Carbon market vigilantes

The case for carbon-linked bonds

"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a . 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

- James Carville, political adviser to President Clinton

One of the challenges that investors must face in managing an exposure to carbon markets is anticipating how governments will respond in the face of political pressure to water down their commitments when the going gets tough. In economic terms, investors run the risk of ‘time-inconsistency’, i.e. that governments will behave inconsistently over time, promising to maintain a strong carbon price today, but relent when circumstances change tomorrow.

Any market that is heavily influenced by government policy is exposed to the risk of time-inconsistency. For climate policy, the risks are especially pronounced since the costs are borne today, yet the gains lie many years into the future and are subject to high uncertainty. A future where the men and women in charge of the incumbent government may have long since been voted out of office, let alone still in the employment of seeking power and influence.

Building on this idea, I first introduced my model for how to think about the price of carbon in Carbon is an emerging asset class, but what is it?. In the article, published in January 2022 I outline why the carbon price in a regulated compliance market is best thought of as a currency, one built on trust that the government will remain committed to a strong carbon price, even when political considerations might steer them otherwise: