Texto 2 concept note workshop-1

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ESTE TEXTO NÃO REFLETE UMA POSIÇÃO DA SECRETARIA DE ASSUNTOS ESTRATÉGICOS
A monetary based financial device to trigger
a low carbon transition and a sustainable
economic recovery
Zero order draft of a study funded by the Caisse des Dépôts et Consignations, Entreprises pour
l’Environnement under the umbrella of Entreprises pour l’Environnement
This draft has been written by Jean Charles Hourcade, Michel Aglietta (Cepii) and Baptiste Perissin-
Fabert, with important inputs from Ruben Bibas, Christophe Cassen and Franck Lecocq (Cired), Igor
Shishlov, Camille Ferron, Romain Morel, Ian Cochran (CDC Climat Research)
Work in progress and under review: not to be quoted
Workshop "Innovative solutions for climate finance, the energy
transition and a EU narrative"
Co-organized by Centre CIRED and IASS Potsdam
July 8th and 9th,2014

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Title: A monetary based financial device to trigger a low carbon transition and a
sustainable economic recovery
Introduction: Carbon Finance and the ‘paradigm shift’ in Climate Negotiations
1. Climate policies in an adverse context: turning the question upside-down
1.1. About the nature of the ‘funding gap’
1.1.1. Assessing the orders of magnitude: incremental vs redirected investments
1.1.2. The nature of the tensions, their heterogeneity and context dependency
1.1.3. Tensions not specific to the 450 ppm scenario
1.1.4. Tensions symptomatic of a deeper re-direction problem
1.2. The rationale for a climate architecture using a financial-monetary device
1.3. Basic principles in a nutshell
2. Components and design of a financial architecture aligning climate and development
objectives
2.1. The Value of Avoided Emissions : a trajectory of notional prices
2.2. Voluntary commitments and pledges; creating a “pull-back” force
2.3. Transforming the carbon based liquidity into real wealth
2.4. Using a diversity of canals to redirect savings
2.5. Supporting the Namas, the specific contribution of the Green Climate Fund
3. A virtuous circle between environmental, economical and macro-financial integrity
3.1. Drivers of the leverage effect on low carbon investments
3.1.1. Risk-adjusted profitability of one LCI: a non-linear mechanism
3.1.2. Pools of low-carbon investments
3.1.3. LCI backed by carbon assets and firm’s value: back to the Capital Asset Pricing
model
3.2. A contribution to sustainable economic globalization
3.2.1. The macro-financial interest of a stable benchmark
3.2.2. Clearing up a foggy business environment and getting the world out of the
doldrums
3.3.3 Climate policies and reduction of structural imbalances in the world economy
Conclusion

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Introduction: Carbon Finance and the ‘paradigm shift’ in Climate Negotiations
In the succession of Conferences of the Parties since 1995, the Cancun conference (COP-16)
marked, a turning point. It called for ‘‘…a paradigm shift towards building a low-carbon
society that offers substantial opportunities and ensures continued high growth and
sustainable development’’ (paragraph 10). It introduced a notion of ‘equitable access to
sustainable development1
(EASD) “in the context of “shared vision for long-term cooperative
action” and ‘global peaking of GHG emissions”.
This perspective being an shifts the negotiations away from adversarial competitive game
among nations for deciding who shall be allocated “how much” of the remainder of the
emissions budget? It calls for a cooperative exercise linking climate policies to other global
and national development issues in a diversity of political, social and economic agendas.
To serve this new paradigm, it establishes a Green Climate Fund (GCF) devoted in part to
funding low-carbon development projects (LCPs) in non-Annex 1 countries, their adaptation
and capacity build up. This GCF is meant to support ‘‘one or more market-based mechanisms
to enhance the cost effectiveness of, and to promote, mitigation actions’’ (paragraph 80).
The establishment of the GCF is a political pre-requisite for overcoming the distrust
cumulated overtime in climate negotiations. Despite its contribution, the Clean
Development Mechanisms (CDM) did not suffice in satisfying the requests of non–annex 1
countries because its revenues were suspected to remain low given the uncertainty about
the deployment of a world carbon trading system, the will of the EU to limit carbon trading
through concrete ceilings and the fact that the only provision of the Kyoto Protocol ‘Article
12(8)) to cover administrative expenses and the costs of adaptation was the payment of a
share of the proceeds of the CDM2
and not of the carbon trading amongst rich countries.
However the GCF is at risk of becoming a new source of misunderstanding. First, pressures
on public budgets in Annex 1 countries after the financial crisis cast doubts about the
amount of funds it will mobilize. Second, given their orders of magnitude at stake, the
financial flows for a transition towards the 2°C objective cannot be provided by the GCF
alone. Third, the context of ‘depression economics’ (Krugman 2009) and of world re-
equilibrium of economic force relationships undermines the political acceptability of large
North/South transfers. Fourth, in this context, many Annex 1 countries will be reluctant to
really engage their own transition, both because of a social resistance to explicit or implicit
carbon pricing, of concerns about competitiveness and employment and of a priority given
to the debt problem and the stability of the banking systems.
1
UNFCCC Decision 1/CP.16, para. 1.6, http://unfccc.int/resource/docs/2010/cop16/eng/07a01.pdf#page=2 (Accessed on
November 22, 2013)
2
The Brazilian proposal of a compliance fund was not retained and the perspective of a restoration fund to
unlock the discussions came too late at COP6

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Waiting for the re-establishment of a stable growth regime would mean the end of climate
policies because of the uncertainty about the date of a re-establishment credible enough to
create a political ambiance conducive to climate policies. Without an early redirection of
their investments dynamics, emerging economies will soon be locked into carbon-intensive
development patterns. The evidence of this lock-in will then be an argument used in
developed countries for not engaging a fast refurbishment of their existing capital stock.
This study starts from the intuition that the only way out to solve the contradiction between
the urgency of climate action and the fact that it cannot be on the top of real political
agendas, it is logical to examine it through the lens of the climate agnostic policy-makers.
Through this lens, climate action will be worth undertaking, beyond symbolic gesticulations,
only if it helps to respond to short term concerns like poverty alleviation, the stability of
financial systems and the world economic recovery. This does not come to push climate
change into the background. This comes, on line with the UNFCCC political agreement, to
tackle it in the perspective of sustainable development and of the repeated calls for Green
Marshall plans or Green Growth since the nineties.
In a first section we show why, given the deep transformations required by the 2°C targets,
climate finance cannot remain a marginal department of global finance. In second one we
sketch the components and the design of a climate-friendly financial architecture and we
examine, in a third section, the conditions under which it can trigger a virtuous circle between
environmental, economical and macro-financial integrity over our century.

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I
Climate policies in an adverse context? turning the question
upside-down
1.1. About the nature of the ‘funding gap’
1.1.1 Assessing the orders of magnitude: incremental vs redirected investments
An indicator of the problem to be solved is the gap between the US$ 100 billion a year by
2020 to which 2020 Annex 1 countries committed to at Copenhagen and the $15 billion per
year envisaged by the EU member states in a first step. Applying the same share of the GDP
(0.082%) to all Annex I countries would lead to $31 billion transfers to non-Annex 1 countries.
Although representing only about one third of the commitments, they would increase by one
third pre-2008 overseas development assistance, hence the temptation of simply
greenwashing existing transfers.
This is all the more embarrassing that the real ‘funding gap’ at stake is significantly higher.
The US $140–$175 billion a year by 2030 appraised by the World Development Report
(World Bank 2009) actually correspond to US $264–$563 billion upfront financing needs, 1,9
3,2 . The former figure assesses the payments due over the duration of the projects to cover
capital and operation costs, including the interest to be paid to a patient lender; the latter,
between 1,9 and 3,2 higher is the cash necessary to cover the cost of the equipments before
they enter into operation. Hence, the funding gap would not be 66% of the needs but
between 82 and 89% of the needs.
Moreover, the incremental investment costs are only the tip of the ‘financial iceberg’. Its
hidden part is the redirection of investments flows. If the capital cost of a given quantity of
‘clean’ electricity is say 30% higher than this of a coal plant, the real amount of investment
to be redirected is 130%. Moreover, higher energy efficiency and lower consumption of end-
use energy will not be achieved without redirecting investments in infrastructure, material
transformation and manufacturing sectors. This reassessment of the orders of magnitude at
stake does not necessarily mean that the challenge is impossible to meet. It means that
changing the climate policy paradigms calls for changing its economic framing.
To understand why and how, we conducted, with the IMACLIM-R model and in collaboration
with the team of the IEA in charge of the World Energy Outlook, numerical experiments for
twelve countries and world regions: USA, Canada, European Union, Rest of the OECD, Russia,
Middle-East, Africa, Brazil, China, India, Rest of Asia and Rest of Latin America. The results
are for 2035 assuming policies starting in 2010. Thus, they should be interpreted as
meaningful over a t+25 time period rather than for a precise date.

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1.1.2 The nature of the tensions, their heterogeneity and context dependency
In this exercise, thanks to the hybrid nature of IMACLIM, we can impose the technical
structure of the energy system projected by the three WEM scenarios (technical coefficients,
fuel mixes, energy intensity, energy costs, capital costs) to four macroeconomic contexts
(see Table 1). The WEM scenarios are a CPS scenario taken here as a baseline, a NPS scenario
corresponding to efforts to internalize environmental concerns and security issues and a 450
ppm scenario. The four macroeconomic contexts retain the same overall productivity trends
as WEM but are characterized by different assumptions about:
1. The savings rates: a) savings rates derived from World Bank (2013) and exogenously
imposed to the model b) savings rates endogenously calculated by the model to provide the
investments required to fulfill expected final demand
,
2. The international flows of capital: a) a “balanced capital flows” scenario which
assumes the reduction to zero of net capital flows of all regions in 2020 and b) an
“imbalanced capital flows” scenario with a linear reduction of imbalances by 2100 ( ⅔ of the
original imbalances persist in 2035)
Exogenous saving rates Endogenous saving rates
Balanced capital flows Exo – B End – B
Imbalanced capital flows Exo – I End – I
Table 1 – Macroeconomic context
The four macroeconomic contexts logically result in different growth rates for each the
world region (see Annex 1). What might be of surprise is that, at the world level, the
aggregate GDP growth rate in the 450 ppm scenario is slightly higher than in the CPS
baseline in whatever macroeconomic context. This little gain should not be over-interpreted
but it means that comparing 450 ppm scenarios to non-optimal baselines changes the
assessment of the interplay between climate policies and growth.
Setting aside the case of oil & gas exporting regions3
, the small gain registered in the energy
importing countries, is driven by three major mechanisms a) the recycling of the revenues of
carbon prices into lower household’s taxes b) the postponement of tensions on oil and gas
which leads to lower costs of fossil energies and lower volatility of their prices and
c) optimistic assumptions on energy efficiency which comes to inject of a higher productivity
of the energy production factor.
3
Logically, the 450 ppm scenarios leads to lower GDP growth rates for these regions except in scenarios with endogenous
savings where lower revenues from oil and gas exports are compensated by high energy efficiency gains, a higher share the
GDP invested in non-energy industry and a higher domestic demand for non-energy products. This can be interpreted as the
end of the resource curse syndrome.

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One reason why this reassuring picture should not be over-interpreted is that this type of
modeling experiment does not capture the possibility of funding shortages: the energy
supply and demand of the WEM scenarios are imposed, triggering the required investments.
The judgment on the plausibility of a frictionless deployment of these scenarios can thus be
formed, ex-post, through the analysis of some macroeconomic indicators.
At the World level, the needs of energy related investment are lower, in 2035, in the
450ppm scenario than in the CPS baseline. This is not as paradoxical as it seems since a far
lower energy demand leads to lower energy supply (-40%). But this result is very unevenly
distributed with drastic falls of energy investments in the O&G exporting regions due to
lower necessity to invest for the expansion of export oriented oil and gas capacities. In these
regions the share of the energy investments over the GDP passes from between [36% -
47.4%] in the CPS scenarios to [27.7% - 35.5%] depending on the macroeconomic context.
In the other regions, the incremental investment costs to achieve a 450 ppm target in are
significant. They are between [14G$ - 42G$] in the US, [35G$ - 65G$] in the EU, [90G$ -
155G$] in China and [45G$ - 58G$] in India and [??G$ - ??G$] for Brazil4
. The increase goes
along with a structural change of these investment with a share of the demand-side
investments multiplied by 2.6 on average between the CPS and the 450ppm scenario:
multiplication by 3.25 for the EU, 2.9 for China and India, 2.3 for the US (which can conduct a
higher share of their decarbonisation through gas).
One first vision of the macroeconomic implications of these figures can be derived from the
evolution of the share of energy investments on GDP between the CPS and the 450 ppm
scenarios in different macroeconomic contexts. This evolution represents a modest drain on
GDP of [0.1% - 0.13%] for the US, [0.6% - 0.11%] for the EU, [0.21% – 0.34%] for China and
[0,57% - 0,86%] for India5
. This does not means that the transition will be easy; the GDP is
not a ‘jelly’ easy to manipulate and even a transfer lower than 1% might be difficult to
achieve. This means that a low carbon transition does not require a huge pressure on the
consumption levels of current generations and is not primarily a problem of trade-off
between current and future generations.
A good indicator of potential tensions is the variation of the share of the energy
investments in total investments. The ratio between the maximum and the minimum values
of this indicator in our scenarios is 1, 25 for the US, 1,38 for the EU and 1,63 for China for
example; these orders of magnitude are far from being marginal: the higher this ratio, the
higher the tensions on real interest rates and the lower is the probability to get the energy
4
Given the level of aggregation of IMACLIM-R we do not provide results for the non-energy exporting countries of Africa
and of the rest of Oecd, Latin America and Asia. However, the range [??G$ - ??G$] for these three major economies is
consistent with the US $264–$563 billion upfront given by the WB (2009) for the totality of the developing world
5
The drain is higher in emerging economies because of a higher energy intensity of their GDP and because they are in a
‘catch-up’ phase with a high dependence upon energy intensive sectors (cement, steel, glass, non ferrous).

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investments funded or, in case of strong political will imposing their funding, the higher the
risks of crowding out other investments.
1.1.3 Tensions not specific to the 450 ppm scenario
Analyzing the share of energy investments on total investments shows an intriguing result.
The dispersion of this indicator is lower comparing the three WEM scenarios for the same
macroeconomic context than comparing the same WEM scenarios in the four contexts. For
the world, it reaches 34.8% and 28.6% for the NPS and 450 scenarios respectively, whereas
the dispersion drops to 16.2% to 22.0% if we compare each energy scenario for each of the
four macroeconomic contexts.
The consequence is that, if we classify the scenarios in descending order of the share of
energy investment on total investments displayed in table 4, we find, for example for the
USA, a classification with two 450 ppm cases on the top but followed by two CPS scenarios
and one 450 ppm scenario in the bottom third of the list. The ranking is:
450/450/CPS/CPS/NPS/NPS/450/CPS/450/NPS/CPS/NPS. Therefore the 450 ppm scenarios
do not always appear as the most strained. The CPS scenario itself, in certain contexts, can
trigger financial tensions and this casts doubts about its frictionless deployment. The 450
ppm scenarios even provide a hedge against macroeconomic uncertainties with, in almost all
regions, a lower dispersion of its share of energy investments in total investments.
This changes the way of addressing the funding of the low carbon transition since it might be
that the baseline will not materialize in the real world. Comparing the CPS and 450 ppm
scenarios without considering the uncertainty about their deployment becomes misleading
and the very notion of incremental costs, analytically useful, a fragile decision criterion. The
question is rather whether the policies supporting the 450 ppm scenario can contribute
overcoming the financial barriers to the expansion of energy systems and redirect to the
energy sector part of the available savings which currently go ‘elsewhere’. More precisely, if
they lead to a slightly higher share of the GDP invested in production, then the low carbon
transition could be conducted without crowding out investments on other economic sectors.
1.1.4. Tensions symptomatic of a deeper re-direction problem
Passing from framing the transition towards a low carbon economy in terms of ‘how to fund
incremental investments’ to ‘how to redirect investments’ is all the more important that the
demand-side of this redirection concerns sectors like building, transport, material
transformation, and a part of manufacturing industry. These sectors represent 41% of the

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world gross capital formation (see www.EUKLEM.net). A back of the envelop calculation 6
shows that accounting for the induced investment in these sectors augments by 20% the
incremental investments of the low carbon transition and, more importantly, leads to
redirected investments7
eight times higher the incremental investments.
Here lies the reason why, unless the UNFCCC objectives are de facto abandoned, the climate
policies cannot be isolated from the overall macroeconomic and industrial policies. This
diagnosis opens paradoxically an opportunity to change the current intellectual atmosphere
vis-à-vis climate policies. These imply indeed a redirection of investments within the energy
sector, but the deployment of the energy sector itself, independently from climate policies
confront a problem of redirection of investments within the production sectors, and the
development of these sectors in turn confront a problem of redirection of savings.
It climate policies are part of a larger problem of redirection of savings and investments, it is
thus logical to examine them through the lens of the climate agnostics primarily concerned
by the stability of financial systems and of the world economic recovery after the 2008 crisis.
Their concerns are legitimate because the symptoms that led to unstable financial
dynamics are still prevalent:
- The ultra-low interest rate policy of the central banks in advanced countries has
exacerbated the search for yield higher than ‘public bonds’ by holders of cash (financial
departments of multinational companies, institutional investors like mutual funds or pension
funds). Those holders have moved in and out of capital assets because they are very
sensitive to tiny changes in the communication of central banks that might hint to future
changes in interest rates. In wholesale short term money market, prior to 2008 these volatile
capital flows were channeled through wholesale funding instruments (ABS and CDOs) issued
by shadow banks (broker-dealers, conduits and SIVs8
). These instruments have disappeared
but the mistrust in the banking system has motivated continuous build-up of institutional
cash pools. The high demand for safe short-term instruments provoked an increase of the
value of bonds and driven to zero their interest rate. The shortfall of such instruments was
aggravated because foreign central banks buy them for reserve keeping. Ultimately there a
mass of liquidity higher than bonds that can be backed on public assets.
6
We assume that, in 2020: a) 25% of the investments of the households, business and financial intermediaries in
residential and non residential infrastructures is redirected towards low carbon options with an extra unit cost of
5% b) 10% of the investment of the transportation sector (a low percent because of the low substitutability
between rail based and road bases transport) with an extra unit cost of 10% c) 33% of the electricity and gas
investment with an extra unitary up-front investment of 20% d) a decrease by 10% of the investment in mining
and carrying d) 20 % of the investments in machines
7
If, for example, the investment on a ULCOs technology for steel industry is 30% higher than in the basic
oxygen steelmaking with coke and blackfurnace, this is 100% of the investment which has to be redirected
8
ABS stands for Asset-backed securities
CDOs stands for Collateralized Debt Obligation
SIV stands for Special Investment Vehicle
LOLR stands for Lender-of-last-resort

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- The way governments and central banks have dealt with casualties due to excessive
risk- taking did not succeed to combat the too-big-to-fail syndrome and the imposition of a
higher equity capital on total assets to hedge against ratios the risk of losing control remains
an unachieved business. Therefore existing cash pools are largely outside banks because of
widespread distrust. They have been estimated by the IMF (Polszar, 2011) at $3400bns in
2010 against $3800bns in 2007 and $100bns in 1990)9
.
- Firms operating in a business environment which prioritizes, since the eighties, the
shareholder value against the maximization of the long-term growth typical of a ‘managerial
economy’ (Roe 1994). This a main cause of the obsession for liquidity. The profusion of cash
in large companies fuelled bursts in dividend distribution and share buyback to boost equity
prices. It contributes to exacerbating unqualities of income distribution. Investment rates
have thus declined with lack of effective demand and flagging credit demand by SMEs is met
with bank reluctance to lend. Investors face a kind of ‘‘Buridan’s donkey dilemma10
, the
donkey which died of hunger and thirst because it hesitated too long between eating oats or
drinking water: they do not know in what long term investments the money should go.
Viewed through this lens, the financing problem posed by the low carbon transition does
not come from a lack of fund. It comes from the inability of the present system of financial
intermediation to fund productive investments. Higher and more stable growth would be
possible by resorbing excess liquidity via heavy taxes which is highly unlikely, or by matching
Treasury bill issuance and the volume of cash pools which is not recommendable in time of
consolidation of public debts or by expanding the umbrella of the LOLR4
to non-banks which
is not a palatable option either. The only viable solution is creating intermediaries able to
bridge long-term assets and short-term cash balances, the preferred support of saving, so
that they are invested productively, without incurring the risks of excess leverage, maturity
mismatch and interconnectedness (illiquid long-term assets financed by short-term,
unsecured liabilities of money market funds) that have fostered the systemic crisis.
The question though is whether climate finance can provide the opportunity to create such
an intermediation. If it can lower the investment risks of low carbon projects and redirect
savings towards productive activities, it will reduce the magnitude of the cash-pools and fuel
the world growth engine by shortening the trickling down of current savings to productive
investments.
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They are held by 1) global non-financial corporations and institutional investors outside the banking system 2)
mutual funds and hedge funds (managed liquidity and cash collateral associated with securities lending) 3) the
overlay of derivatives linked to derivatives-based investment 4) wealthy individuals and endowments.
10
This legend is a caricature of Jean Buridan, a theologian at the Sorbonne in the 14th
century, who argued that a
wise conduct is to postpone decisions up to the availability of the necessary information. The legend counts the
sad story of a donkey whodies hesitating between oats and the pail of water placed at equal distance from him. A
non-directed inflow of money comes to add more oats and water in front of it without breaking its hypnosis.

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This would be all the more timely that the globalization pattern is changing. What the OECD
development department calls “shifting wealth” is indeed taking a new course. Export-led
growth and reserve accumulation in emerging economies fuelled by excess credit growth in
a host of OECD countries is being replaced by more inward-focused growth with the
widening middle class in emerging economies, pressures for higher wages and services and a
huge investment demand driven by urbanization and environmental concerns.
This mutation also concerns international financial intermediation. European banks have
retrenched on their home borders since the Euro zone crisis and no longer borrow dollars via
their US subsidiaries to relend worldwide. Faced with this vacuum Asian development banks
and sovereign wealth funds are stepping up their ventures. A financial model emerges,
based on long-term bilateral financial contracts at agreed upon prices backed by
government guarantees and on Bond issuance substituting national currencies to dollar.
1.2. The rationale for a climate architecture using a financial-monetary device
The diplomatic momentum that led to the Kyoto Protocol was not a result of an ex ante fully
fledged vision of a global climate architecture, although it was on line with views early
developed by, for example, Grubb (1990) or Agarwal & Narain (1991). It was, rather, the
outcome of a succession of diplomatic fait accompli (Bodansky, 2001): inter alia the principle
of common but differentiated responsibilities (Article 3.1, UNFCCC, 1992), a quantity-based
approach to settle countries’ commitments that exempted developing countries from such
commitments prior to 2012 (Berlin COP 1, 1995), and the possibilities, under Articles 17 and
12 of the Kyoto Protocol, of carbon trading between countries and of a project-based Clean
Development Mechanism (CDM) between developed and developing countries. This
architecture was meant to organize North–South transfers large enough to spur the South to
make significant quantitative commitments post-2012.
In the immediate aftermath of the Kyoto conference11
, the Kyoto Protocol was often presented as
implying a world carbon market generating the same carbon price imposed on all the carbon
emitters. This mental map was validated by the fact that most modeling exercises assume carbon
markets as mechanisms connecting ‘technical abatement cost curves’ all over the world as if
decarbonization was operated by “GHGs abatement factories” selected in a descending merit
order12
. This mental map is misleading because the abatement factory metaphor:
11
The KP actually follows stricto sensu a subsidiarity principle: a) emissions allowances are allocated to nation states b)
countries select domestic policies to meet their emissions caps given their national development objectives, and c) an
international carbon market instituted amongst governments facilitate them to meet their commitments cost-effectively.
This inter-countries market would generate a world carbon price, but domestic carbon prices could differ. A country
meeting its GHGs emissions targets without carbon prices but through traffic regulation (e.g. speed limit), housing programs
or subsidies to low carbon electricity could nevertheless participate in international carbon trading.
12
Many sources of the wedges between technical, social and macroeconomic cost curves have been underlined as early as
the IPCC SAR (1996, chapter 8), and encompasses a rich array of literature about the double dividend hypothesis which
assumes that fiscal reforms can lower the social cost of environmental policies and can even turn into a gain. For a short

12
- It implies as though an Indian peasant was selling permits to the French tourist flying to the
Seychelles. But the transaction is not that simple. First, say 50€/t, carbon price directly impacts the
fuel for irrigation, with a possible direct non-linear negative effect on the earnings of the Indian
peasant. Second this peasant will be affected by the propagation of higher energy prices throughout
the entire Indian economy. Finally, many intermediaries might divert the money flows before it
reaches peasant’s pocket.
- It ignores the wedge between technical costs, GDP variations and welfare variations caused
by: i) incomplete and fragmented markets (not only energy markets but also other markets, e.g. real
estate markets or a dual economy in perpetual restructuring), ii) structural unemployment, iii)
absence of compensation mechanisms for the adverse distributional effects of policies, iv) distorting
fiscal systems, v) weak policy regimes, vi)under-protected property rights, and vii) investments risks
in unpredictable business environment13
. This is the place where domestic policies14
addressing these
wedges are critical for breaking the mechanical link between “burden sharing” and “target setting”.
It assumes that micro decisions are made in function of levelized costs which is a misrepresentation
of the rationale of firms’ decisions in a business environment very sensitive to the ups and downs of
the shareholder value. In such a context, options are not selected by firms in descending merit order.
They are selected in function of their impact on the value of the firm. Risk adjusted costs are critical
for this impact and are dependent upon the magnitude of the upfront costs, upon the time profiles
of the difference between revenues and operational costs and upon the risks associated with each of
these three parameters.
The first of these reasons questions the capacity of monetary compensations to mitigate the
heterogeneity of adverse effects of higher energy prices; the second questions the interplays
between climate policies and other public policies; the third questions the capacity of carbon
price only policies to redirect investments and calls for examining financial instruments.
We are not in the idealized world pictured in Figure 1, where economic agents “see” the
entire trajectory of carbon prices equal to the SCC along the optimal least-cost pathway to
achieve a given climate objective. In this world, decisions are made today on long-lived
investments as a function of, say 200$/tCO2 in 2080 even though the current prices are
10$/tCO2. In the real world, economic agents do not ‘see’ the 200$/tCO2 because long term
synthesis see Ghersi and Hourcade (2009). The fourth assessment report of the IPCC placed a useful caveat on the vision
described by modeling exercises which assume long term balanced growth pathways and “use a global least cost approach
to mitigation portfolios and with universal emissions trading, assuming transparent markets, no transaction cost, and thus
perfect implementation of mitigation measures throughout the 21st century” (IPCC AR4 WGIII SPM Box 3, 2007).
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Here lays the fundamental reason why a carbon-price-only framework hardly offers an acceptable deal for
emerging and developing countries.This should not be a surprise for economists who, a very long time ago,
warned that recommendations – here a carbon price- valid in a 1st best world are not necessarily valid in a 2nd
best one (Lipsey and Landcaster, 1956; Guesnerie, 1980).
14
+ include Weitzman 2014 Can Negotiating a Uniform Carbon Price Help to Internalize the Global Warming Externality?
Political economy argument in favor of the carbon tax : the proceeds of the tax remains into the country, there is no
transfer from one to another country. Governments can decide domestically how to recycle the proceeds.

13
markets are missing, because carbon price signals in infrastructure sectors (energy,
transportation, building) are swamped by many other distorted signals (like the prices of real
estates) and because of regulatory uncertainty which cast doubts about the permanence of
price signals.
Fig. 1: The expectation gap. Agents today consider the carbon price a, and do not anticipate its evolution
beyond t1. In case of full confidence in public policies and clear perception of carbon price signals they see the
entire trajectory O. If carbon prices are blurred by other imperfect signals (including low confidence in public
policies), a carbon price c >b has to be launched. It leads to the L curve in the case of endogenous technical
change.
Actually there are two major arguments for articulating carbon prices signals and carbon
finance:
- The first is to bridge very quickly the ‘expectation gap’ in view of avoiding emerging
economies to be locked into carbon intensive development patterns. Doing so only by
means of the carbon prices would imply very high prices in the short term to cover the
Carbon
Price
Timet1
Optimal trajectory
assuming « perfect
expectations »
(O)
Optimal trajectory
assuming « limited
expectations »
(L)
a
c
b

14
“noise” of other signals (figure 1) and these very high prices will exacerbate transition costs.
The role of domestic policies mobilizing a broader set of economic signals (real estate and
land prices, labor markets, reforms of regulatory regimes of infrastructure sectors) is
important to lower these noises together. But, there is an irreducible level of regulatory
uncertainty, and no political power can make credible commitments about the future carbon
prices during several decades. Carbon finance is a credible way of making such commitments
- The second is that carbon prices hurt installed capital stock whereas commitments to
issue carbon assets aim at redirecting new capital stock. Then necessity of carbon finance
can thus be advocated through a political economy argument, the fact that it will raising a
lesser mobilization of vested interests. But there is another argument, more ethical in
nature. Behaviors enabled by this capital stock (mobility, housing modes, location of human
settlements) result from an implicit social contract, cheap energy and environmental
innocuousness of fossil energies. That climate policies question this social contract is a real
obstacle to their deployment and the role of carbon finance is to facilitate the renegotiation
of this contract because it does not penalize populations trapped in the consequences of the
past contract.
But the consideration of the existing capital stocks and vested interest is at risk of resulting
into lobbying games for subsidies and exemptions which, in addition to important economic
inefficiencies and political arbitrariness of climate policies. This is why a device is needed
which does not hit existing capital but sends the same carbon price signal to new
investments. Organizing carbon finance around an agreed upon and agreed upon price of
carbon is then first pre-requisite for making a new low-carbon social deal happen while
guaranteeing economic efficiency.
A second pre-requisite is to avoid additional burdens on tax payers or on public budgets
deficits. The only leeway, technically, is then a monetary based mechanism and this makes
sense, if, as stated in section 1 the core issue is to creates the perspective of safe productive
investment avenues to attract savings out of speculative investments and to reduce the
vulnerability of the financial systems.
1.3. Basic principles in a nutshell
In this context, options to prime the funding pump of the low-carbon transition despite
limited carbon markets are many. However, given the tensions on public budgets and on the
banking systems, there is no other margin of freedom than internalizing the “social value” of
avoided carbon emissions into the economy by means of a carbon-based monetary
instrument. For the climate agnostics, compared with the “unconventional monetary
policies” implemented to restore confidence on the monetary and financial systems after

15
2008, this value is of interest only if it is used in a system helping the banks to develop their
credit activities towards productive investments.
The basic wrinkle consists in injecting central bank liquidities into the economy, provided
that they are used to fund low-carbon investments. Governments would provide a public
guarantee on a new carbon asset, which allows the central bank to provide new credit lines
refundable with effective CO2 emissions abatement. This targeted credit facility makes it
possible to expand credit to LCPs as it offsets LCPs' financial risk perceived by the banks and
investors relatively to BAU projects and would make these projects more attractive.
However, such monetary device may follow the four basic principles pictured in figure 1.
(I) The international community recognizes that avoided GHGs emissions is “something
of value” measured by the « social cost of carbon » (SCC). Governments commit, on a
voluntary basis, but within a framework agreed upon by the UNFCCC, to back a new class of
eligible « carbon assets » recognized by the central bank of their monetary zone. These
carbon assets are a quantity of carbon abatement (to be specified later) valued at the SCC.
(II) Building on this guarantee, Central Banks of participating countries (of Annex 1 in a
first step) open « credit lines » to commercial and development banks provided that the
money is used to issue ‘carbon certificates’ ‘CC) and back low rate loans to LCIs in the issuing
country or in any country participating to the system. The Central Banks announce that they
will accept the CC as repayment after due verification of the reality of the investments
reduction. These CC are then converted into carbon assets while entering central bank’s
balance sheet. This comes to a money issuance based on the guarantee that “something of
value” has been created in the form of low-carbon equipments.
(III) The CC are delivered by an independent international Supervisory Body, established
under the UNFCCC, like the CDM Executive Board, to secure the environmental integrity of
the mechanism (rules for the attribution of CC, monitoring of the completion of LCIs) and its
developmental effectiveness. The latter is guaranteed by the consistency of the funded
investment with a list of NAMAS selected by the participating countries to secure the
alignment of mitigation actions with development objectives.
(IV) Banks or specialized climate funds use the carbon-based monetary facility to back
highly rated climate-friendly financial products, such as “AAA” climate bonds, in order to
attract long-term saving. Institutional investors could be interested in safe and sustainable
bonds instead of speculative financial products for both ethical and regulatory purposes. Part

16
of the CC are used to scale up the Green Climate Fund in order to secure multilateral
cooperation around climate policies and the funding of NAMAS without crowding out
overseas assistance by each individual country.
Figure 1: The key elements of a climate-friendly financial architecture

17
II
Components and design of a financial architecture aligning climate
and development objectives
This proposal rests on four essential features that we explore more in depth in this section:
 An agreement on the « social cost of carbon » amongst countries participating to the
system including both countries accepting to issue carbon assets and countries accepting the
preconditions to receive funding for their NAMAS through this channel,
 Rules for the emission of ‘carbon based liquidity’ and for the ‘drawing’ on these
liquidity so as creating a ‘pull-back’ force guiding the participating countries towards
emissions trajectories consistent with the 2°C objective
 A mechanism transforming the carbon based liquidity into real wealth and carbon
assets and supporting climate-friendly financial instruments apt to attract long term saving
 The establishment of an independent international Supervisory Body in charge of
controlling the effectiveness of emission reductions and rewarding LCPs with CC.
2.1. The Value of Avoided Emissions : a trajectory of notional prices
The last COP has confirmed the long term objective of preventing a temperature increase
greater than 2°C above pre-industrial levels. Admittedly, this is close to acknowledge a social
cost of the carbon externality (SCC) or a social value of the avoided emission of carbon.
In theoretical economic models, this SCC is the value which equates the marginal damage
caused by one additional emission of CO2 and the marginal cost of avoiding this emission
along an optimized trajectory. The value of the SCC is highly controversial in the literature
(Tol 2008; Dumas et al 2010) since it depends on a large set of parameters amongst which
not only the pure time preference which crystalizes the dispute amongst economists, but
also the costs of carbon-free techniques, the beliefs about the climate change damages and
about the rate of arrival of new information about these damages. The polemic about the
Stern report shows that no agreement there might be a long way before agreeing on a
workable range of values, even in case of agreement on a low pure time preference as
suggested by the last IPCC report.
Things differ if one starts from the political deal made by the international community
around a 2°C temperature target. In this case, it is possible to calculate the trajectory of
costs for meeting this target under various scenario assumptions. Uncertainty is still
important but results from about 900 modeling exercises synthesized in graph 1 by the last
IPCC report (chapter 3) show ranges of carbon prices which are still large but provide a

18
corridor within which a political deal can be made: shows a maximum likelihood space of
carbon prices ranging from 28$/tC02 to 50$/tCO2 in 2020 and between 110$/tCO2 and
190$/tCO2 in 2050. Ultimately an agreement around a notional value of avoided carbon
emissions (VAE) 15
will be political in nature translating the willingness of governments to
pay for mitigating climate change.
Fixing this VAE implies an agreement on an initial price of carbon increasing over time for at
a pre-determined rate. This is important to launch a credible signal on the long term and to
compensate the penalizing role of discount rate against infrastructure investment. To
reconcile the credibility of the economic signal and the necessity to revise initial choices in
function of new information the VAE can be revised every five year time period but without
changing the VAE incorporated in the past contracts.
One major advantage of fixing this VAE worldwide is that it will secure the overall economic
efficiency of the Green Climate Fund and of any other bilateral climate initiatives, prevent
the risks of fragmentation of these initiatives16
and to send a comprehensive signal to
investors and, upstream, to R&D, city planning and infrastructure managers.
A political agreement on a SVE should be easier than on a carbon tax or national emissions
cap because it serves as a notional price paying for avoided CO2 emissions entailed in low-
carbon investments. Contrary to a carbon tax, that must be paid for each unit of carbon
15
This is the meaning of social cost of carbon integrated as a notional value by the US ($42), the UK ($60) and Frace ($130)
for 2030 in the analysis of public investment decisions
16
See the Paris Declaration on Aid Effectiveness

19
emissions, it does not impose a direct short term extra costs on neither the public budget, or
firms and consumers. It is a signal for future investments which does not hurt existing
capital, entails less direct distributive impacts and therefore less risk of blocking coalition
from the owners of carbon-intensive capital.
A political agreement on a VAE should be easier than on a carbon tax or national emissions
cap because contrary to a carbon tax, that must be paid for each unit of carbon emissions, it
does not impose a direct short term extra costs on neither the public budget, or firms and
consumers. It is a signal for future investments which does not hurt existing capital, entails
less direct distributive impacts and therefore less risk of blocking coalition from the owners
of carbon-intensive capital. Moreover, each government will value the avoided carbon
emissions it in function of its own perception of the domestic co-benefits of climate
mitigation (air pollution, benefits of the recycling of the revenues of carbon pricing, energy
security). Hence countries might agree the same VAE for various reasons and it is
questionable that gains in development benefits through a differentiation of the VAE are
worth the risk of endless controversies about the rules for this differentiation.
More important is to hedge against the vagaries of market exchange rates. The VAE value
would be nominally similar to the 35$ per ounce of gold under the Bretton Woods regime.
But, since the exchange rates are the relative values of the VAE in national currencies will
thus differ from one country to another and will be submitted to variations large enough to
generate time inconsistencies of investment projects funded in several countries overtime.
This is why the world SVC should be the weighted average, in purchasing power parity (PPP),
of national prices. The internal returns of investment projects, would then all be implicitly
computed in PPP price system (reviewed every five years) which would minimize the
inefficiencies caused by the volatility of exchange rates.
2.2. Voluntary commitments and pledges; creating a ‘pull-back’ force
The voluntary adhesion to the system should be based on commitments to issues carbon
assets. Given the political constraints of the current negotiation process and the experience
of the failure of the Kyoto Protocol, this system should follow five principles: a) keep an
allocation of targets and timetables per countries with a controlled degree of “when” and
“where’” flexibility (COP3, 1997), b) leave all latitude to Parties to select the NAMAS apt to
align their climate and development policies so that there is no misgiving about
environmental colonialism (Agarwal and Narain, 1990), c) follow principle of “common but
differentiated responsibilities (CBDR)” in accordance with the article 3.1 of the UNFCCC, d)
secure that renegotiations every five years will not generate instable signals for economic
agents (Hourcade et al., 1993) and d) motivate countries to respect announced emissions
pledges and to narrow the gap between these pledges and an emissions trajectory
compatible with the 2°C target e) deprive a defaulter country of the benefits of the system

20
like in Carraro and Siniscalco’s approach (1998) of technological cooperation or in Victor’s
proposal of a club of voluntary countries (Victor, 2011).
A mechanism can be organized around carbon based assets could meet these principles
through a pull-back force anchored around two pillars. The first pillar rests on allocating to
each participating country part of the global emissions budget17
. The agreement on an
allocation rule is ridden with controversies. However, what makes a compromise18
easier
than in the case of a cap and trade system is that the latter triggers immediate adverse
impacts for households and industry of countries with tighter carbon constraints and
possible high drains on GDP for importers of carbon allowances. The second pillar rests on
emissions pledges and commitments to issue carbon assets as means of motivating
countries each country to announce emissions reductions every five year time period and to
keep their announcements. Let us glance through the panels A, B, C how countries can be
guided towards their convergence trajectory:
- Pull-back force for Annex 1 countries and all countries over their convergence
trajectory. The panel A describes the situation in 2015 of two developed countries C1 and C2
characterized by the same gap (200 GtCO2) between their GHG emissions in 2015 and their
convergence trajectory in 2020. These countries have accepted to issue a quantity of carbon
assets representing half of this gap. Consequently, in 2015, their central banks open credit
lines for 100GtCo2 each at a VAC of 50$. But country C2 proves less virtuous than country C1
and conducts less domestic abatement efforts. It then uses only 1000$ of the credit lines to
support these efforts and let 4000$ available for projects abroad against 2000$ only for
country C1.
As described in panel B country C2 is ‘penalized’ in 2020 by a larger gap between its
emissions and its convergence trajectory (500 GtCO2 instead of 300 GtCO2). If the VAC is
now 60$/tCO2 it is obliged to open 15000$ credit lines (instead of 9000$ for country C1). It is
thus confronted to the risk of an increasing drift of outflows of capital. Here lies the pull-
back force to incentivize it to make more domestic efforts and use domestically a higher
share of its carbon assets. Between 2020 and 2025 it uses domestically two thirds of the
credit lines emitted by its Central Bank, which leaves 5000$ for funding LCI abroad. It is thus
achieved in Panel C by a reduced gap with its convergence trajectory (400 GtCO2) and then is
rewarded by a lower obligation of issue carbon assets.
17
We do not enter here in the discussion of the normative allocation. To avoid endless controversies, it should be
clear from the beginning that it will be a mix of two criteria (convergence of emissions per capital and
convergence of emissions per GDP).
18
A lot of mixed formula incorporating per capita convergence in a broader system based on historical trends
have been put forward (Agarwal and Narain, 1991; Jacoby et al., 1999; Colombier, 1998; Frankel, 2007,Bossetti
and Frankel, 2011)

21
- Pull-back force for the developing countries: In panel A, developing countries
D1 and D2 share the same gap of 300 GtCO2 below their respective convergence trajectory.
Because they are not at the same phase of their development, this trajectory increases from
900 GtCO2 to 1200 GtCO2 for country D1 between 2015 and 2025 whereas the trajectory of
D2 reaches a pick of 1200 GtCO2 in 2025.
In 2015, the behavior of the two countries differs in terms of ambition of pledges for 2020.
Country D1 announces 200 GtCO2 below its normative trajectory whereas as country D2
announces 100 GtCO2. Then, country D1 will have a drawing right on 2/3 of the available
amount of credit lines issued by developed countries. Here lies the pull-back force for these
countries: the more ambitious are their pledges (measured by the gap with their
convergence rule) the more they will be beneficiaries of capital inflows. To prevent false
announcements it will suffice to discount the theoretical drawing rights in t by the gap
between the emissions registered in t and the pledges announced in t-1. Note that, beyond
2030, country D2 overshoots its normative peak and then becomes an issuer of carbon
assets.
Panel A (2015) Country C1 Country C2 Country D1 Country D2
GHG emissions (2015) (GtC02) 1000 1300 600 1000
Convergence Trajectory
(2020) (GtC02) 800 1100 900 1300
Carbon Asset Issuance
($*GtC02) 50*100=5000$ 50*100=5000$
Outflows (2015->2020) -2000$ -4000$
Inflows (2015->2020) 4000$ 2000$
Pledge (2020) 900 1200 700 1200
Panel B (2020) Country C1 Country C2 Country D1 Country D2
(2025) (GtC02) 600 700 1100 1200
($*GtC02) 60*150=9000$ 60*250=15000$
Outflows (2020->2025) -4000$ -5000$
Inflows (2020->2025) 4500$ 4500$
Pledge (2025) (GtC02) 700 900 1000 1100

22
Panel C (2025) Country C1 Country C2 Country D1 Country D2
(2030) (GtC02) 400 700 1200 1200
($*GtC02) 70*100=7000$ 70*100=14000$ 0$
Outflows (2025-2030) -4000$ -7000$ 0$
Inflows (2025-2030) 11000$
Pledge (2030) (GtC02) 500 700 1200 1100
Actually over time all countries will be discouraged to announce lax emissions pledges. The
rationale of the expected virtuous behavior is as follows: the development benefit of the
mechanism will be tangible to those issuing and receiving countries which will make the
system increasingly attractive for all countries which might create a movement of expanding
climate coalition. In this system, the net capital flows will go from the North to the South.
The total investments in the energy transition over 2010-2035 are of the same order of
magnitude in the OECD countries [5950 G$ - 6300g$) and in the Developing Countries (OPEC
excluded) [6040 G$ - 6500 G$) and there will be a higher share of cost-effective
opportunities in the latter. It is also interesting to note that, one or two decades ahead,
emerging economies like China, Mexico and Brazil will overshoot their convergence budget
and contribute to the system as net issuer of carbon assets.
For this system to work, a global body has to be set up under the UNFCCC or any other UN
organization to manage the MRT system, register the issuance of emissions of carbon assets
and their use, like in a form of clearinghouse. This is critical to create a credible information
basis to facilitate the renegotiations of the pledges every five years.
2.3. Transforming the carbon based liquidity into real wealth
The key is to secure that the carbon based liquidity really supports the creation of ‘real
wealth’ and is not a pure ‘greening’ of the perverse commerce of promises which provoked
the 2008 crisis. The basic principle is that Central Banks accept carbon certificates as
repayment of their credit instead of cash and enhance the risk-adjusted profitability of low
carbon investments, before transforming the initial credit lines into carbon assets.
There are many possible circuits through which this transformation can be operated because
there are many types of financial intermediaries and many types of enterprises which must

23
be mobilized. Before commenting upon this diversity, and for clarity sake, let us however
describe the ‘banking canal’ which will likely be the most important.
2.3.1. From the credit lines of the Central Banks to carbon assets: the circuit of balance
sheets
Building on the political agreement on the SCC, a new class of carbon assets is created by the
Central Bank. Their value is the agreed value of the SCC and their quantity is determined by
an overall volume of emission reduction.
The attribution by the central bank of a conventional value to this carbon asset in the same
fashion as gold under the Bretton Woods regime for instance, does not infringe on its
independence. It is justified by an upstream political agreement on the SCC and backed upon
the existence of effective emission reductions.
We list in Table 1 the components of central bank's balance sheet. Gold, special drawing
rights, securities are part of the asset side while currency in circulation and bank’s deposits
appear on the liability side.
Table 1: Central bank’s balance sheet
In accordance with government’s willingness to value emission reduction, the central bank
announces that it will provide commercial banks with new liquidities to fund low-carbon
projects. It also announces that it will accept as repayment “carbon certificates” (CC) which
would testify effective carbon emission reduction. The value of the CC will be given by the
politically negotiated SCC.
Tables 1, 2, 3, and 4 offer a numerical example of the balance sheet consequences for the
central bank and a commercial bank of a 1000 loan to a low-carbon entrepreneur expected
to realize 10 units of CO2 emission reduction. The SCC is set at 10, which values the expected
emission reduction at 100.
Table 2 indicates that the loan to the entrepreneur is divided into two credit lines. On the
first line, the commercial bank borrows 900 deposits at rate rd
and lends 900 at rate rl
. The
second line refers to the 100 liquidities equivalent to the value of expected emission
reduction lent by the central bank to the commercial bank that can be paid back with

24
certified emission reduction. Prudential rule about minimum capital requirement only
applies to the first credit line (900 rl
), as a zero coefficient risk is applied to the line coming
from the carbon-based liquidities. Then net worth increase of the bank should only be
+0.08*900rl
instead of 0.08*1000rl
as in the BAU case, that is the funding of a conventional
project.
The central bank owns a new 100 claim on the commercial bank. Thanks to the 1000 loan,
the entrepreneur launches a project with expected returns RLC
which makes the total
expected revenues amounting to 1000 RLC
. Two lines appear in the liability side of the
entrepreneur’s balance sheet corresponding to two types of debt: 900 will be paid back with
the monetary revenues of the projects and at the interest rate rl
, and 100 paid back with
effective emission reduction19
.
Table 1: Balance sheets at the opening date of the low-carbon loan
During the payback period of the loan, the entrepreneur gradually reimburses the loan with
monetary revenues of the project as suggested by table 3. As the project realizes emission
reductions, the entrepreneur receives carbon certificates.
19
In this example, we assume the project realizes the 5 units of expected emission reductions.

25
Table 2: Balance sheets at mid-maturity of the low-carbon loan
At the end of loan maturity, table 4 indicates that the entrepreneur has paid back the entire
900 debt with the monetary revenues of the project and has gotten 10 CC for the emission
reduction her project has achieved. Capital constraint for the commercial bank gets null and
only the second credit line remains unchanged in the balance sheets.
Table 3: Balance sheets at the end of the payback period of the low-carbon loan before the
asset swap
The last step of this process is an asset swap performed by the central bank who accepts the
10 CC as repayment of its 100 financial claims. This results in cancelling out the second credit
line corresponding to the “carbon debt” of the low-carbon project. Total amount of carbon-
based liquidities that the central bank can issue is reduced by 100.

26
Table 4: Balance sheets after the carbon asset swap
For commercial banks in a process of deleveraging, this new credit facility will encourage
them to expand their lending activity, instead of accumulating liquid reserves. An additional
regulatory incentive for the banks might be that a high share of LCPs in their loan book
would make their balance sheet less risky, since this share of their assets would benefit from
a public guarantee. One could even imagine that they keep part of the carbon assets. Banks
would then be rewarded with a reduction of the cost of their prudential capital constraint.
They could be indeed allowed to apply a zero risk coefficient – in the same fashion as for
sovereign bonds – to the fraction of the loan that comes from central bank liquidities backed
upon the value of emission reduction. Along the same line, it could be envisaged that
enterprises keep the carbon assets in their balance sheet to improve their value in terms of
Capital Asset Pricing Model.
2.3.2. Using a diversity of canals to redirect savings
In addition to inciting the banking system to better support low-carbon transition, the
virtuous cycle between climate policies, economic growth and a sounder financial order will
depend of the efficacy of the system to redirect of private saving toward LCP&P. In addition
to banks and sovereign Wealth Funds most of the financial intermediaries could be
mobilized: public private and corporate pension funds, insurance companies, endowments
and investment management companies.
The basic principle to build up is that the financial institutions could use the carbon-based
monetary facility to back highly rated climate-friendly financial products attractive for
households and institutional investors because the offer AAA-rated ‘‘climate colored’’ bonds
(like the green bonds of the World Bank) instead of speculative financial products for both
ethical and regulatory purposes.

27
Figure 2: Climate finance as a means to redirect long term saving toward low-carbon investments
2.3.3. Supporting the Namas, the specific contribution of the Green Climate Fund
This monetary based system is not likely to crowd out conventional overseas assistance since
it relies on totally different channels. However the suspicion of imposing a carbon
conditionally to funding at risks of threatening other development priorities is still pervading
the discussions. This is why it matters to selects eligible projects within the NAMAs proposed
by the national authorities of the recipient country which define those of the mitigation
measures which are on line with their development objectives. This consistency check will be
one of the most important role of the Supervisory Body of the system, under the UNFCCC, in
addition to determining the expected “avoided emissions” and confirming ex-post the
emission reductions achieved based on verification reports by accredited independent
entities. This process is similar to the manner in which the funds of the Marshall Plan where
managed post World War II (Schelling 1997).
However, both to clear up any suspicion of political deals in bilateral initiatives and to
reinforce the overall efficacy of mitigation actions it matters to reinforce the role of the
Green Climate Fund. Despite still unresolved debates, this fund will receive budgetary
contributions and small taxes on financial transactions, international shipping or
international aviation, but there is a risk that its funding capacity will remain limited, in
absolute terms and by comparison with the flows generates by bilateral initiatives.
The architecture designed above supports bilateral initiatives between the issuers and the
beneficiaries of the carbon assets. It is meant to attract private funds but does not respond
the legitimate claims of a strong multilateral system. The judgment about the right balance
between bilateral and multilateral systems is political in nature but there is no contradiction
between both. Indeed, since the proposed system links the issuance of carbon assets to past
responsibility of Annex 1 countries, a share of these assets could contribute to provide

28
capital outlay of the Green Climate Fund in order to increase its potential leverage effect of
this multilateral tool.
3.2. Securing LCPs environmental and developmental quality of the LCI
The reliability of this architecture rests on its capacity to certify that LCIs make a real
contribution to development and emission reductions. Thanks to the CDM, an important
experience has been accumulated in project assessment. But the problem to be solved for
triggering a wave of LCI is no longer to guarantee the additionally of each project on a case-
by-case basis from a counterfactual and controversial baseline but a statistical additional, so
that the pool of projects supported by the system yields a total of carbon abatement higher
than what would have otherwise occurred.
Three cases may appear:
(i) projects pay for themselves, the carbon certificates system would thus have
only helped to bridge a credibility gap inhibiting their adoption so far;
(ii) projects are able to pay back their loan if a cost of carbon appears in whatever
form, hopefully higher that the ex-ed SCC;
(iii) projects are in default payment because of mismanagement, technical failure,
or because they actually had little chance of success.
The challenge is thus to trigger a wave of investments in a situation of ignorance of the
precise outcome of each individual project and to reach a portfolio of LCIs both
economically viable and environmentally efficient. Focus on very high accuracy in the
allocation of carbon certificates would end up freezing investments while laxity would lead
to subsidizing projects that would have been funded anyway. The trade-off between these
two risks will ultimately result from learning process through which an independent
committee would progressively refine the assessments in function of experience and local
circumstances but with no retroactivity on past allocations). It can be secured in three steps:
(i) define a taxonomy of LCIs (size, technology, time horizon) and determine the
potential abatement (volume and time profile) to be expected from projects fitting within
each category of this taxonomy (for example a unitary capacity of hydropower). This
potential abatement will be used for every project of deployed in the country during the
considered time period. It will conventional in nature but its determination can rely on
modeling exercises providing orders of magnitude of the avoided carbon emissions
associated, for various growth scenarios, to main types of LCIs (hydro-power, solar or wind
power plants, transport infrastructure, building insulation, etc.). These values can be
reasonably bound by systematic model comparison and sensitivity analysis, through an
international expertise committee.

29
(ii) calculate the expected present value of avoided emission: let A(t) be the CO2
abatement yielded by the project at each point in time, t0 the date of the launching of the
project, N the project life-time and i the discount rate, the present value of the CO2
abatements can be computed as follows
0
0
( ). ( )
(1 )
t N
t
t
A t VAE t
NPV
i



 . and the number of
allocated carbon certificates will be
0
.
t
NPV
VAE

(ii) determine the amount of carbon certificates allocated to each kind of LCI by dividing
the present value of projects by the VAE at the date of project launching and, to secure the
0
.
t
NPV
VAE

In the same spirit, the monitoring of projects (and possible invalidation of part of the carbon
certificates) has to rely on simple observable criteria to assess the degree of effectiveness of
the project in comparison with its ex-ante objectives (in terms of carbon emissions when this
is possible, in terms of indicators of physical achievement for transportation or building
infrastructure).
To set up such a process with a minimum degree of credibility would certainly have been
risky two decades ago. But we can now benefit from the experience of the Clean
Development Mechanism (CDM) which is to date the largest carbon offset mechanism in the
world – with over 7,000 projects.
This experience show first the importance of upfront transaction costs as a major barrier
for the implementation of projects. They include Project Design Document (PDD)
development, validation costs (internal and auditing), UNFCCC registration fees and the cost
of installing the monitoring system. They vary drastically depending on the type of project
and technologies and on the concerned sectors, ranging from EUR 37,000 for small-hydro
projects to EUR 434,000 for very large adipic acid N2O projects. They are also submitted to
scale effects (Figure 1) which indicates the necessity of specific procedures so as to avoid the
crowding out of small scales projects which might be the projects yielding the most of
development benefits in some countries and regions.

30
Figure 1 – MRV costs in the CDM
Source: CDC Climat Research based on Warnecke et al. (2013), Bellassen and Stephan
(forthcoming
Building upon (Shishlov and Bellassen 2012), to strike a right balance between lowering
transaction costs and the incentive to operate low carbon investments it is possible to define
criteria for a MRV process aiming at statistical environment additionally of the system.
a) standardization of the baseline setting: necessary to demonstrate the
additionally of the project represents half of upfront transaction costs in the CDM (Guigon,
Bellassen, and Ambrosi 2009). Abandoning project-by-project assessment will result in a
significant reduction of transaction costs without undermining the environmental integrity
of the system because, given the accumulated CDM experience, it is possible to set up
acceptable ‘counterfactuals’ like those developed by the Program of Actions (PoA)
framework as well as in the new sectorial crediting mechanisms. Based on discussions about
country-wide standardized baselines for different sectors in COP11 (Montreal), COP16 in
Cancun provided the possibility for host countries to submit standardized baselines
concerning all or part of the country (UNFCCC 2011). This will overcome the problem of
information asymmetry between the project developers and the regulator. But the problem
of the regulator will be the level of the stringency of the baseline and/or of the share of CC

31
allocated for an expected deviation from the baseline not to discourage the supply of
projects without compromising the environmental integrity of the program (Millard-Ball
2013).
b) positive lists: those already implemented within the CDM can be used as a first
basis for further standardization. Certain types of projects that meet minimum criteria can
be assigned a standardized, conservative amount of credits per operation period with
conservative discount in proportion of the uncertainty about their environmental
performance. The current list of projects automatically deemed additional include small
scale off-grid and grid-connected renewable energy, rural electrification project activities
using renewable energy sources in countries with rural electrification rate is less than 20%,
mass transit and bus lane in Least Developed Countries (LDCs), etc. This list can be
progressively extended to minimize both the “false positives” generating windfall profits
and the “false negatives” of lost opportunities (Trexler et al 2006). In this search for avoiding
free riding without high transaction costs it makes sense to have more stringent screenings
on projects with best leverage ratios than in projects (sectors, regions) with insufficient
financing adopted where the list of eligible project types expands over time in line with MRV
complexity and cost.
c) monitoring: the CDM project developers already devise a monitoring plan that
provides for “the collection and archiving of all relevant data necessary for estimating or
measuring anthropogenic emissions by sources of greenhouse gases occurring within the
project boundary during the crediting period”. The CDM Project Standard further specifies
that variables that continuously affect the amount of GHG emissions (reductions) - such as
the quantity of fuel input or the amount of gas captured – must be measured constantly.
Variables that remain largely unchanged, e.g. emissions factors, must be measured or
calculated once a year. The MRV system for a non-project based system may provide a
certain degree of flexibility to developers in order not to impede projects in sectors where
high level of monitoring are unachievable or too costly, e.g. transportation or forestry. This
may be done through discounting the amount of carbon certificates in proportion to the
overall monitoring uncertainty. Project developers can thus be encouraged to save on
monitoring costs at the expense of less carbon certificates awarded.
d) Verification: the use of accredited auditors for verification is necessary to reduce
the moral hazard to overestimate emission reductions. They key is the consistency check, by
an accredited auditor, between project description and implementation of the project. A
similar verification approach is applied in most carbon accounting systems, be it national
GHG inventories or an ETS. Since the third party tends to be paid directly by the verified
entity, a potential conflict of interest arises. However, the risk of losing the accreditation is
typically a much stronger incentive and keeps auditors from being complacent with their
client (Cormier and Bellassen 2012). Another option is to levy a share of the proceeds on the

32
system to pay directly the auditors. In order to keep verification costs at a reasonable level,
the stringency of verification is adapted to the importance of information. Auditors should
be encouraged to focus on larger sources of potential overestimations while small sources of
errors may be ignored. The threshold of “materiality” depends on the size of the project.
Typically in the CDM it ranges from 10% of total emissions reductions for micro-scale
projects (renewable energy projects of up to 5 MW and energy efficiency projects of up to
20 GWh of energy savings per year) to 0.5% for large scale projects that reduce more than
500,000 tons of carbon dioxide equivalent per year. Another potential approach that may be
considered is the “fire alarm”, i.e. the auditor conducts random spot-checks and focuses on
“suspicious” numbers.
d) Transparency: transparency improves the credibility of the system and allows
“learning-by-doing” among participants. However, there is a trade-off between transparency
and confidentiality especially when sensitive financial information is concerned. In the CDM
all the documents related to the project – project design, names of project participants,
methodology, validation and verification reports etc. – must be made public. The complete
transparency of the mechanism enables constructive criticism to emerge from a great
variety of stakeholders: project developers, e.g. through the International Emissions Trading
Association (IETA), auditors, e.g. through the Designated Operational Entities and
Independent Entities Association (DIA) and NGOs such as Carbon Market Watch or Sandbag.
The general tendency is to put little confidentiality on the reported data. This transparency,
however, may be used to obtain commercially sensitive information on the reporting
companies. This is why, for example, reported data is confidential in the Shenzhen ETS
where the problem is particularly acute as companies are asked to report their added value
as well as their emissions.
e) Timing the issuance of CC: by comparison with the current CDM, one advantage of
a system based on CC, is that the ‘cash’ is available immediately for the project developer in
exchanged of the commitment to reimburse this cash in the form of certified CC. However, it
still matter for the investors to have a precise information about the pace at which these CC
will be swapped into carbon assets because this determines the risk of being forced to
reimburse the loan in cash in case of non-certification. This information will be key for the
assessment of the debt servicing and mitigating the “MRV risk”. This is why it might be
reasonable to have part of the ‘asset swap’ carried out for example in three steps: one third
after the completion of the equipment and certification that they are conformed with the
initial plan, one third at the half of a conventional date of economic completion of the
project (lower than its technical and economic lifetime) and one third at this date.

33
III
A virtuous circle between environmental, economic and macro-
financial integrity
Figure 4 pictures three legitimate concerns aroused by the type of mechanism outlined
above: (i) risk of lax monetary creation under the pretext of carbon savings, (ii) risk of
‘‘carbon bubbles’’ (iii) risk of low-quality LCPs, both in terms of development and carbon
abatement.
Figure 4. Advantages and risks associated with the issuance of carbon assets.
To assess the first ‘inflationary’ risk it matters to remind that both the quantity and the price
of carbon assets are fixed over a given period. To give the orders of magnitude at stake let us
come back to the scenarios provided in the first section this note and let us assume that:
- the real trajectory followed by the OECD countries in 2035 is the CPS scenario
(which is a pessimistic view because, if we assume that the system works after 2015, the
OECD will follow another baseline)
- the VAC is 200$ per ton of CO2equivalent, which is the upper bound of the
likelihood space of prices of carbon given by the last IPCC report for this time horizon
- half of the gap between the CPS baseline and the 450 ppm is retained for calculating
the issuance of ‘credit lines’ leading ultimately to the creation of carbon assets

34
Under these hypotheses, the issuance of carbon assets in 2035 would represent 1% of the
GDP. But this is with no leverage of private savings and private loans. Assuming a 10%
leverage, then the issuance would be 0,1% of the GDP. This is the real upper bound of the
possible values; assuming 100$ and a 20% lower baseline would give 0,04% of the GDP. The
‘inflationary’ risk is all the more low that the LCI produce the collateral of this money and
that it is always possible to change the share of the gap between GHGs emissions and the
convergence trajectory which determines the volume of carbon assets.
The inflationary risk due to a possible ‘carbon bubble’ is also low because even though there
will be a secondary market of CC or bonds backed on carbon assets, their price will be
constrained by the fact that, ultimately the CC will be reimbursed at their face value.
More serious is the moral hazard problem which arises for both banks and project
developers faced with the incentive to fund low environmental quality LCIs or on assets with
high level quality but speculative in nature (real estates). The banks should indeed be
interested in funding LCIs because carbon certificates increase their legal reserves, and the
project developers cannot but be interested in overestimating the mitigation contribution of
their project. The only possible response lies in the quality of the MRT process described in
the previous section and which incorporates, in addition of criteria of environmental quality,
a procedure to secure the consistency of the projects with explicit NAMAS.
But, this risk has to be weighed against the benefits of the system both to trigger a wave of
LCIs and to contribute to sustainable development pathways.
3.1. Drivers of the leverage effect on low-carbon investments
Three mechanisms determine the leverage effect [of the mechanism described in Sections 1
and 3] on low-carbon projects. First, the availability of carbon-asset backed loans backed
carbon-assets reduce the cash-flow risk associated with (large) initial investments for project
developers, since their borrowing capacity is increased. Second, holding carbon assets – the
value of which is stable over time – increases firms’ total value. Third, pooling LCPs provides
for additional leverage. We discuss each of these three mechanisms in turn.
3.1.1. Risk-adjusted profitability of one LCI: a non-linear mechanism
In most economic models, technologies are selected based on net present value
maximization, i.e., on the maximization of the discounted sum of project benefits minus
capital expenditures minus O&M costs. This framework is both simple and easily tractable by
modelers.

35
But a sum over time is also a limited metric for assessing projects. In particular, it does not
fully account for differences in time profiles across projects. For example, two projects with
the same net present value might have very different time profile of net costs: one might
have large investment costs upfront, compensated by even larger benefits over time, while
the other may have much smaller investment cost upfront and much smaller benefits down
the road.
Such difference would not matter under unlimited financing capacity. But in the real world,
project developers have limited capacity to finance projects (be it via debt, equity, or self-
finance). Beyond that point, either their margins become too low, or the dividends they serve
their shareholders become too limited. Either way, the value of the firm is impacted, with,
e.g., risk of bankruptcy or of hostile takeover. The key point is that the “true” cost of an
investment for a firm is highly non-linear. In a first approximation, it is as if there was a line
(defined e.g. in terms of in debt to equity ratio or minimal level of profits distributed to
shareholders, etc.) project developers will stay clear off. In other words, they will not consider
projects in which upfront costs might lead them to cross that line.
As investment costs are in general uncertain—and it is worth remembering that
underestimating investment costs by 20% is standard in large infrastructure projects—project
developers will be even more conservative.20
Figure XX illustrates this behavior. It compares the time profile of net benefits of two
investment alternatives. Investment A is assumed to having a higher net present value than B.
A should thus be preferred to B to maximize the long run value of the firm. But A also implies
higher upfront costs--the probability density of which is represented on the left hand-side of
the Figure. The “danger line” is figured in b1.
The risk of crossing the line is highly nonlinear and here lays one major advantage of the
carbon certificates. In fact, allowing project developers to reimburse part of their loans in CCs
instead of cash amounts to displacing the “danger line” downwards (say from b1 to b2) as
commercial banks can lend the same amount in return for money plus some amount in return
for carbon certificates.
It is graphically easy to show out, comparing the black and dashed surfaces in the curve p
which gives the probability distribution of costs, that the impact of CC on the perceived risks
of A might be very non-linear.
20
The time profile of net costs matters all the more if the project developer is in a “shareholder value” regime in
which short-term financial indicators dominate. Whereas in ‘managerial regimes’ managers have broader latitude
to maximize firms long-run growth.

36
Graph n°2: Risk assessment of projects under a ‘shareholder value’ regime
3.1.2. Pools of low-carbon investments: again non-linear mechanisms
The scaling up of finance for low-carbon projects (LCP) is confronted with several barriers
(Hosier and al, 2010), amongst which:
 the fragmentation of climate finance initiatives,
 the lack of maturity of low-carbon technology,
 the lack of information about economic and financial performances of LCPs,
 the instability of climate policy and regulation
All these barriers make low-carbon sector look more risky for investors than BAU sectors.
Such excess-risk perception increases the funding costs of LCPs that may turn to be too
expensive for some projects which will not be able to meet financial closure (De Gouvello et
al., 2011). This is why well-tailored financial instruments are needed to offset such excess-
risk and raise finance for LCPs.
Without pretending to give realistic figures, let us explore the mechanism behind the
leverage potential of carbon certificates to get a fictive portfolio of 10 LCPs funded. We
consider three funding cases:

37
(V) each projects asks individually for a loan to a commercial bank
(VI) a specialized public climate fund is set up to pool fund raising by means of climate
bonds
(VII) a collateralized debt obligation vehicle is designed to pool the risks
Table 1 presents the financial features of the pool of LCPs. Each project requires a loan of
100 M$. They are ranked according to their credit rating from AA to BB+. This credit rating is
mainly driven by three parameters: the internal rate of the project if it is successful, its
default rate over 10 years and its recovery rate, which gives the fraction of projects’
revenues that is recoverable in case of default.
The key parameter is the ‘loss given default’: investing 100 M$ in LCP1 exposes to a risk of
losing 0,243 M€ whereas investing in LCP10 exposes to a risk of losing 11,86 M$. A 1G$
invested in the entire portfolio of LCPs is exposed to a loss of US$ 38.7 million and would be
rated BBB.
The performance of the projects in terms of expected emission reduction, listed in the third
column, is assumed to be equal among projects (200 000 ton of CO2).
Table 1: Financial features of a US$ 1 billion portfolio of 10 LCPs. Only 3 LCPs out of 10 are funded
with a loan interest rate higher than 12%. If a carbon-based monetary policy is implemented (with an
agreement on a US$ 20 SCC) then 7 out of ten are funded.

38
a) The limited channel of direct bank financing
If LCPs tries to raise funds by asking individual loan to commercial banks, only the most
profitable projects will have a chance to get funded. Because of missing information about
financial and economic performances of LCPs, commercial banks may require very high
interest rate in order to hedge against perceived risks of LCPs. Assuming that commercial
banks do not know the precise credit rating of projects but only know that this rating can be
comprised between AA and BB+, then they will apply the interest rate corresponding to the
greatest risk, that is BB+ associated with 1186,6 basis points over the risk-free rate. This will
result in an interest rate higher than 12%21
and thus the funding of only the first 3 LCPs of
the portfolio with internal rates of returns higher than 12%. Under those funding conditions,
the 7 other projects with IRRs below 12% will indeed fail to meet financial closure. Public
finance instruments such as concessional loans, public guarantees which aims at lowering
the interest rate may help some of the projects to meet the breakeven point. But the
leverage effect of such instruments is expected to be low because of transaction costs to
tailor financial instruments to each project.
Now, if the carbon-based monetary device presented above, was implemented with say an
agreement on a US$ 20 SCC, and if LCPs completed their expected emission reduction, they
would be rewarded with CC CC valued at US$ 4 million (20x200 000) that can be used to
repay part of the loan. This will result in lowering the cost of debt service and therefore
increase IRR. The IRR of LCP7, for instance, would increase up to 12,5% (108/96) and thus
makes it possible for the project to sustain a US$ 96 million loan at an interest rate of 12%.
For project with IRR below 8% the monetary device will not suffice to meet financial closure.
b) Scaling the leverage of public money invested in a specialized climate fund
Instead of looking for direct bank financing, a specialized climate funds managed by
commercial or development banks, with internal capacity to identify and assess LCPs could
be set up in order to intermediate finance from capital markets to LCPs as suggested by de
Gouvello and Zelenko (2010) with their Low-Carbon Development Facility proposal. The
basic principle is to calibrate the paid-in-capital of such a funds in order to raise a multiple of
this capital by means of highly rated climate bonds, the proceeds of which being lent to
LCPs. Contingent upon the size of the paid-in-capital, this basic financial scheme makes it
possible to turn a BBB portfolio of projects into AAA climate bonds. To sustain US$ 1billion
AAA climate bonds, in our simple numerical example, a paid-in-capital of US$ 38 million
21 12-month EU libor is currently fluctuating around 0,5%

39
would be sufficient to hedge against the acceptable level of loss of AAA bonds. If the
leverage of public funds is defined as the ratio of collected private money over the amount
of public money invested then in this example, filling up the paid-in capital of the funds with
$US 38 million of public money yields a leverage ratio of 26 as it makes it possible to raise
$US 1 billion of private capital. But if public money is too scarce to fill the paid-in-capital,
then it may benefit from the carbon-based monetary instrument. With 2 million tons of
avoided CO2 emissions, the portfolio of LCPs can be rewarded with CC valued at US$ 40
million that could fill the paid-in-capital and act as an appropriate buffer against potential
loss. Note that this mechanism could successfully apply to the Green Climate Fund which is
still looking for a business model to raise US$ 100 billion a year.
Figure 2: A public climate fund to intermediate private capital

40
c) The potential of risk pooling by securitization
Even though the second channel may prove to be cheaper than the first one, it still requires
public expenditures to fill up the paid-in-capital. More sophisticated financial vehicles such
as collateral debt obligations (CDO) could make it possible to fund the entire portfolios of
LCPs in a totally private fashion. The basic principle of such financial vehicle consists of
turning a portfolio of LCPs into different financial products incorporating different levels
(tranches) of risks (from equity to senior AAA debt) sold to private investors with different
risk profiles (from hedge funds to institutional investors). If the CDO matches investors’ risk
profiles as in the example presented in figure 2, then the entire portfolio of LCPs gets funded
by private capital. Starting from a portfolio with an average risk of 387 basis point, the CDO
creates financial products with the same average risk but different expected returns.
Such mechanism rests on the assumption that deep financial markets make it possible to
hedge against risks by means of diversification techniques. Such mechanisms which are
promoted by financial actors such as Bloomberg New Energy Finance (with the proposal of a
so-called Big Green
Bucket) are very enticing as it requires no public money. However, CDOs proliferation have
been key drivers of the last financial crisis and one may be legitimately skeptical about the
ability of sleight-of-hand finance to reach socially desirable goals if it is not carefully
regulated. One basic safeguard would be to forbid the design of cascades of CDO to keep a
visible link between financial vehicle and the underlying risks arising from LCPs.
Figure 2: The private channel of CDOs to fund LCPs

41
3.1.3. LCI backed by carbon assets and firm’s value: back to the Capital Asset Pricing model
Together with making investment with upfront capital cost less risky, both the existence, in
the portfolio of the firm, of assets backed by carbon certificates and ultimately on the carbon
assets with a value guaranteed by the Central Banks is apt to change the strategic planning of
firms. This is easy to show with the simplest version of the capital asset pricing model.
The simplest expression of the economic value added of the firm (EVA) writes, with R the net
return of this asset (after payment of the debt service, k the weighted average capital cost of
the firm and the SE its capital equity:
This expression simply means that, if the firm generates no value if it is not capable to
generate returns higher than the returns expected to pay its capital costs. The lower the
average capital cost of the firm the higher is its value. The average capital cost of the firm is
the weighted average capital cost of its assets, namely the return expected on this asset. The
required return ki of an asset ‘i’ writes, with kf the return of a risk-free asset, km the average
the risk premium associated to the asset ‘i’
the lower is the required return on asset and the higher its contribution to the
value of the firm. This value in turn writes:
This means that is low when the value of co-variance of the value of the asset ‘i’ and of
the other assets of the market portfolio is low. The more a firm holds assets of which value is
stable by comparison with other assets in which it could invest, the higher is its value.
Thus carbon assets can be of strategic interest for firms submitted to the constraint of the
shareholder value, and this might be an important source of the leverage effect of the CC.
3.2. A contribution to a sustainable economic globalization
3.3.1. The macro-financial interest of a stable benchmark
One legitimate concern about the scaling up of climate finance through the creation of
carbon assets will generate inflation and, through the financial intermediaries necessary to
create assets apt to diversify the risks and to finance portfolios of LCPs, facilitate the
emergence of carbon bubbles like the real estate bubbles.
.EVA R k SE 
* ( )i f i m fk k k k  
( ; ) / ( )i Cov i m V m 

42
Actually, the risk of a ‘‘carbon bubble’’ followed by a ‘‘carbon subprime’’ crisis if it turns out
that LCPs do not bring the expected paybacks, is very low. Indeed, while the increase in the
value of real estate assets rested on very low interest rates and was unbound, the SCC value
would be known with certainty. In other words, the emergence of a ‘‘carbon bubble’’
through the assets acting as non-bank banks is blocked by the very existence of a
predetermined value of carbon.
The system we have thus far sketched incorporates two mechanisms that should avoid the
monetary flexibility granted by carbon assets to result in monetary inflation and systemic
risks for the financial and banking system:
- carbon certificates are authenticated by control procedures based on technical
information which do not exist for other investments,
- if CC are traded in a secondary market, their price will stay in a rather narrow margin
of fluctuation around its face value at which the Central Bank accepts it as repayment,
Certainly, the risk of because obviously default payments of a significant share of LCPs
cannot be totally excluded, forcing governments to back the debt in the last resort and
eventually provide ‘‘hard cash’’ as investors would call upon the public guarantee. Countries’
taxpayers would then later pay a debt service due to misdirected and mismanaged projects.
However, the orders of magnitude of this carbon based monetary creation are far lower
than the several percent of the GDP issued by the Federal Bank in the US and the EU Central
Banks to rescue the banking systems since 2008: 0,1% of the GDP of the OECD countries in
2035 and cumulated carbon assets in the balance sheets of central banks amounting to 1,5%
of this GDP.
Technically this risk can be lowered by adjusting the number of carbon certificates available
for each type of project. But, more fundamentally, they have to be appreciated by
comparison with the current situation of difficulty to direct savings towards long-term
productive investments instead of speculative assets.
The basic principle of currency backed on a carbon asset is governments injecting liquidities
into the economy with the help of central banks, provided that the money is used to fund
low-carbon investment. Governments provide a public guarantee on a new carbon asset
which allows the central bank to issue carbon-based liquidities that can be considered as
``equity in the commonwealth''. Such equity pays dividends in the form of ``actual wealth''
created by productive low carbon investments and averted emissions in the short term, a
stronger resilience of the economy to environmental shocks in the long term. The overall,
non-climate related, benefits from monetary emissions based on a stable benchmark can be

43
better appreciated by coming back to one major problem of the growth regime triggered as
soon as financial deregulation has started.
Figure 1 visualizes this problem: the ‘Great Moderation’ of business cycles 22
and financial
cycles of far larger magnitude and far longer time span than in the past23
. The latter cycle is
measured by the gap relative to trend of an index combining credit growth and asset prices
(a mix of equity, bonds, real estate price indices).
Figure 1. Business and financial cycles in the US (1980-2011)
This misalignment, over long periods of time, of asset prices and very long run benchmarks
has pervasive efficiency costs (and also exchange rates) swamping the signals on which
investors should base their decisions. It is propelled by private credit dynamic fed and its
magnitude is caused by the self-fulfilling beliefs of market participants that prices will go on
moving the way they have gone before. Financial intermediaries are governed by the same
self-fulfilling expectations as their borrowers since they lent money to finance speculative
positions on asset prices took the assets as collaterals of their loans: more credit thus led to
higher asset prices, higher value of collateral, lower perceived risk premiums on loans and
speed up in credit growth.
The asset prices thus cannot be vectors of adjustment in the macro economy. They
exacerbate real disequilibria, as was observed with the cumulative global imbalances in the
balance of payments and in the balance sheets of financial institutions, which receded only
22
The first appearance of the label “great Moderation” can be found in the paper by James Stock and
MarkWatson (2002), “has the business cycle changed and why?”, NBER Macroeconomics Annual.
See also P.M. Summers (2005), “What caused the great Moderation? Some cross-country evidence”. Federal
Reserve Bank of Kansas City Economic Review, n°90
23
Schularick M and Taylor A. (2009), “credit booms gone bust: monetary policy, leverage cycles and financial
crises, 1870-2008”, NBER Working Paper, n°15512

44
in the financial crisis. Price reversals arise only through crises that are endogenous as
“booms gone busts” while unknown tipping points shift the mood of market participants
from euphoria to panic.24
If the macro prudential policies are not strong enough to mitigate the impact of the reversal
in asset prices, finance is not self-stabilizing and a single-handed monetary policy only
focused to low inflation alone is not conducive either to macro stability. Real imbalances are
even magnified by the Great Moderation in inflation, because the huge gyrations in asset
prices are real price changes25
.
One response is a renewed version of the Chicago Plan 26
but it is politically demanding since
it implies that banks are treated as public utilities. To be safe in any circumstances, they
would be required to buy Treasury securities for a large share of their deposits and lend only
to highly-rated borrowers. The bulk of credit would then be channeled through from
securitized lending and corporate bonds. However, in narrowing the scope of bank activities,
this plan widens the role of financial intermediaries on the wholesale money market with
shadow banks playing the role of liquidity suppliers. It thus moves fragilities from one
compartment of the financial system to the next.
Another response is to anchor money on a basket of commodities like in the Keyne’s Bancor
proposal at Bretton-Woods. The obstacles to such a Bancor remain but concerns behind this
proposal also remain. Carbon-based assets get a large significance in this perspective, since
they can incentivize financial intermediation to do its job of financing the real economy
instead of pursuing capital gains magnified by higher and higher leverage. They are not a
substitute for stricter financial regulation and will not suffice in preventing financial crises
which arose even in the Gold Standard era, while the first brand of financial globalization
spread worldwide. However, they can contribute to the search for a more stable financial
context and this is the reason why, although the issuance of carbon assets should result from
the voluntary initiative of countries, their international recognition matters.
A portion of carbon assets could first be used to capitalize the Green Climate Fund and reach
levels of capitalization out of reach by the only goodwill of the tax payers of the Annex 1
countries. As suggested by De Gouvello and Zelenco (2010) this Fund could issue Green
Bonds to be acquired by institutional investors worldwide27
searching for diversifying their
portfolios in alternative assets. If the Fund could accumulate $100bns up to 2030 and if it
24
Adrian T., Covitz D. and Liang N. (2013), « Financial Stability Monitoring », Fed NY Staff Reports, n°601,
February
25
Michel Aglietta (2014), “l’aggiornamento des politiques monétaires”, in les Banques Centrales,
26
references
27
C. De Gouvello and I. Zelenko (2010), « scaling up the financingof emission reduction projectsfor low carbon
development in developing countries.Proposal for a low-carbon development facility”, Policy research Working
Paper, World Bank.

45
invested in well-diversified projects, so that one can assume that the probability density
function is Gaussian, it would have 99.9% probability that its capital base could absorb its
losses. Hence, it could issue $1trn bonds to leverage its financing and back credit facilities to
developing countries on real wealth and low-carbon investments28
.
Carbon assets would then de facto acquire the status of world reserves and this opens a
wider perspective to lower one source of tensions in the economic globalization process, i.e.
the distortions in exchange rates due to the ‘‘war-chest’’ of official reserves accumulated in
the emerging world after the 1980s/1990s financial crises in Latin America and Asia. Those
reserves invested mainly in US Treasury securities were built to protect export-led growth
strategies against exchange-rate appreciation and chiefly as self-insurance against currency
crises. Carbon-based reserve assets could allow these economies to increase and diversify
their foreign exchange reserves in a way conducive to cooperation against a global
externality. This concern was underlined by Zhu Xiaochuan, the governor of the People’s
Bank of China when he called for a SDR reserve-based system in 2010. C. Jaeger, A. Haas and
K. Töpfer (2013) show how this proposal could contribute to sustainable development.
If countries with non-convertible currencies have access to a pool of supranational carbon-
based assets, they would be less inclined to run balance-of-payment surpluses, since they
would get their reserves in proportion to emission reductions they finance domestically.29
3.3.2.Clearing up a foggy business environment and getting the world out of the doldrums
The virtuous cycle, potentially triggered by redirecting savings towards low carbon
investments thanks to a carbon-based monetary tool, cannot be understood without coming
back to the paradox of the coexistence of a vast pool of savings and of over-indebtedness
and its impact on real economies.
Since the financial crisis the world economy has languished. The stimulating plans after 2009
succeeded in supporting 3% growth rate in the US in 2010, after two years of recession.
Growth slowed down to 1,8% in 2011and 2.5%,in 2013, fostering a debate on “secular
stagnation”. The recovery was interrupted in Europe with the Euro zone crisis starting in
2010. Real GDP growth of EU-27declined 0.6% from 2007 to 2012 and an almost zero growth
is in 2013. The large emerging countries (Brazil, India and even China) suffered a lackluster
performance in 2013, expected to be prolonged according to the latest World Economic
Outlook (April 2014).
28
The same mechanism could be used by a European Central Bank recognizing carbon assets emitted by its
members
29
This would also spread the gains from seignior age and reduce the perverse effect that forces the United States
to pump out more US$ assets for global reserves.

46
One key underlying mechanism is the deleveraging of the private sector. Planning horizons
of firms and households have not adjusted to the length of the downward phase of the
financial cycle, which is longer than a standard business cycle. It follows that the economic
landscape has become fragmented in developed countries. Households are still digesting the
impact of the property bust in many countries. Small and medium size enterprises struggle
to get credit, while big corporations are awash with cash they do not know how to use
productively. As a consequence investment has been hit more than overall growth (-14% in
the EU between 2008 and 2012).
A carbon-based financial architecture, instead of crowding out productive investment, could
thus help overcoming the ‘‘Buridan’s donkey dilemma’’ by indicating where to invest in this
subdued business climate. For example, institutional investors like pension funds currently
tend to be cautious enough to avoid getting involved in investments that look safe while
masking ventured assets. It would complement carbon price signals which are swamped by
the regulatory uncertainty about tax reforms, the future of carbon trading systems, the
regulation of infrastructure sectors, the geopolitical sensitivity of oil prices and the volatility
of the currency exchange rates.
3.3.3 Climate policies and reduction of structural imbalances in the world economy
To understand why a carbon-based transformation of the international financial system
might trigger a “green growth” regime it is useful to advocate Schumpeter. He taught that
financial crises pinpoint transitions in growth regimes because the upward momentum
preceding crises piles up distortions in market structures and income distribution, while the
downward resolution phase is the search for the adaptation to an incipient technological
innovation wave. Those industrial revolutions are the sources of long-term growth. They
reshape capital accumulation over the long run because they transform the consumption
patterns and the social institutions. However an innovation wave can take off only when its
promises have captured the animal spirits of finance.
The environment is a potential new frontier of innovation supporting a new growth regime,
if it is conceived as the basis for a new social contract in developed countries and for
eradicating poverty and redirecting the economic catch-up of developing countries. The
boost on economic growth might be significant not only because the concerned sectors
represent a dominant share of investments, but also because they are both critical for social
inclusiveness and inward oriented growth, targeted to local markets.

47
The concerned sectors represent indeed 40% of the gross capital formation and the
redirection of these investments is critical for changing development pattern. Let us remind
the orders of magnitude at stake including the supply side energy investments, the demand
side energy investments and the upstream or collateral investments in infrastructure
sectors, material transformation and manufacturing industries: an issuance of credit lines
amounting to 0,12% of the OECD GDP in 2035 would redirect (assuming a leverage ratio of
10 between public money and private finance) about 1000 G$ in 2035 corresponding to
around 8% of the world GCF.
A carbon-based financial architecture could thus to changing the preference of investors
over the last decade for very liquid or speculative options (US treasury bonds or real estate
and commodities) at the expense of genuine investments in future potential growth30
. It
would not crowd out productive investment but could help the “donkey” to decide, and
divert part or the savings from speculative options. For example institutional investors like
pension funds currently tend to be cautious enough to avoid getting engaged with products
that look safe while masking ventured assets.
This diversion from speculative options is all the timelier as the context of reduction of
public and private spending to reimburse outstanding debts may generate a failure on the
demand side of the economy. Within this framework, when the IMF or the European Central
Bank intervene to rescue a bankrupt country, part of the financial support could be delivered
under the form of carbon assets, so that it would be conditional on the launching of a wave
of low carbon investments. The difference with the traditional Keynesian compact is that
credits facilities are backed on infrastructures as real assets.
This might have a significant impact or the future of the world economic equilibrium. Over
the past decades emerging economies grounded their economic catching up on export-led
strategies sometimes at cost of backwardness of the domestic infrastructure. Since 55 % of
carbon savings investment would take place in developing countries a carbon-based finance
would result in domestically reorienting a fraction of the savings that currently flow into the
world financial system (from China to the US for example). Implementing a more
‘‘endogenous,’’ inward oriented, growth pattern might become both attractive for domestic
political reasons and less risky, thanks to the expansion of domestic investment
opportunities opened by the low carbon transition.
Another side benefit of the issuance of carbon-based international reserve assets would be to lower
the tensions on exchange-rates. These risks are partly due to the high precautionary reserves
accumulated in the emerging world after the 1980s/1990s financial crises in Latin America and Asia.
30
Ben Bernanke, Governor of the U.S. Federal Reserve Board recognized as far back as 2005:”During the past
few years, the key asset-price effects of the global saving glut appear to have occurred in the market for
residential investment, as low mortgage rates have supported record levels of home construction and strong gains
in housing prices.”

48
This “war-chest” of official reserves is a self-insurance to protect export-led growth strategies against
exchange-rate appreciation. Carbon-based reserve assets could then allow emerging
economies to increase and diversify their foreign exchange reserves. They would thus be less
inclined to run Balance of Payment surpluses, since they would get their reserves in
proportion to emissions reductions they finance domestically. This would also contribute to
spreading the gains from seignior age and reducing the perverse effect that forces the US to
pump out more US$ assets for global reserves.
More fundamentally, carbon-based reserve assets would help solve structural imbalances of
the world economy: huge capital flows from China to the US, the catching up of emerging
economies grounded on export-led strategies sometimes at the cost of backwardness of the
domestic infrastructure, undermine the social contract in many OECD countries. Since the
new carbon-based financial products could be attractive as well for private savings of
emerging countries, the carbon-based finance would result in domestically reorienting a
fraction of the savings that currently flow into the rich countries’ banking systems. The
strategic choice for these economies would thus be between a) continuing mercantilist
exchange rate policies and purchasing power gains in favor of reserves accumulation and b)
implementing a more “endogenous”, inward oriented, growth pattern. This second option
might become attractive with a higher guarantee that less export-oriented strategies do not
lower the pace of growth and then trigger domestic social tensions.
A climate-friendly financial architecture would then help pinpoint the thin pathway
between extreme rigor which would freeze economic growth (and throw some regions into
recession) and extreme laxity which would push the burden of debt onto future generations.
It would transform the climate challenge from a pure constraint to a lever for sustainable
growth backed by a ‘green’ content. This would have a critical impact on the developing and
emerging economies which will account for a dominant share of the infrastructure market
over coming decades.
Annex 1 countries would assume their historical responsibility in the climate affair and the
financial breakdown, without putting huge pressure on their weakened taxpayers. They
would do so in a way consistent with their budgetary constraints and their concerns about
employment and social stability. Embarked upon in the form of a forward contract, with
carbon reduction as an effective under layer, governments, industries and trade-unions
would then be interested in the emergence of any form of carbon price.
Conclusion:
To sum up this monetary instrument is tantamount for the central bank to buying a service
of carbon emission reduction at a price justified by society’s willingness to pay for a better

49
climate. Carbon-based liquidities can be therefore considered as ``equity in the
commonwealth''. The equity pays dividends in the form of ``actual wealth'' created by
productive low carbon investments and averted emissions in the short term, a stronger
resilience of the economy to environmental and financial shocks in the longer term. The
proposed system would send a carbon price signal (through the SCC) while being politically
acceptable because it does not impose direct costs on firms or consumers. It also stimulates
mitigation efforts efficiently without imposing demands on industrialized country
government budgets. It will also help to divert a share of private savings from speculative
assets to productive low-carbon investments. Hopefully, the scale of this system could be
large enough to make a significant contribution to the global mitigation effort and to
stimulate economic growth
This perspective will never reach the diplomatic agenda, unless it is perceived by the high
level policy-makers as responding to the specific problems of each region.
Let us start with the emerging countries which exert de facto a vetoing power, because their
lack of involvement is a convincing argument in the US and the EU to mobilize public opinion
against significant international commitments. However Brazil, China, India, South-Africa
have the same interest in receiving a support to redirect their infrastructure policies towards
low-carbon and less energy-intensive choices (Shukla and Dhar, 2011). This is a matter of
energy security, of more inclusive regional and urban development and of less exposure to
turmoils of currencies and domestic asset prices by sudden changes in the direction of cash
flows.
China has a specific problem due to the inversion of its pyramid of age between 2020 and
2030 and the fall of its saving rate. It might be trapped, at the same time horizon, in a high
energy intensive carbon pathway which might turn it very vulnerable to any energy shock.
This is why China has embarked in a new stage of reform under the heading of sustainable
growth. An overhaul of the price system to transform the structure of returns and risks,
specifically introducing a carbon price and pushing up the price of electricity and fossil fuels,
is underway. It aims at changing priorities from maximum growth to diversified axes of
development: urbanization targeting new multi-polar cities over 20 years, reducing energy
and carbon intensity in industry and developing high-end services.
Europe is specifically interested in complementing its current fiscal compact by a ‘green
growth’ compact to reinforce a unity currently undermined by trade imbalances amongst
partner countries. An inclusive economic paradigm could be facilitated by the creation of
environment-friendly jobs through the whole range of the productive structure (housing
rehabilitation, recycling, local transports, bio agriculture and preventive health care). Such a
policy has the additional merit of reducing energy intensity, abating carbon emission,

50
stimulate regional demand and diminishing dependency of Europe towards primary
commodity producers. Europe could thus match its own interest with a leading role in
climate negotiations to recover the leadership obtained with the Kyoto Protocol (C. Jaeger et
al. 1998).
Policy lines might move in the US where multiple climate catastrophes, including Sandy that
hurt badly New York City, have revealed the decay of public infrastructures and the lack of
public services in adverse conditions. Yet, vested interests in the US bet on cheap energy due
to massive investment in fracking shale gas. The core issue is whether shale gas will be used
as a “manna from heaven” to maintain their historical development pattern, or as a tool to
facilitate the switching towards low energy-intensive patterns. The upgrading of climate
finance sketched in this paper might incite them to follow the second option given its
economic and geopolitical side-dividends.
One cannot either disregard the palatability of the suggested perspective for the oil and gas
exporters which are the other key players of a long term energy transition under climate
constraints. Depending on the design of the post-2015 climate regime (including the absence
of effective regime), they might perceive climate policy as a threat because of their adverse
impact of the prices of fossil fuels or as a way of escaping the resource curse by using long
lasting rents to switch towards viable industry, agriculture, transport and energy systems.

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