Climate linkers
In this paper, Chikhani and Renne propose a novel class of financial instruments indexed to climate-related variables, such as global temperatures, carbon concentrations, or sea levels. They call these “climate linkers.” These instruments would serve three main purposes:
- First, they would facilitate sharing (physical) long-term climate risks by providing an alternative and complementary source of reinsurance to the insurance industry’s goals in offering protection, as well as to those seeking to transfer long-term climate-related exposure.
- Second, they will create a novel market for climate risks that could stimulate investors to better understand and incorporate them in their analyses.
- Third, they will provide a source of information on market participants’ expectations regarding future climate. This information would be captured in real-time, at high frequency.
They develop a tractable integrated assessment model (IAM) which can be solved instantaneously and offers quasi-analytical pricing formulas for climate-indexed bonds, swaps, or options.
Equipped with our model, we examine, in particular, climate risk premiums. Because of the insurance provided by a bond (positively) indexed on temperature, investors would demand a lower average return on such a bond than on conventional bonds. Our findings highlight the sensitivity of climate risk premiums to the assumptions regarding (i) damages associated with temperature increases and (ii) feedback effects between temperatures and emissions.
Climate Linkers: Rationale and Pricing
Authors: Pauline Chikhani, Jean-Paul Renne
From: University of Lausanne
The benefits of sustainability-linked bonds
In this paper, Kölbel and Lambillon analyze the benefits of issuing another class of financial instruments related to climate, namely the sustainability-linked bonds (SLB). Unlike the linkers above, SLBs directly contribute to the fight against climate change by providing funding for mitigation or adaptation projects. SLBs have been around since December 2018 and as of June 2022, their outstanding value has grown to over USD 193.1 billion. Unlike Green Bonds which have a “use of proceeds” clause, stating that the financing will be used for green corporate investments, SLBs can be used for general corporate purposes and thus create a financial incentive for issuers to achieve the specified sustainability target.
Our results suggest that issuing an SLB yields an average premium of -9 basis points on the yield at issue compared to a conventional bond, although this premium decreased over time. On average, the savings from this reduction in the cost of debt exceed the maximum potential penalty that issuers need to pay in case of failure of the sustainability performance target. This suggests that SLB issuers can benefit from a ’free lunch’, i.e. a financial benefit despite not reaching the target.
Who pays for sustainability? An analysis of sustainability-linked bonds
Authors: Julian F. Kölbel, Adrien-Paul Lambillon
From: University of St. Gallen; University of Zurich
