Financing the Climate Opportunity Fund
Attracting sufficient, low-cost private capital to finance the annual payments of the Fund to member countries will be critical for the success of the proposed mechanism. This entry discusses how this can be achieved.
The Fund will have to have a strong credit quality based on the financial backing of participating countries. This requires a robust political and legal framework as well as the financial strength of participants. Further, it might be optimal for participating countries to collectively provide more than 100% of the required credit support in order to avoid constraining the credit quality of the Fund by the credit of its weaker members. As an example, members could each provide a guarantee for 105% of their respective share of the Fund’s liabilities.
Beyond its credit strength, the Fund will also have to optimize the structure of its liabilities to target various investor groups. This optimization and the operations of the Fund could be carried in partnership with an existing international organization with relevant capabilities such as the World Bank. Offering the benefit of a green, sustainable and socially responsible investment could be an additional attraction on top of the returns paid to investors.
The long-term financial strength of the Fund under various scenarios will be another important consideration for private investors. Checks and covenants could be put in place in order to ensure that the finances of the Fund are sustainable irrespective of future developments. One example would be establishing a cap on total annual payments. If the sum of individual annual entitlements from the Fund exceeds this cap, all payments could be scaled back on a pro rata basis to comply with the annual cap. This could be achieved either by reducing the carbon price or by lowering the individual benchmarks on a pro-rata basis. Lowering the benchmarks is probably preferable to lowering the carbon price as lowering the carbon price would reduce the marginal benefit of additional emission cuts for participants.
A second mitigant to an unsustainable build up of debt by the Fund could be the requirement to cap the Fund’s liabilities to those relating to a certain period on a rolling basis. As an example, if this period would be set at 20 years, all liabilities that relate to the period preceding the past 20 years would always need to be repaid through contributions from participants as opposed to through new debt issuance. Such covenants would also mitigate the risks related to prediction errors i.e. if the actual emissions and finances of the Fund turn out to be considerably different to expectations at the time of its establishment.
Importantly, neither of these covenants would significantly change the motivation of countries to join and to curb emissions. Based on experience, 20 years is more than long enough for decision-makers to heavily discount future obligations in favor of short-term gains. Similarly, even if an annual cap on Fund payments reduces the payment received by an individual country, any marginal reduction it can achieve will still secure it a larger share of the overall payments and hence larger receipts at the expense of other participants. It is worth noting that such a scenario bears similarity to the tragedy of the commons, but in this case the resource that is overused is the Fund’s annual payment pool and the incentive of countries is to cut emissions beyond the level that would maximize their collective short-term benefits defined as the sum of Fund payments less the cost of emission reduction.
The allocation of future liabilities among participating countries will be another important element of the agreement and the Fund’s operations. Our proposal is to allocate liabilities based on participants’ benchmark emission level over time, which probably serves as a good proxy for a fair and effective allocation reflecting the size of countries, their contribution to climate change (at least on a forward looking basis) and their potential to benefit from the Fund’s payment, which should be proportional to their benchmark. This allocation could be further refined for instance by applying different weights to benchmarks of different years or linking the allocation of liabilities to future variables and hence making it dynamic. Of course, a completely different allocation mechanism could also be considered.
Note that the Fund’s liabilities and hence the required financial backing by participants remains contingent on countries reducing emissions to below their benchmark and the size of future costs depends on the sum of these emission savings. To the extent the liability of countries to the Fund could be structured in a way that keeps them off balance sheet for governments under the applicable accounting rules, this would provide an additional incentive for governments to join the agreement.