Insuring the Rain Forest with Green Bonds - Part II

Summary

In a previous article we discussed the importance of the UN-REDD Programme as well as the obstacles to its further implementation.  Recognizing the impact that the retreat of the tropical forests is having on global warming, the United Nations launched the UN-REDD Programme, Reduced Emissions from Degradation and Destruction in 2008 to help support countries REDD+ 

Analysis

In a previous article we discussed the importance of the UN-REDD Programme as well as the obstacles to its further implementation.  Recognizing the impact that the retreat of the tropical forests is having on global warming, the United Nations launched the UN-REDD Programme, Reduced Emissions from Degradation and Destruction in 2008 to help support countries REDD+ efforts, which is a mechanism that seeks to align a number of disparate constituencies, giving each an economic reason for maintaining the forest and thus benefiting the environment.  The essential goal of the Programme is to make the maintenance of the tropical forest more profitable than its destruction. The REDD mechanism received great support at the recent Conference of the Parties at Copenhagen and was a centerpiece of the resultant Copenhagen Accord.  REDD carries benefits with it beyond its carbon emissions focus; loss of forests worldwide has put strains on the lifestyles of local communities and indigenous peoples.  Loss adversely impacts biological diversity and ecosystem services.

The successful implementation of any REDD program requires several separate and disparate groups to act together, each for their own individual benefit; the indigenous population, local and federal governments, the United Nations and investors.  The benefits to these groups are significant; the indigenous people get improved roads, schools and hospitals while maintaining their homeland in a relatively pristine state, the local and federal governments will not have to spend resources to develop infrastructure while also benefiting from the improved political stability thus reducing the need for significant security expenditures, the United Nations is able to positively impact the environment through a reduction in global warming, and investors can reap significant returns on investments, often in excess of ten times the original investment, that, in most cases, are only in the ten million dollar range.

While the returns alone should appeal to investors of all types, and the ecological component should specifically appeal to investors who have a humanitarian or green mandate as part of their investment guidelines, there is one specific industry that, more than almost any other financial service industry, will be impacted by the forthcoming changes in the global climate, the insurance industry.  The entire insurance industry is based upon the proper analysis of large pools of information leading to a determination of risk, how to provide protection for that risk and how to price the product protecting that risk in a profitable way.  The insurance industry relies on its many actuarial tables when pricing products.  Actuarial tables are based upon long term data, seeking to establish patterns of consistency that will allow the insurance companies to properly determine future payouts etc.  The actuaries who develop these tables love stability. Unfortunately for the insurers, they are facing instability in the one arena that will most impact their actuarial tables, essentially rendering their actuarial tables obsolete, the global climate.  As a result of global warming peoples’ lives will be shortened or lengthened, storms will get more or less frequent, crops will or will not flourish; the problem is, no one knows what the exact impact will be, but they know there will be an impact.  The one certainty is that the insurance industry's profitability will be hurt as a result of the climatic uncertainty.

What can insurance companies do to mitigate this risk?  Many industry leaders have been advocating for the industry to address global warming at its source with new products and business practices that reduce emissions.  Green Street Partners, together with some of its clients, have developed an innovative bond program that will facilitate investments into REDD programs.  As noted above, one of the largest single contributors to global warming is the destruction and degradation of the tropical forests.  The destruction of a tropical forest negatively impacts the environment on a few levels; the tree that is felled can no longer absorb carbon out of the atmosphere and a felled tree may end up releasing its stored carbon when it is burned. Therefore, there is now a tremendous focus on the drivers of deforestation and placing a value on forests as an alternative to deforestation.  REDD programs address these concerns as they allow for the maintenance of the forest through proper forest management, generation of income from carbon credits and selected tree harvesting and logging.

Consequently there is a compelling need for new, creative investment products that will attract private sector investors.  While there are green sectoral bonds currently in the marketplace, none are built around a sustainable REDD program.  Revenues from a REDD program include forest management, carbon credits and eco tourism, all of which can combine to create an appealing financial instrument for private investors seeking both safety and yield while supporting the maintenance of the tropical rainforests which are critical to the reduction of global warming.

Despite the obvious benefits of REDD programs, private investment in this sector has been relatively negligible to date.  In order to change this dynamic Green Street Partners has developed a template for a green bond with the proceeds to be used for an investment in a REDD program.  The proposed green bond will have a GIC, a guaranteed investment contract that guarantees repayment of principal and interest and are typically sold by insurance companies, that will enhance the bonds rating well into the investment grade category. The hypothesis is a 5-10 year bond secured by the cash flow derived from the carbon credits generated under the REDD program.  With a GIC wrap and a market coupon this instrument should get an AA or AAA rating.  Depending on the country where the REDD program will reside there may be a need for political risk insurance but that will be factored into the pricing.  It is important to note that REDD programs, managed properly, allow for the careful cultivation of the forests, thus there can be several revenue streams in addition to that generated by the carbon credits: timber, eco tourism, R&D explorations and the like.  Additionally, the fixed yield can be augmented by a special return tied to the price of carbon and applicable to the carbon credit industry.  The insurance industry is uniquely positioned to both implement and augment this green bond concept.  This new product will provide the insurance industry with a conservative, environmentally favorable investment vehicle that companies in the industry can use to diversify their portfolios in a socially conscious way while reaping benefits from several sectors, including public relations and return on investment, which should prove to be too meaningful for the industry to ignore.