September 26, 2014 / 11:15 AM / 3 years ago

AFRICA INVESTMENT-Africa adds climate change bonds to global warming arsenal

JOHANNESBURG, Sept 26 (Reuters) - Global warming in Africa may soon move bond markets.

In 2016, the first climate change bonds will be issued from Africa - unique instruments that will enable the world’s poorest continent to tap both capital markets and donor funds to bolster its defenses against extreme weather events such as prolonged drought or extreme heat.

The plan, unveiled on the sidelines of the U.N. climate summit in New York this week, will see an initial issue of around $200 million for up to five years.

If successful, the bonds will be rolled out every five years over a period of at least three decades, potentially creating the conditions for a secondary market to take root.

The bonds are being developed by, and will be issued by, African Risk Capacity (ARC), an agency of the African Union created earlier this year to improve the region’s ability to plan, prepare and respond to natural disasters and climate change.

They are not the same as green bonds, which are linked to investments perceived as environmentally friendly, such as the construction of wind farms.

Rather, they will be modeled on catastrophe bonds, a recognised asset class traded since the 1990s and created to support U.S. reinsurers who had too much risk in their portfolios, such as exposure to hurricane damage in Florida.

The introduction of climate change bonds comes against a backdrop of a flurry of African Eurobond issues in recent years.

“These will be the first climate change bonds and the first Africa-specific catastrophe bonds,” said Joanna Syroka, senior programme advisor for ARC.

“So it will be something investors will not have in their portfolios and will help them to diversify risk,” she told Reuters in a telephone interview from New York.

BIG YIELDS, BIG RISK

Catastrophe, or “Cat bonds”, work like this: investors put up the capital, which then sits in a collateral account as either cash or very safe triple-A-rated instruments.

Investors get a high yield or premium but here’s the catch: if disaster strikes, the bonds can default and anyone who has bought into them can lose their principal.

In the case of climate change bonds, the plan is for investors to put up the capital while the yield will be leveraged from donor funds or aid, Syroka said.

Pay-outs for disasters will be tied to “extreme climate indices” still under development.

“We’ll be designing extreme climate indices that will track extreme weather events across different regions of Africa and by that I mean drought, heat, and rainfall,” said Syroka.

If the index does not do anything out of the ordinary then the investors in the bond will get their capital back in five years, along with the coupon.

But if it exceeds some kind of threshold that indicates an extreme weather event has occurred in the region, then some or all of the principal will be paid out to participating states to help them mitigate the impact or respond to a disaster.

“It would have to be something extreme and really unexpected to trigger the threshold of the index,” Syroka said.

At present five African countries - Niger, Senegal, Mauritania, Kenya and Mozambique - are eligible to take part in the planned bonds because they are already part of ARC’s sovereign risk pool insurance scheme, also set up to deal with droughts, floods and other server weather occurrences.

More countries are expected to sign up before the first bonds are issued and the indices will be tailored to the regions where member states are found. For example, cyclones are only relevant for southern Africa.

Africa as the world’s least-developed region produces little of the greenhouse gases, such as emissions from coal-fired plants, that most scientists link to rapid climate change.

But it is the continent widely seen as most vulnerable to a changing climate as much of its population is poor, rural and often dependent on rain-fed agriculture.

In a few years’ time, expect some bond traders may be watching the weather in Africa as keenly as corn traders. (Editing by Susan Fenton)

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