Stockholm (NordSIP) – Ensuring their ability to smoothly navigate the energy transition is a priority for large global investors and policymakers. In a recent research paper, Ulf Erlandsson, CEO and Founder of the Anthropocene Fixed Income Institute (AFII) notes that there is “a substantial disconnect between investment exposures and the success or failure of policymaking”.
According to the article, an asset owner that believes that market-wide risky asset returns will be lower and/or more volatile in case of a failed energy transition has few ways to hedge the portfolio accordingly. Politically, while governments may want to transition their economies the long-term financial benefits of doing so may come in conflict with short-term electoral considerations. A non-political commitment mechanism could improve the credibility of transition promises.
Erlandsson’s research article introduces a new type of bond called a Transition Linker, which allows investors to hedge risky asset return correlation with national energy transition progression. These proposed securities share features with inflation-linked bonds, convertibles and other performance-linked bonds, and is a sovereign bond where the coupon level adjusts in several steps if the issuer under- or outperforms vis-à-vis externally committed transition decarbonisation targets.
“We show how the transition linker can be useful in asset allocation with the investment hypothesis that risky asset returns will be lower and/or more volatile in case of an unsuccessful transition. At the same time, the linker provides cost-of-capital incentives for the issuer (the government) to generate policies that increase the transition likelihood,” Erlandsson explains.
“The linker can also be used to derive implied probabilities of reaching transition targets, providing investors, the general public and the issuers themselves important real-time information on transition progress,” Erlandsson continues.
The paper also develops a pricing approach for transition linkers and discusses various structural implementations to accommodate traditional mainstream fixed income books. The article also includes the analysis of a hypothetical transition linker format for the case of Japan, an already active sovereign issuer of inflation linked and transition bonds.
“For issuers of transition linkers, there are several advantages. First of all, successful achievement of targets will lead to lower cost-of-debt than in the vanilla debt case. More ambitious targets will further lower that cost. Second, transition linkers will provide a much more timely and objective measurement of the credibility of transition plans. This could help mitigate an ever-present critique of transition measures. Thirdly, transition linkers can be highly standardised and are general corporate proceed type of bonds, avoiding costly and time-consuming programs to track bond proceeds and impacts,” Erlandsson concludes.
