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What impact bonds can learn from the carbon market

Written by Shelagh Whitley

​These days there is a lot of chatter in development circles about Development Impact Bonds (DIBs) as a financial solution to a wide range of challenges. The aim of these bonds is to use a payment for performance model (PfP) to direct the resources and innovation of the private sector toward the development goals of donors and governments.

The carbon market is currently the largest PfP mechanism in the development space. As donors, foundations and charities seek out innovative mechanisms for generating and delivering aid, there is a lot that can be learned from the humble carbon credit.

There are multiple elements of the carbon marketthat hold lessons for DIBs. These include its successes in mobilising private investment, crowdsourcing impact methodologies, and transparency, and its weaknesses in failure to maintain demand, limited support for the poorest countries, and high transaction costs.

For now, let’s focus on two of these lessons.

1)     Generating demand from the private sector

It is not evident where initial demand will come from for DIBs.

Private money flowed to the carbon markets at scale because of demand in countries that had set caps on emissions under a UN agreement (the Kyoto Protocol). The most notable demand centre was a trading system established in Europe, where industry and power companies had to reduce emissions, pay a penalty, or purchase carbon credits.

From 2003 to 2013, the UN-led portion of the carbon market attracted investment of over US$215 billion to projects in developing countries. These funds went towards the establishment of over 70,000 emission-reduction projects, ranging from clean cook stoves in West Africa, to gas capture from landfills and farms in Brazil, to solar and wind energy in China.

But just as demand can be created, it can be taken away.

Low caps in the emission-trading scheme, failure to reach a new agreement through the UN in 2009, and the financial crisis led to a significant drop in carbon prices. The value of credits from projects in developing countries fell from over €20 in 2008 to below €1 today.

Short-term demand for DIBs is predicted to come from ‘altruistic’ elements of the private sector and, over the longer term, from developed and developing country governments. However, without public-sector demand at scale, it seems unlikely that we will see private finance flowing.

One option to kick-start these instruments could be donor commitments to directing a proportion of aid through impact bonds, along the lines of Advanced Market Commitments for vaccines. This approach is already being discussed as a panacea for the ailing carbon market. Also, in the absence of a strong carbon-price signal, climate bonds are attracting increasing levels of investment. As developers of climate bonds have significant carbon-market expertise, they would be fruitful collaborators with those exploring DIBs.

2)     Crowd-sourcing approaches for impact measurement

Within the DIBs model, there has been minimal discussion of the processes and infrastructure needed for impact measurement and third-party verification.

Carbon-market investors were willing to put their money into projects in developing countries on the basis that they would receive credits with a market value. The issuance of these credits only took place once the emission reductions were achieved and verified through an internationally agreed (and UN-approved) process.

One of the most critical elements of this UN process was that anyone could propose a new methodology to account for carbon-emission reductions. Thus far there are over 200 approved and active methodologies for measuring the greenhouse gas reduction impact of projects, on the basis of which the UN has issued over 1 billion carbon credits. This crowd-sourced and open-source approach quickly allowed a large number of different project types to be implemented across 88 developing countries, all of which generated a standardised tradable asset.

Those seeking to generate DIBs will need to measure outcomes in education and health, for example, which may be even less tangible than emission reductions. DIBs developers could benefit significantly from the lessons in impact assessment, verification and third-party auditing learnt in the carbon markets.

Many other lessons from the carbon market would be very useful for developers of DIBs. These include approaches for standardising contracts, ensuring both commercial confidentiality and transparency, baseline setting (using control groups), determining additionality (how to decide if it would have happened anyway), avoiding leakage (how to avoid diversion of funds from activities with impacts that are difficult to measure), and preventing perverse incentives and fraud.

Rather than reinventing the wheel, we need to mobilise the knowledge and resources we already have. First steps are to convene some key actors and thinkers in the same space, from the world of DIBs, the carbon market and beyond.