23 December 2015

Cracking the VW case with NOx bonds

Environmental policy performance bonds could help prevent a repeat of the Volkswagen emissions scandal, say Michael Mainelli and Abdeldjellil Bouzidi

"Decades ago, when our car had the 'knocks', we added lead to our fuel.  Now when our car has the NOx, we use our bypass software."

 In September 2015, environmental regulators found that German car maker Volkswagen had intentionally programmed turbocharged direct injection diesel engines to activate certain emission controls only during laboratory testing. The software allowed the vehicles' nitrogen oxide (NOx) output to meet regulatory standards during testing but produce up to 40 times higher NOx output in real-world driving.

At present, Volkswagen appears to have applied this 'cheat' to an estimated 11 million cars worldwide. In October, the crisis deepened with 'irregularities' surrounding the fuel consumption measurements and carbon dioxide (CO2) emitted by 800,000 cars. 

The scale of the deceptions, number of recalled vehicles, environmental damages, effects on health, and even the death toll largely due to heart and lung disease, are still unclear.  The UK's Department for Environment Food & Rural Affairs believes "that the effects of NO2 on mortality are equivalent to 23,500 deaths annually in the UK." Transport is responsible for about 47% of UK NOx emissions, but "around 80% of NOx emissions in areas where the UK is exceeding NO2 limits are due to transport".

The European Environment Agency estimates NOx emissions due to transport at around 46% across Europe. Researchers wonder "if strategies used by manufacturers to fool the testing system have contributed to the unexpected failure of countries to reach NOx targets."

While the extent of the swindle is still being calculated, the ramifications of the scandal in distrust of car makers, regulators, politicians and business are even murkier. So what could help solve this case?

We would like to propose a novel, yet simple, approach to ensure that future regulatory structures provide a school of hard financial knocks to automotive firms that transgress policy objectives: environmental policy performance bonds.

Policy performance bonds for car companies

Automotive firms, like Volkswagen, could be forced to sell such bonds in order to enter national markets.  One example might be NOx bonds, which would link bond interest payments to a NOx emission reduction target.

An investor in a NOx bond would receive an excess return if the issuing firm's environmental reduction targets are not met.  For example, the bond might pay an extra percentage point of interest for each 5% an automotive company's emissions are above a target. 

Failure to meet targets would mean higher interest payments to investors. NOx targets could be linked to the number of cars sold in a specific region (Europe or the US for example) or country. If the company or companies achieve NOx reduction objectives, no extra interest is paid. If they fail, they could pay a punitive interest rate depending on the deviation from the target. The bonds would align financial and environmental incentives and help automotive firms regain customer and investor confidence.

Policy performance bonds for global environmental regulation

A government would set out appropriate environmental targets, e.g. average NOx levels from sampling stations a decade ahead, or overall carbon dioxide (CO2) emissions by vehicles, or average end-user fuel consumption per vehicle kilometre travelled.

These targets would be linked to a variable bond interest rate, e.g. a base rate plus 1% interest per percentage point a target is exceeded. The effect of a 10% overshoot of NOx targets on a bond with a base rate of 5% would be a bond that paid 15% – quite a significant interest rate. Automotive companies would be uncomfortable issuing such bonds unless they were clear that they intended to ensure targets were met.

An acceptable base rate is likely to be set by the market at slightly less than a traditional automotive bond, largely because there is significant upside for investors if firms in aggregate fail to achieve the target. Firms issuing such bonds ought to hope for low base rates while there is uncertainty. In effect, investors should be providing firms with loans at below typical base rates in return for betting against them on achieving targets. The maturity date for the bonds should be set over a reasonable time period, perhaps a decade. 

Of course, the net effect would be to encourage appropriate investment in achieving pollution reduction targets. If the low-pollution future fails to arrive, automotive firms wind up paying investors higher interest rates on their debt. If the low-pollution future does arrive, automotive firms had the incentive to help deliver it. If firms tell the truth, they get cheap money. If firms are not committed, they pay.

There are some obvious niggles. Not all transport companies are equal. Firms might be 'encouraged' to issue bonds in line with sales or market share or calculated pollution. And not all NOx or CO2 or fuel consumption is from transport.

This last observation leads to considering widening the scheme to other sectors. Equally, it invokes caution in ensuring the bonds are effective sticks but not punitive instruments.  Further, these could be group targets, e.g. automotive emissions in total for a country. As a group target, automotive bonds might encourage a more systemic approach working together on traffic reduction or advanced technologies.

With a group target, firms would have an incentive for policing each others' compliance. In an ideal world, the automotive industry might issue a 'funding principles aligning financial and environmental incentives' report each year.

With so much uncertainty about automotive company morals, firms will need ways to distinguish themselves in a crowded market. They also urgently need to regain stakeholders' confidence and to act instead of react, waiting for financial punishment from regulators. The more firms issued such bonds, the more convinced the market would be that they indeed intend to contribute to reducing emissions and achieving other environmental targets.

Professor Michael Mainelli is executive chairman of Z/Yen Group, a commercial think-tank for the City of London and principal advisor to Long Finance, where CO2 government bonds were first proposed in 2009.

Dr Abdeldjellil Bouzidi is an economist, lecturer, entrepreneur and independent researcher. He recently founded Emena Advisory, a strategy-consulting firm and is a member of France's Official Statistical Authority.