is in a “shareholder value” regime in

which short-term financial indicators dominate. Whereas in ‘managerial regimes’ managers have broader latitude

to maximize firms long-run growth.

36


Graph n°2: Risk assessment of projects under a ‘shareholder value’ regime

3.1.2. Pools of low-carbon investments: again non-linear mechanisms

The scaling up of finance for low-carbon projects (LCP) is confronted with several barriers

(Hosier and al, 2010), amongst which:

the fragmentation of climate finance initiatives,

the lack of maturity of low-carbon technology,

the lack of information about economic and financial performances of LCPs,

the instability of climate policy and regulation

All these barriers make low-carbon sector look more risky for investors than BAU sectors.

Such excess-risk perception increases the funding costs of LCPs that may turn to be too

expensive for some projects which will not be able to meet financial closure (De Gouvello et

al., 2011). This is why well-tailored financial instruments are needed to offset such excess-

risk and raise finance for LCPs.

Without pretending to give realistic figures, let us explore the mechanism behind the

leverage potential of carbon certificates to get a fictive portfolio of 10 LCPs funded. We

consider three funding cases:

37


(V) each projects asks individually for a loan to a commercial bank

(VI) a specialized public climate fund is set up to pool fund raising by means of climate bonds

(VII) a collateralized debt obligation vehicle is designed to pool the risks

Table 1 presents the financial features of the pool of LCPs. Each project requires a loan of

100 M$. They are ranked according to their credit rating from AA to BB+. This credit rating is

mainly driven by three parameters: the internal rate of the project if it is successful, its

default rate over 10 years and its recovery rate, which gives the fraction of projects’

revenues that is recoverable in case of default.

The key parameter is the ‘loss given default’: investing 100 M$ in LCP1 exposes to a risk of

losing 0,243 M€ whereas investing in LCP10 exposes to a risk of losing 11,86 M$. A 1G$

invested in the entire portfolio of LCPs is exposed to a loss of US$ 38.7 million and would be

rated BBB.

The performance of the projects in terms of expected emission reduction, listed in the third

column, is assumed to be equal among projects (200 000 ton of CO2).

Table 1: Financial features of a US$ 1 billion portfolio of 10 LCPs. Only 3 LCPs out of 10 are funded

with a loan interest rate higher than 12%. If a carbon-based monetary policy is implemented (with an

agreement on a US$ 20 SCC) then 7 out of ten are funded.

38


a) The limited channel of direct bank financing

If LCPs tries to raise funds by asking individual loan to commercial banks, only the most

profitable projects will have a chance to get funded. Because of missing information about

financial and economic performances of LCPs, commercial banks may require very high

interest rate in order to hedge against perceived risks of LCPs. Assuming that commercial

banks do not know the precise credit rating of projects but only know that this rating can be

comprised between AA and BB+, then they will apply the interest rate corresponding to the

greatest risk, that is BB+ associated with 1186,6 basis points over the risk-free rate. This will

result in an interest rate higher than 12%21 and thus the funding of only the first 3 LCPs of

the portfolio with internal rates of returns higher than 12%. Under those funding conditions,

the 7 other projects with IRRs below 12% will indeed fail to meet financial closure. Public

finance instruments such as concessional loans, public guarantees which aims at lowering

the interest rate may help some of the projects to meet the breakeven point. But the

leverage effect of such instruments is expected to be low because of transaction costs to

tailor financial instruments to each project.

Now, if the carbon-based monetary device presented above, was implemented with say an

agreement on a US$ 20 SCC, and if LCPs completed their expected emission reduction, they

would be rewarded with CC CC valued at US$ 4 million (20x200 000) that can be used to

repay part of the loan. This will result in lowering the cost of debt service and therefore

increase IRR. The IRR of LCP7, for instance, would increase up to 12,5% (108/96) and thus

makes it possible for the project to sustain a US$ 96 million loan at an interest rate of 12%.

For project with IRR below 8% the monetary device will not suffice to meet financial closure.

b) Scaling the leverage of public money invested in a specialized climate fund

Instead of looking for direct bank financing, a specialized climate funds managed by

commercial or development banks, with internal capacity to identify and assess LCPs could

be set up in order to intermediate finance from capital markets to LCPs as suggested by de

Gouvello and Zelenko (2010) with their Low-Carbon Development Facility proposal. The

basic principle is to calibrate the paid-in-capital of such a funds in order to raise a multiple of

this capital by means of highly rated climate bonds, the proceeds of which being lent to

LCPs. Contingent upon the size of the paid-in-capital, this basic financial scheme makes it

possible to turn a BBB portfolio of projects into AAA climate bonds. To sustain US$ 1billion

AAA climate bonds, in our simple numerical example, a paid-in-capital of US$ 38 million

21 12-month EU libor is currently fluctuating around 0,5%

39


would be sufficient to hedge against the acceptable level of loss of AAA bonds. If the

leverage of public funds is defined as the ratio of collected private money over the amount

of public money invested then in this example, filling up the paid-in capital of the funds with

$US 38 million of public money yields a leverage ratio of 26 as it makes it possible to raise

$US 1 billion of private capital. But if public money is too scarce to fill the paid-in-capital,

then it may benefit from the carbon-based monetary instrument. With 2 million tons of

avoided CO2 emissions, the portfolio of LCPs can be rewarded with CC valued at US$ 40

million that could fill the paid-in-capital and act as an appropriate buffer against potential

loss. Note that this mechanism could successfully apply to the Green Climate Fund which is

still looking for a business model to raise US$ 100 billion a year.

Figure 2: A public climate fund to intermediate private capital

40


c) The potential of risk pooling by securitization

Even though the second channel may prove to be cheaper than the first one, it still requires

public expenditures to fill up the paid-in-capital. More sophisticated financial vehicles such

as collateral debt obligations (CDO) could make it possible to fund the entire portfolios of

LCPs in a totally private fashion. The basic principle of such financial vehicle consists of

turning a portfolio of LCPs into different financial products incorporating different levels

(tranches) of risks (from equity to senior AAA debt) sold to private investors with different

risk profiles (from hedge funds to institutional investors). If the CDO matches investors’ risk

profiles as in the example presented in figure 2, then the entire portfolio of LCPs gets funded

by private capital. Starting from a portfolio with an average risk of 387 basis point, the CDO

creates financial products with the same average risk but different expected returns.

Such mechanism rests on the assumption that deep financial markets make it possible to

hedge against risks by means of diversification techniques. Such mechanisms which are

promoted by financial actors such as Bloomberg New Energy Finance (with the proposal of a

so-called Big Green

Bucket) are very enticing as it requires no public money. However, CDOs proliferation have

been key drivers of the last financial crisis and one may be legitimately skeptical about the

ability of sleight-of-hand finance to reach socially desirable goals if it is not carefully

regulated. One basic safeguard would be to forbid the design of cascades of CDO to keep a

visible link between financial vehicle and the underlying risks arising from LCPs.

Figure 2: The private channel of CDOs to fund LCPs

41


3.1.3. LCI backed by carbon assets and firm’s value: back to the Capital Asset Pricing model

Together with making investment with upfront capital cost less risky, both the existence, in

the portfolio of the firm, of assets backed by carbon certificates and ultimately on the carbon

assets with a value guaranteed by the Central Banks is apt to change the strategic planning of

firms. This is easy to show with the simplest version of the capital asset pricing model.

The simplest expression of the economic value added of the firm (EVA) writes, with R the net

return of this asset (after payment of the debt service, k the weighted average capital cost of

the firm and the SE its capital equity:

This expression simply means that, if the firm generates no value if it is not capable to

generate returns higher than the returns expected to pay its capital costs. The lower the

average capital cost of the firm the higher is its value. The average capital cost of the firm is

the weighted average capital cost of its assets, namely the return expected on this asset. The

required return ki of an asset ‘i’ writes, with kf the return of a risk-free asset, km the average

the risk premium associated to the asset ‘i’

the lower is the required return on asset and the higher its contribution to the

value of the firm. This value in turn writes:

This means that is low when the value of co-variance of the value of the asset ‘i’ and of

the other assets of the market portfolio is low. The more a firm holds assets of which value is

stable by comparison with other assets in which it could invest, the higher is its value.

Thus carbon assets can be of strategic interest for firms submitted to the constraint of the

shareholder value, and this might be an important source of the leverage effect of the CC.

3.2. A contribution to a sustainable economic globalization

3.3.1. The macro-financial interest of a stable benchmark

One legitimate concern about the scaling up of climate finance through the creation of

carbon assets will generate inflation and, through the financial intermediaries necessary to

create assets apt to diversify the risks and to finance portfolios of LCPs, facilitate the

emergence of carbon bubbles like the real estate bubbles.

.EVA R k SE

* ( )i f i m fk k k k

( ; ) / ( )i Cov i m V m

42


Actually, the risk of a ‘‘carbon bubble’’ followed by a ‘‘carbon subprime’’ crisis if it turns out

that LCPs do not bring the expected paybacks, is very low. Indeed, while the increase in the

value of real estate assets rested on very low interest rates and was unbound, the SCC value

would be known with certainty. In other words, the emergence of a ‘‘carbon bubble’’

through the assets acting as non-bank banks is blocked by the very existence of a

predetermined value of carbon.

The system we have thus far sketched incorporates two mechanisms that should avoid the

monetary flexibility granted by carbon assets to result in monetary inflation and systemic

risks for the financial and banking system:

- carbon certificates are authenticated by control procedures based on technical

information which do not exist for other investments,

- if CC are traded in a secondary market, their price will stay in a rather narrow margin

of fluctuation around its face value at which the Central Bank accepts it as repayment,

Certainly, the risk of because obviously default payments of a significant share of LCPs

cannot be totally excluded, forcing governments to back the debt in the last resort and

eventually provide ‘‘hard cash’’ as investors would call upon the public guarantee. Countries’

taxpayers would then later pay a debt service due to misdirected and mismanaged projects.

However, the orders of magnitude of this carbon based monetary creation are far lower

than the several percent of the GDP issued by the Federal Bank in the US and the EU Central

Banks to rescue the banking systems since 2008: 0,1% of the GDP of the OECD countries in

2035 and cumulated carbon assets in the balance sheets of central banks amounting to 1,5%

of this GDP.

Technically this risk can be lowered by adjusting the number of carbon certificates available

for each type of project. But, more fundamentally, they have to be appreciated by

comparison with the current situation of difficulty to direct savings towards long-term

productive investments instead of speculative assets.

The basic principle of currency backed on a carbon asset is governments injecting liquidities

into the economy with the help of central banks, provided that the money is used to fund

low-carbon investment. Governments provide a public guarantee on a new carbon asset

which allows the central bank to issue carbon-based liquidities that can be considered as

``equity in the commonwealth''. Such equity pays dividends in the form of ``actual wealth''

created by productive low carbon investments and averted emissions in the short term, a

stronger resilience of the economy to environmental shocks in the long term. The overall,

non-climate related, benefits from monetary emissions based on a stable benchmark can be

43


better appreciated by coming back to one major problem of the growth regime triggered as

soon as financial deregulation has started.

Figure 1 visualizes this problem: the ‘Great Moderation’ of business cycles 22and financial

cycles of far larger magnitude and far longer time span than in the past23. The latter cycle is

measured by the gap relative to trend of an index combining credit growth and asset prices

(a mix of equity, bonds, real estate price indices).

Figure 1. Business and financial cycles in the US (1980-2011)

This misalignment, over long periods of time, of asset prices and very long run benchmarks

has pervasive efficiency costs (and also exchange rates) swamping the signals on which

investors should base their decisions. It is propelled by private credit dynamic fed and its

magnitude is caused by the self-fulfilling beliefs of market participants that prices will go on

moving the way they have gone before. Financial intermediaries are governed by the same

self-fulfilling expectations as their borrowers since they lent money to finance speculative

positions on asset prices took the assets as collaterals of their loans: more credit thus led to

higher asset prices, higher value of collateral, lower perceived risk premiums on loans and

speed up in credit growth.

The asset prices thus cannot be vectors of adjustment in the macro economy. They

exacerbate real disequilibria, as was observed with the cumulative global imbalances in the

balance of payments and in the balance sheets of financial institutions, which receded only

22

The first appearance of the label “great Moderation” can be found in the paper by James Stock and

MarkWatson (2002), “has the business cycle changed and why?”, NBER Macroeconomics Annual.

See also P.M. Summers (2005), “What caused the great Moderation? Some cross-country evidence”. Federal

Reserve Bank of Kansas City Economic Review, n°90

23Schularick M and Taylor A. (2009), “credit booms gone bust: monetary policy, leverage cycles and financial

crises, 1870-2008”, NBER Working Paper, n°15512

44


in the financial crisis. Price reversals arise only through crises that are endogenous as

“booms gone busts” while unknown tipping points shift the mood of market participants

from euphoria to panic.24

If the macro prudential policies are not strong enough to mitigate the impact of the reversal

in asset prices, finance is not self-stabilizing and a single-handed monetary policy only

focused to low inflation alone is not conducive either to macro stability. Real imbalances are

even magnified by the Great Moderation in inflation, because the huge gyrations in asset

prices are real price changes25.

One response is a renewed version of the Chicago Plan 26 but it is politically demanding since

it implies that banks are treated as public utilities. To be safe in any circumstances, they

would be required to buy Treasury securities for a large share of their deposits and lend only

to highly-rated borrowers. The bulk of credit would then be channeled through from

securitized lending and corporate bonds. However, in narrowing the scope of bank activities,

this plan widens the role of financial intermediaries on the wholesale money market with

shadow banks playing the role of liquidity suppliers. It thus moves fragilities from one

compartment of the financial system to the next.

Another response is to anchor money on a basket of commodities like in the Keyne’s Bancor

proposal at Bretton-Woods. The obstacles to such a Bancor remain but concerns behind this

proposal also remain. Carbon-based assets get a large significance in this perspective, since

they can incentivize financial intermediation to do its job of financing the real economy

instead of pursuing capital gains magnified by higher and higher leverage. They are not a

substitute for stricter financial regulation and will not suffice in preventing financial crises

which arose even in the Gold Standard era, while the first brand of financial globalization

spread worldwide. However, they can contribute to the search for a more stable financial

context and this is the reason why, although the issuance of carbon assets should result from

the voluntary initiative of countries, their international recognition matters.

A portion of carbon assets could first be used to capitalize the Green Climate Fund and reach

levels of capitalization out of reach by the only goodwill of the tax payers of the Annex 1

countries. As suggested by De Gouvello and Zelenco (2010) this Fund could issue Green

Bonds to be acquired by institutional investors worldwide27 searching for diversifying their

portfolios in alternative assets. If the Fund could accumulate $100bns up to 2030 and if it

24

Adrian T., Covitz D. and Liang N. (2013), « Financial Stability Monitoring », Fed NY Staff Reports, n°601,

February 25

Michel Aglietta (2014), “l’aggiornamento des politiques monétaires”, in les Banques Centrales, 26

references 27

C. De Gouvello and I. Zelenko (2010), « scaling up the financingof emission reduction projectsfor low carbon

development in developing countries.Proposal for a low-carbon development facility”, Policy research Working

Paper, World Bank.

45


invested in well-diversified projects, so that one can assume that the probability density

function is Gaussian, it would have 99.9% probability that its capital base could absorb its

losses. Hence, it could issue $1trn bonds to leverage its financing and back credit facilities to

developing countries on real wealth and low-carbon investments28.

Carbon assets would then de facto acquire the status of world reserves and this opens a

wider perspective to lower one source of tensions in the economic globalization process, i.e.

the distortions in exchange rates due to the ‘‘war-chest’’ of official reserves accumulated in

the emerging world after the 1980s/1990s financial crises in Latin America and Asia. Those

reserves invested mainly in US Treasury securities were built to protect export-led growth

strategies against exchange-rate appreciation and chiefly as self-insurance against currency

crises. Carbon-based reserve assets could allow these economies to increase and diversify

their foreign exchange reserves in a way conducive to cooperation against a global

externality. This concern was underlined by Zhu Xiaochuan, the governor of the People’s

Bank of China when he called for a SDR reserve-based system in 2010. C. Jaeger, A. Haas and

K. Töpfer (2013) show how this proposal could contribute to sustainable development.

If countries with non-convertible currencies have access to a pool of supranational carbon-

based assets, they would be less inclined to run balance-of-payment surpluses, since they

would get their reserves in proportion to emission reductions they finance domestically.29

3.3.2.Clearing up a foggy business environment and getting the world out of the doldrums

The virtuous cycle, potentially triggered by redirecting savings towards low carbon

investments thanks to a carbon-based monetary tool, cannot be understood without coming

back to the paradox of the coexistence of a vast pool of savings and of over-indebtedness

and its impact on real economies.

Since the financial crisis the world economy has languished. The stimulating plans after 2009

succeeded in supporting 3% growth rate in the US in 2010, after two years of recession.

Growth slowed down to 1,8% in 2011and 2.5%,in 2013, fostering a debate on “secular

stagnation”. The recovery was interrupted in Europe with the Euro zone crisis starting in

2010. Real GDP growth of EU-27declined 0.6% from 2007 to 2012 and an almost zero growth

is in 2013. The large emerging countries (Brazil, India and even China) suffered a lackluster

performance in 2013, expected to be prolonged according to the latest World Economic

Outlook (April 2014).

28

The same mechanism could be used by a European Central Bank recognizing carbon assets emitted by its

members 29

This would also spread the gains from seignior age and reduce the perverse effect that forces the United States

to pump out more US$ assets for global reserves.

46


One key underlying mechanism is the deleveraging of the private sector. Planning horizons

of firms and households have not adjusted to the length of the downward phase of the

financial cycle, which is longer than a standard business cycle. It follows that the economic

landscape has become fragmented in developed countries. Households are still digesting the

impact of the property bust in many countries. Small and medium size enterprises struggle

to get credit, while big corporations are awash with cash they do not know how to use

productively. As a consequence investment has been hit more than overall growth (-14% in

the EU between 2008 and 2012).

A carbon-based financial architecture, instead of crowding out productive investment, could

thus help overcoming the ‘‘Buridan’s donkey dilemma’’ by indicating where to invest in this

subdued business climate. For example, institutional investors like pension funds currently

tend to be cautious enough to avoid getting involved in investments that look safe while

masking ventured assets. It would complement carbon price signals which are swamped by

the regulatory uncertainty about tax reforms, the future of carbon trading systems, the

regulation of infrastructure sectors, the geopolitical sensitivity of oil prices and the volatility

of the currency exchange rates.

3.3.3 Climate policies and reduction of structural imbalances in the world economy

To understand why a carbon-based transformation of the international financial system

might trigger a “green growth” regime it is useful to advocate Schumpeter. He taught that

financial crises pinpoint transitions in growth regimes because the upward momentum

preceding crises piles up distortions in market structures and income distribution, while the

downward resolution phase is the search for the adaptation to an incipient technological

innovation wave. Those industrial revolutions are the sources of long-term growth. They

reshape capital accumulation over the long run because they transform the consumption

patterns and the social institutions. However an innovation wave can take off only when its

promises have captured the animal spirits of finance.

The environment is a potential new frontier of innovation supporting a new growth regime,

if it is conceived as the basis for a new social contract in developed countries and for

eradicating poverty and redirecting the economic catch-up of developing countries. The

boost on economic growth might be significant not only because the concerned sectors

represent a dominant share of investments, but also because they are both critical for social

inclusiveness and inward oriented growth, targeted to local markets.

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The concerned sectors represent indeed 40% of the gross capital formation and the

redirection of these investments is critical for changing development pattern. Let us remind

the orders of magnitude at stake including the supply side energy investments, the demand

side energy investments and the upstream or collateral investments in infrastructure

sectors, material transformation and manufacturing industries: an issuance of credit lines

amounting to 0,12% of the OECD GDP in 2035 would redirect (assuming a leverage ratio of

10 between public money and private finance) about 1000 G$ in 2035 corresponding to

around 8% of the world GCF.

A carbon-based financial architecture could thus to changing the preference of investors

over the last decade for very liquid or speculative options (US treasury bonds or real estate

and commodities) at the expense of genuine investments in future potential growth30. It

would not crowd out productive investment but could help the “donkey” to decide, and

divert part or the savings from speculative options. For example institutional investors like

pension funds currently tend to be cautious enough to avoid getting engaged with products

that look safe while masking ventured assets.

This diversion from speculative options is all the timelier as the context of reduction of

public and private spending to reimburse outstanding debts may generate a failure on the

demand side of the economy. Within this framework, when the IMF or the European Central

Bank intervene to rescue a bankrupt country, part of the financial support could be delivered

under the form of carbon assets, so that it would be conditional on the launching of a wave

of low carbon investments. The difference with the traditional Keynesian compact is that

credits facilities are backed on infrastructures as real assets.

This might have a significant impact or the future of the world economic equilibrium. Over

the past decades emerging economies grounded their economic catching up on export-led

strategies sometimes at cost of backwardness of the domestic infrastructure. Since 55 % of

carbon savings investment would take place in developing countries a carbon-based finance

would result in domestically reorienting a fraction of the savings that currently flow into the

world financial system (from China to the US for example). Implementing a more

‘‘endogenous,’’ inward oriented, growth pattern might become both attractive for domestic

political reasons and less risky, thanks to the expansion of domestic investment

opportunities opened by the low carbon transition.

Another side benefit of the issuance of carbon-based international reserve assets would be to lower

the tensions on exchange-rates. These risks are partly due to the high precautionary reserves

accumulated in the emerging world after the 1980s/1990s financial crises in Latin America and Asia.

30

Ben Bernanke, Governor of the U.S. Federal Reserve Board recognized as far back as 2005:”During the past

few years, the key asset-price effects of the global saving glut appear to have occurred in the market for

residential investment, as low mortgage rates have supported record levels of home construction and strong gains

in housing prices.”

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This “war-chest” of official reserves is a self-insurance to protect export-led growth strategies against

exchange-rate appreciation. Carbon-based reserve assets could then allow emerging

economies to increase and diversify their foreign exchange reserves. They would thus be less

inclined to run Balance of Payment surpluses, since they would get their reserves in

proportion to emissions reductions they finance domestically. This would also contribute to

spreading the gains from seignior age and reducing the perverse effect that forces the US to

pump out more US$ assets for global reserves.

More fundamentally, carbon-based reserve assets would help solve structural imbalances of

the world economy: huge capital flows from China to the US, the catching up of emerging

economies grounded on export-led strategies sometimes at the cost of backwardness of the

domestic infrastructure, undermine the social contract in many OECD countries. Since the

new carbon-based financial products could be attractive as well for private savings of

emerging countries, the carbon-based finance would result in domestically reorienting a

fraction of the savings that currently flow into the rich countries’ banking systems. The

strategic choice for these economies would thus be between a) continuing mercantilist

exchange rate policies and purchasing power gains in favor of reserves accumulation and b)

implementing a more “endogenous”, inward oriented, growth pattern. This second option

might become attractive with a higher guarantee that less export-oriented strategies do not

lower the pace of growth and then trigger domestic social tensions.

A climate-friendly financial architecture would then help pinpoint the thin pathway

between extreme rigor which would freeze economic growth (and throw some regions into

recession) and extreme laxity which would push the burden of debt onto future generations.

It would transform the climate challenge from a pure constraint to a lever for sustainable

growth backed by a ‘green’ content. This would have a critical impact on the developing and

emerging economies which will account for a dominant share of the infrastructure market

over coming decades.

Annex 1 countries would assume their historical responsibility in the climate affair and the

financial breakdown, without putting huge pressure on their weakened taxpayers. They

would do so in a way consistent with their budgetary constraints and their concerns about

employment and social stability. Embarked upon in the form of a forward contract, with

carbon reduction as an effective under layer, governments, industries and trade-unions

would then be interested in the emergence of any form of carbon price.

Conclusion:

To sum up this monetary instrument is tantamount for the central bank to buying a service

of carbon emission reduction at a price justified by society’s willingness to pay for a better

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climate. Carbon-based liquidities can be therefore considered as ``equity in the

commonwealth''. The equity pays dividends in the form of ``actual wealth'' created by

productive low carbon investments and averted emissions in the short term, a stronger

resilience of the economy to environmental and financial shocks in the longer term. The

proposed system would send a carbon price signal (through the SCC) while being politically

acceptable because it does not impose direct costs on firms or consumers. It also stimulates

mitigation efforts efficiently without imposing demands on industrialized country

government budgets. It will also help to divert a share of private savings from speculative

assets to productive low-carbon investments. Hopefully, the scale of this system could be

large enough to make a significant contribution to the global mitigation effort and to

stimulate economic growth

This perspective will never reach the diplomatic agenda, unless it is perceived by the high

level policy-makers as responding to the specific problems of each region.

Let us start with the emerging countries which exert de facto a vetoing power, because their

lack of involvement is a convincing argument in the US and the EU to mobilize public opinion

against significant international commitments. However Brazil, China, India, South-Africa

have the same interest in receiving a support to redirect their infrastructure policies towards

low-carbon and less energy-intensive choices (Shukla and Dhar, 2011). This is a matter of

energy security, of more inclusive regional and urban development and of less exposure to

turmoils of currencies and domestic asset prices by sudden changes in the direction of cash

flows.

China has a specific problem due to the inversion of its pyramid of age between 2020 and

2030 and the fall of its saving rate. It might be trapped, at the same time horizon, in a high

energy intensive carbon pathway which might turn it very vulnerable to any energy shock.

This is why China has embarked in a new stage of reform under the heading of sustainable

growth. An overhaul of the price system to transform the structure of returns and risks,

specifically introducing a carbon price and pushing up the price of electricity and fossil fuels,

is underway. It aims at changing priorities from maximum growth to diversified axes of

development: urbanization targeting new multi-polar cities over 20 years, reducing energy

and carbon intensity in industry and developing high-end services.

Europe is specifically interested in complementing its current fiscal compact by a ‘green

growth’ compact to reinforce a unity currently undermined by trade imbalances amongst

partner countries. An inclusive economic paradigm could be facilitated by the creation of

environment-friendly jobs through the whole range of the productive structure (housing

rehabilitation, recycling, local transports, bio agriculture and preventive health care). Such a

policy has the additional merit of reducing energy intensity, abating carbon emission,

50


stimulate regional demand and diminishing dependency of Europe towards primary

commodity producers. Europe could thus match its own interest with a leading role in

climate negotiations to recover the leadership obtained with the Kyoto Protocol (C. Jaeger et

al. 1998).

Policy lines might move in the US where multiple climate catastrophes, including Sandy that

hurt badly New York City, have revealed the decay of public infrastructures and the lack of

public services in adverse conditions. Yet, vested interests in the US bet on cheap energy due

to massive investment in fracking shale gas. The core issue is whether shale gas will be used

as a “manna from heaven” to maintain their historical development pattern, or as a tool to

facilitate the switching towards low energy-intensive patterns. The upgrading of climate

finance sketched in this paper might incite them to follow the second option given its

economic and geopolitical side-dividends.

One cannot either disregard the palatability of the suggested perspective for the oil and gas

exporters which are the other key players of a long term energy transition under climate

constraints. Depending on the design of the post-2015 climate regime (including the absence

of effective regime), they might perceive climate policy as a threat because of their adverse

impact of the prices of fossil fuels or as a way of escaping the resource curse by using long

lasting rents to switch towards viable industry, agriculture, transport and energy systems.

texto 2 concept note workshop-1

Environment

carbon finance

low carbon transition

low carbon investments

climate negotiations

climate finance

carbon assets

lowcarbon society

climate policies