Pioneering a New Financial Instrument to Help Combat Climate Change

To help keep finance flowing to projects that combat climate change, the World Bank and partners are developing an innovative pilot program that allows project developers and financiers to compete in an online auction to deliver the largest number of emissions reductions at the lowest cost.

The Pilot Auction Facility for Methane and Climate Change Mitigation (PAF) will auction price guarantees for CO₂ emission reductions from projects. The auction, by selecting the cheapest mitigation opportunities offered, is expected to maximize the amount of emission reductions achieved per dollar spent. This could have huge implications for the future of climate finance: auctions and price guarantees have the potential for replication and scaling-up by the Green Climate Fund and others.   

The auctions will target specific sectors, starting with technologies that reduce methane emissions, such as methane capture projects at landfill, animal waste, and wastewater sites. A large number of these projects exist in developing countries, and in many cases they are struggling financially. Yet the additional revenue required to unlock these investments is often small. It has been estimated that, counting all developing countries, there are methane reducing projects that could deliver as much as 8,200 million tons of carbon dioxide emission reductions at less than $10 per ton in incremental cost financing.

While the pilot will have resources to support only a sub-set of these, the potential for scaling up is massive.

“We hope this pilot auction facility will be an efficient way to reduce emissions and price carbon. If so, it will be the latest example of the kind of financial innovation needed to spur the private sector investment for scaled up climate action,” said Rachel Kyte, World Bank Group vice president and special envoy for climate change.

In subsequent auctions, the PAF will consider other sectors and technologies. And outside of the PAF’s pilot, the combination of auctions and price guarantees has the potential to go well beyond emission reductions, to target other types of results such as access to energy, health benefits like reducing asthma-inducing air pollution, and preventing stunted crops.

The PAF’s price guarantees will take the form of put options that permit their holders to sell future emission reduction credits to the facility at a known minimum price. This price is determined by the auction.  

Put options are commonly used by commodity producers to lock in a floor price for their product without limiting any upside price gains, and can best be thought of as price insurance. 

For example, a farmer buys put options at the beginning of the season to sell his grain in the event there is a market-wide bumper crop at harvest and the price for grain collapses. Given a low market price, the farmer exercises the option to sell his produce at the fixed price. The option acts as price insurance to guarantee a minimum return to the farmer, removing worry and allowing him to make the necessary investments in seed, fertilizer, equipment, etc.  However, at harvest, if market price for grain is above the option-guaranteed price, the farmer could then sell the grain on the market rather than exercising the option – and the option expires unused.       

In the case of the PAF, the put option will be for emission reductions, or carbon credits, to be generated by climate-smart projects. The project developers and investors, that believe they can generate emission reductions most cheaply at a specified premium, will win the auction for the put options. This determines the floor price. Just as with the farmer and his grain, the option owners are guaranteed this minimum price giving them the confidence to invest in green projects.  

This minimum price is backed by donor contributions to the PAF, which has a targeted capitalization of $100 million. Importantly, put options must be redeemed with future emission reductions, ensuring that the PAF incentivizes future mitigation and isn’t swamped by credits trading on today’s carbon markets. 

Testing the use of auctions and put options to remove risk from climate-friendly investments is particularly important at a time when the lack of a robust price on carbon is causing investments by the private sector in developing countries to slow down. 

The facility will ensure results on the ground by paying the put option strike price only once the emission reductions are independently verified by auditors. Also, the put options will be tradable, which means for example that if the buyer of the put option has a landfill that is not generating the volume of carbon credits anticipated, the holder can transfer ownership of the put option to another developer who thinks his project will generate eligible emission reductions and can make use of the put option. This tradability from one option holder to another maximizes the likelihood that the PAF achieves its full potential to reduce emissions. 

Delivering climate finance at the scale needed for a 2-degree-warmer world requires new and bold approaches like the PAF that borrows tools from capital and carbon markets. The private capital currently sitting on the sidelines in global markets can be tapped to support local entrepreneurs investing in climate mitigation projects. The PAF, while just a pilot, will sustain this momentum and demonstrate a proof of concept for an efficient way to maximize the use of scare public funds for investments in climate change mitigation.