Policy Research Working Paper 11114 Innovative Financial Instruments and Their Role in the Development of Jurisdictional REDD+ Alexander Golub Marek Hanusch Diogo Bardal Bruce Ian Keith Daniel Navia Simon Cornelius Fleischhaker Economic Policy Global Department May 2025 Policy Research Working Paper 11114 Abstract Achieving global net zero carbon emissions requires stop- trading, enhancing its utility for both issuers and buyers of ping deforestation and making full use of tropical forests as carbon credits in the framework’s jurisdictional programs. carbon sinks. Market instruments for the sale and purchase The paper shows how a combination of forest carbon bonds, of emission outcomes coming from Reducing Emissions where countries sell forward (or commit) their emission from Deforestation and Forest Degradation framework pro- reduction outcomes, as well as call and put options can be grams could play a very significant role in achieving this used to de-risk and encourage early investment in jurisdic- goal. The development of these markets has been insuffi- tional Reducing Emissions from Deforestation and Forest cient so far: their scale as of today is much lower than what Degradation framework programs. To quantify the value would be required to generate meaningful resources for the of these innovations, the paper evaluates the potential scale countries that host tropical forests, and the quality of exist- of these instruments for the case of Brazil. The estimates ing instruments is generally insufficient to allow a scaling up suggest that the amounts that could be mobilized would in demand. However, efforts to improve the transparency represent a critical contribution to effective forest conserva- and integrity of these instruments are accelerating, par- tion. The proposed instruments and methods can be used ticularly around jurisdictional Reducing Emissions from by other tropical nations that are prepared to implement Deforestation and Forest Degradation framework programs. a large-scale jurisdictional program. Although the paper In parallel with these efforts, innovations in financial instru- acknowledges that the current state of carbon markets ments suited for the framework’s carbon markets are also would still not allow their deployment in the short term, taking place, but their scale is limited so far. This paper the conclusion is that these instruments have significant looks beyond the current state of the framework’s carbon potential, and their future development could be an import- markets to consider a set of innovative financial instruments ant contribution to the establishment of successful markets that would allow completing the infrastructure of emissions for the conservation of tropical forests. This paper is a product of the Economic Policy Global Department. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at mhanusch@worldbank.org. The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Produced by the Research Support Team Innovative Financial Instruments and Their Role in the Development of Jurisdictional REDD+ Alexander Golub, Marek Hanusch, Diogo Bardal, Bruce Ian Keith, Daniel Navia Simon, and Cornelius Fleischhaker Key words: JREDD+, Forest carbon bond, Emissions trading; Call and put options; Brazil. JEL: Q52, G23, Q23, Q58 1. Introduction Forests have a critical role to play in global efforts to achieve net zero emissions, as well as for maintaining biodiversity, contributing to human health, and stabilizing weather patterns, among others. Achieving global emissions reduction requires making the most of forests’ ability to store carbon and, urgently, to limit emissions coming from their destruction. In many developing countries with tropical forests, deforestation is the reflection of an unsustainable economic model that favors resource extraction and frontier expansion. Moving toward a more sustainable growth model in which economic development is consistent with standing forests, a fundamental shift in the growth model is needed. Hanusch (2023) and Cheston et al. (2023) suggest that ending Amazon deforestation will require a policy package that includes a mix of effective conservation policies and economic policies that foster productivity through structural transformation while promoting sustainable rural livelihoods. Such structural economic shifts will require a potential sizable upfront investment across different sectors, including direct forest conservation but also in other areas. Revenues obtained under the REDD+ (Reducing Emissions from Deforestation and Forest Degradation) framework could become a relevant source of financing for the countries hosting the largest tropical forests to achieve this goal. Forest carbon is an essential component of these countries’ natural capital, and its conservation will have long-lasting benefits for the global community. These facts suggest an opportunity to leverage forest carbon’s future value to pay for the investments required in the near-term to stop deforestation and promote sustainable development. In this regard, both public funds (international and domestic) and the engagement of private capital play an essential role in jumpstarting a REDD+ program and in scaling up the supply and demand of emission reductions. However, realizing this value in a way that is aligned with the needs of tropical forest countries and the global community has proven largely futile to date. Currently, forest carbon emissions reductions (ERs) are traded on voluntary markets at relatively low prices. The average price of REDD+ ERs stood at US$11.21/tCO2 in 2023. This is a significant increase from previous years: $3.9/tCO2 in 2019, $4.7/tCO2 in 2020, US$5.78/tCO2 in 2021 and US$10.14/tCO2 in 2022 (Forest Trends 2023; Trove Research 2021). 1 However, the volumes in the market are still very small and the prices are still too low to provide sufficient incentives to stem deforestation in tropical forest countries. As a result of underinvestment combating these phenomena, deforestation and forest degradation continue and countries are losing their emissions reduction potential. Since achieving emissions reductions from the forest sector is relatively cheap compared to other sectors, the world is losing emissions reductions that are urgently needed to slow climate change and limit the cost of the global transition to net zero. Understanding the future value of forest carbon is essential to encourage investment in its protection. Golub at al. 2023 and Fuss et al. 2021 estimate an average cost of US$30-US$50/tCO2 associated with economically viable REDD+ supply needed to narrow the emissions gap. Even with these higher prices, according to mark to model valuations, REDD+ could potentially produce net global cost savings of US$33 trillion over the next 50 years for the transition to net zero (see Fuss et al. 2021). These estimates suggests that the problem is not lack of value 1 Preliminary assessment of carbon price for 2023 (https://3298623.fs1.hubspotusercontent- na1.net/hubfs/3298623/SOVCM%202023/2023-EcoMarketplace_SOVCM-Nov28_FINALrev-1.pdf) 2 of avoiding deforestation, but rather finding ways to unlock its full potential. The issue is how to mobilize investors and countries to act on this value. The unprecedented scale of ERs supply (hundreds-million tCO2 a year) that would be associated with large reductions in deforestation, requires building innovative institutions to implement these REDD+ programs. The development of well-functioning jurisdictional approaches is widely understood to be critical for the scaling up of deforestation efforts (see WEF 2023). Delivering the required ER volume on a project-by-project basis would be impossible. Well-described in the literature (see, for example: Golub et al. 2018; Wunder et al. 2020; Nepstad et al. 2021; Essen and Lambin, 2021) and tested in different countries, 2 jurisdictional approaches (JREDD+) provide the required framework to start and scale up REDD+ programs. The main feature of JREDD+ programs is that the quantification of carbon emission reductions is performed for whole geographical areas covering a regional or national jurisdiction. Payments are based on the avoidance of deforestation in this geographical area and are received by institutions that have the responsibility to control deforestation in it. This compares with REDD+ project approaches, where individual developers claim emission reductions if they do not deforest specific plots they own or manage. JREDD+ approaches have benefits in terms of their environmental integrity (Espejo, Becerra-Leal and Aguilar-Amuchastegui, 2020) and important work is ongoing on “nesting” of jurisdictional and project approaches (World Bank, 2021). Successful dynamics of JREDD+ will require scaling up both demand and supply in parallel. Different countries are at different stages of JREDD+ readiness. Brazil already has existing JREDD+ systems, notably at the state- level, but so far it has not been able to carry out large-scale sales of these credits. In other parts of the world, JREDD+ approaches are gaining increasing traction, both on the supply and demand of credits. Recently, Costa Rica and Ghana have received payments from the Forest Carbon Partnership Facility (FCPF), 3 and these two countries have also signed binding agreements to sell jurisdictional credits to the LEAF coalition 4 of private purchasers, an important example of private investment following up after the initial phases supported by public funds. Several countries are following this route, with participation in the FCPF and ongoing negotiations with private purchasers: Viet Nam, Nepal, Kenya, Ecuador, and some Brazilian states are important examples here. These are important steps in creating the supply structures and demand sources for JREDD+ credits and establishing its track record. Further scaling up JREDD+ approaches will require increasing the participation of the private sector, both as buyers of credits and as financers for the actions that create ER supply. As the market develops, different agents will have different motivations and different needs for risk management instruments. Some investors will be in search of high-quality REDD+ credits, that measurably and credibly reduce greenhouse gas emissions. Other investors may see opportunities in producing ERs for the emerging ecosystem services market. Some corporations will still consider ER as an Environmental, Social, and Governance (ESG) investment. Providing 2 The Forest Carbon Partnership Facility of the World Bank (FCPF), which has a budget of $1.3 billion (https://www.forestcarbonpartnership.org/), is implementing JREDD+ programs in several tropical countries. Some of them have already delivered their ERs. Emergent (https://emergentclimate.com/) and the Leaf coalition committed US$1.5 billion to purchasers of high-intensity JREDD+ ERs and created a JREDD+ supply pipeline primarily focused on private buyers. 3 Thanks to the FCPF, more than 30 countries are now developing their capacities to launch or expand JREDD+ programs. Fifteen countries have already engaged with the Forest Carbon Fund and are in the process of their first or second ER delivery. 4 https://www.leafcoalition.org/ 3 financial solutions to these different needs will be important to allow an early engagement of private capital, as JREDD+ markets evolve. The main contribution of this paper is to show how innovative institutions and financial instruments could be used, in the context of the ongoing development of JREDD+ programs, to de-risk and leverage private capital, helping host countries to monetize the future value of ERs and receive a fair share of the global economic benefits of avoided deforestation and reforestation, while providing new instruments for investors to obtain value in the context of global decarbonization. Critically, unlike traditional REDD+ projects or other voluntary offset methods, a JREDD+ system produces a truly homogeneous underlying asset: ERs attributed to avoided deforestation in the relevant jurisdiction. This opens the opportunity for the creation of three key financial instruments (carbon bonds, call options, and put options) to develop carbon markets that are useful for investors and countries at the scale required to curb deforestation. Carbon bonds would provide for borrowing against the delivery of future emission reduction outcomes, hence providing tropical forest countries with the resources they need to invest to curb deforestation, while giving investors access to a stable supply of emission reductions. Options (calls and puts) would provide tools to obtain revenue, ensure price discovery and manage risks, both for investors and forest country governments. We offer a numerical example for Brazil (in the Annex) that illustrates how to use carbon bonds, call, and put options to enhance a jurisdictional framework’s ability to leverage private investment and accelerate JREDD+ programs. The specific numbers used in the example give a rough sense of the size of ERs’ value and potential investment that could be mobilized through a large-scale JREDD+ program, even if they do not represent a precise assessment. The results suggest that the scale of mobilization achievable with these instruments is large enough to create strong policy incentives for deforestation avoidance. While our numerical examples are based on Brazil, the findings are applicable to any tropical nation that qualifies for JREDD+ programs. The suggested approach combines the potential of future ER production to finance the upfront investment necessary to expand JREDD+ supply from tens to hundreds of millions of tons of CO2 equivalent in emission reduction per year (related to similar analysis in Golub et al. 2021). This paper is structured as follows. The next section discusses the economics and development drivers of deforestation and the fundamentals of JREDD+. Section 3 presents forest carbon bonds and the use of call and put options to de-risk investments in deforestation avoidance. Section 4 presents an assessment of the estimated revenue mobilization capacity of these instruments. Finally, section 5 summarizes the main conclusions and discusses recommendations. 2. JREDD+ economics: Forest carbon valuation and revenue distribution Evolving global and regional climate policy may create an opportunity for a significant increase in demand for forest carbon. In 2024, about 12.6 GtCO2e, representing 24% of global GHG emissions was covered by regional, national, and subnational carbon pricing initiatives. 5 The price ranged from $0.46/tCO2 to $176/tCO2. A rapid expansion of coverage and an increased strength of climate policy will further stimulate an increase in demand for convenience instruments, including REDD+ while lagging supply could be limited. Thus, corporations will end 5 https://carbonpricingdashboard.worldbank.org 4 up short on abatement. Golub et al. (2018) call this situation an abatement 'short squeeze,' using the financial term. 6 Carbon markets provide a mechanism for private finance to support avoided deforestation and forest restoration. Currently, REDD+ is not accepted in most compliance markets, and transactions primarily occur in the voluntary carbon market. However, this market is shallow and cannot meet the demand for transactions needed to reduce the emissions gap, putting the global economy on track to meet the net zero emissions goal. Despite an increase in the volume and weighted average price of carbon over the past five years, the voluntary carbon market (VCM) continues to be limited in scope. According to the latest analysis by Forest Trends’ Ecosystem Marketplace, the volume of the forest carbon transactions on the VCM has nearly quintupled since 2019, from about 28 million tCO2 to 142 million tCO2 in 2021; then it fell to 35.8 MtCO2 in 2023. This decline in volume reflects the decline of the total volume of carbon transected at the VCM. The forest carbon in 2023 accounted for 34% of the volume. The average price of ERs on voluntary carbon markets has increased from US$3.9/tCO2 in 2019 to US$9.72/tCO2 in 2023. The share of REDD+ on the VCM also went up from about 30% in 2019 to 40% in 2021. 7 In 2022, the total forest carbon transaction was $820, but in 2023, it plunged to $329. 8 Afforestation/Reforestation and Improved Forest Management projects typically earn higher prices due to higher costs involved in these project types as well as the perception by some that carbon removal is more valuable than emission reductions. Neither the price currently paid for forest carbon nor the volume of REDD+ transactions in carbon markets is in line with the net zero goal. The conservation and restoration of tropical forests can fill the emissions gap to transition to a carbon-neutral economy by the middle of this century (Masson-Delmotte et al., 2018, Bush et al., 2019; Fuss et al., 2021). This forest-based emissions reduction is critical to control the cost of the global and regional climate policy adjustment and to avoid an abatement short squeeze. Understanding the inevitability of climate action could motivate corporations to secure a long-term supply of REDD+ in order to control and manage the costs of transitioning to net zero (Golub et al., 2018, 2021). Corporations may also be inclined to use new financial instruments to take long positions in forest carbon in order to hedge against future liabilities or to be exposed to market upside. In light of this potential, it would be wise to develop strategies to rapidly increase the supply of REDD+ credits in response to climate policy adjustments by building more sustainable cities. While doing that, countries will be still benefiting from transactions on voluntary markets. 6 A short squeeze occurs when many investors bet on the stock price to go down, but the stock's price shoots up instead. 7 State of the Voluntary Carbon Markets 2024 https://www.ecosystemmarketplace.com/publications/2024-state-of-the-voluntary- carbon-markets-sovcm/. 8 Same as above. 5 2.1 Using future emission reductions to leverage investment in JREDD+ Obtaining the supply of ERs represented in the previous analysis requires major upfront investments to build institutional capacity and create economic incentives to protect forests (Angelsen et al. 2018; Golub et al. 2021). This investment could be financed from a variety of sources, including international aid and domestic official resources to build necessary institutions and scale up action. Beyond these funds, private investments could be leveraged to scale up JREDD+ and reach the maximum potential of avoided deforestation, especially under the assumption that the private sector will have a material interest in the carbon credits being generated. Financing forest protection through private investment to be remunerated through future REDD+ credits provides several desirable features. It reduces fiscal strain on governments since these activities will no longer need to be financed through taxation or issuance of conventional debt (it may or may not involve on-budget expenditure, depending on institutional structure). It also provides a direct link between resources dedicated to forest protection and results (reduced deforestation leading to creation of REDD+ credits), aligning incentives and providing for greater accountability and possibly innovation in finding the most effective ways to protect forests. Conceptually, the solution is relatively simple: countries could borrow against future ERs that, according to economic analysis of global climate policy, most likely will have value. However, two factors hinder the development of instruments to allow this mutually beneficial trade. First, implementation (or "entry") cost plays a critical role in the initial stage of JREDD+ market development. Building institutions in the host country and market infrastructure constitutes a fixed-cost component. These expenses are independent of the volume of ERs and the sizes of transactions. Therefore, in the initial stages, while volumes remain low, participants’ trades would be uneconomical if they had to sustain all the fixed costs in the system. However, when volume builds up, the weight of these fixed costs declines. Second, information asymmetries and execution risks are pervasive in these markets. As the experience of individual carbon offset projects based on avoided deforestation shows, the variety of projects, with different quality of developers, etc. create a permanent doubt over the whole market, which then increases investors’ supervision costs. To address the performance risk, it is important to establish strong institutions and investment programs that verifiably reduce deforestation. Jurisdictional programs partly alleviate these concerns as the emission reductions are measured for whole jurisdictional territories, hence increasing confidence that the underlying emission reduction assets reflect systemic reductions in deforestation on relevant areas (Espejo, Becerra-Leal and Aguilar-Amuchastegui, 2020). Figure 1 presents the stylized process of using future ER production to leverage investment in JREDD+. The initial JREDD+ interventions supported by international donors help the host country to build the necessary institutions and a legal environment to implement JREDD+. The jurisdictional program will require additional actions to build a legal environment and expand institutions to implement JREDD+, including MRV and enforcement mechanisms, actions to mitigate reversal risk, etc. This expansion requires upfront fixed costs. If ER production stays relatively low, the unit (average) cost will be high while the marginal cost will be low. Expanding the production of ER to a nationwide JRED+ program will result in a rising marginal cost of emission reduction and a decreasing average cost. When there is a fixed cost involved, the average cost follows a U- shaped curve. As the average cost of the JREDD+ program decreases, the benefits of increasing production also increase (increasing return to the scale of the JREDD+ program). Therefore, it is in the best interest of the jurisdiction to produce beyond the point where the average ER cost reaches its minimum. 6 Figure 1: How to use future ERs production to leverage upfront investment Source: Authors The inability to reach and overcome this threshold may result in the so-called “cost trap” discussed in Köhl et al. (2020). The cost trap prevents countries and jurisdictions from participating in the ERs market. Since transaction and implementation costs create this barrier, it is essential to mobilize upfront investment to build relevant institutions and help a host country develop reliable monitoring, reporting, and verification. Financial instruments like forest carbon bonds and options allow a country to scale up production and overcome the threshold before bond maturity. When a country is moving from the initial stage of JREDD+ to a larger program, it faces the risk of falling into the cost trap. However, creating the financial mechanism illustrated in Figure 1 can help to avoid the cost trap and make the JREDD+ program financially viable from its inception. What would remain is a need to create tools to deal with the underlying economic risks in forest carbon markets. These risks are essentially of two kinds. Firstly, there is performance risk as success in implementing the large- scale JREDD+ program and delivering promised ERs on time is not guaranteed. This risk is akin to the credit risk that investors face when lending to any client. Second, there is risk of the price of forest carbon assets falling short of anticipated levels. This is essentially a market risk. Both credit and market risks are standard in financial transactions, and carbon markets would be no different in this regard. Investors and issuers are used to dealing with them but, to do so, they require the appropriate financial instruments. Therefore, the next section focuses on instruments designed to attract private capital, specifically the use of carbon forest bonds, as well as call and put options on futures ERs. It explores the application of these instruments to leverage and de-risk private investment and facilitate consolidation and blending of public and private funding to finance prevention of deforestation and reforestation. 3. Innovative financial instruments to de-risk private investment Carbon-linked bonds are the way to break a vicious cycle in ER supply and demand when a potential buyer cannot find a large amount of forest carbon reduction due to a lack of supply, and the jurisdiction cannot 7 initiate large-scale ER production due to a lack of initial capital. In the paper, we explain how the collateralization of forest carbon opens the door to leverage upfront investment in ER production. When carbon becomes one of the sources of return on investment, it allows the borrower to increase the scope of green finance, expanding interventions beyond the traditional scope of green bonds. Green bonds are financial instruments that are issued to target investors (bond buyers) who are conscious about the environment. Green bonds are becoming an important source of environmental finance. In 2023, the total issuance was about US$400 billion to US$500 billion. 9 In 2022, the issuance of climate green bonds was slightly short of US$500 billion, constituting about 40% of the total climate finance flow estimated by the Climate Bond Initiative and Climate Policy Initiative (CPI). 10 The issuer is responsible for debt repayment and therefore constrained from selecting use of the fund to support no-regret options (investment with environmental effect that also yield market return on investment) or investment to meet pressing environmental and social priorities with no or low financial return. In the latter case the debt will be replayed using public funds. The accumulated experience created the foundation for the academic literature, including several review studies discussing the success and shortcomings of green bonds. Shakai et al. 2023 studied sovereign bonds, conducted panel data analysis, and estimated the green premium called in the literature "greenium". In developed countries, the average green premium was 2.74 bps, while in developing countries, the premium on average was 11.55 bps. The Arab Republic of Egypt had the highest premium of 30 bps, and Australia had the lowest negative premium of -5.3 bps. The overall average premium was estimated at 3.66 bps. 11 The premium is higher if the issuer follows stricter criteria to define green or sustainable investment and if the issuer raises capital to support green investment in developing countries. For example, a US$3 billion, 10-year bond issue has a 20.3 bps premium. 12 Indeed, this green premium is not sufficient to significantly drive down cost of capital for green investment. Collateralization of carbon that could be a byproduct supported by green bounds investment will further reduce the cost of capital for issuers increasing the pool of environment improving investment. Performance-linked and sustainability-linked bonds are relatively new instruments that use collateralized environmental benefits, including carbon, to lower the cost of capital for the borrowers. These instruments are performance-based, whereby their financial or structural characteristics, such as the coupon rate, are linked to the program's performance supported by these bonds. The coupon rate could be adjusted depending on whether the issuer achieves key performance indicators. Failure by the issuer to meet environmental goals may result in a higher coupon. These bonds can also be structured to reward better-than-expected performance with a lower coupon. 9 https://www.climatebonds.net/files/reports/cbi_susdebtsum_q32023_01e.pdf 10 See: https://www.climatebonds.net/files/reports/cbi_sotm_2022_03e.pdf and https://www.climatepolicyinitiative.org/publication/global-landscape-of-climate-finance-2023/ 11 See also: MacAskill, S., Roca, E., Liu, B., Stewart, R.A. and Sahin, O., 2021. Is there a green premium in the green bond market? Systematic literature review revealing premium determinants. Journal of Cleaner Production, 280, p.124491. The authors conducted a comprehensive literature review that showed mixed results. "The findings vary widely in the primary market, where greenium spreads range from −85 to +213 bps.” 12 See: http://www.worldbank.org/en/news/press-release/2023/11/07/world-bank-s-usd-3-billion-10-year-sustainable- development-bond-garners-enthusiastic-support-from-global-investment-comm 8 Examples of such bonds include Viet Nam's carbon-linked bonds and Plastic Waste Reduction-Linked bonds. The return on investment is dependent on environmental performance. In February 2023, the WBG issued a US$50 million 5-year bond to support a water treatment facility in Viet Nam. Verified carbon emissions reduction is a byproduct of the investment project financed by bond proceeds. The novelty of this issuance is monetizing this reduction in carbon emissions. Anticipated carbon emissions reduction is estimated at around 0.6 MtCO2/year or 6 MtCO2 over the 10 years. The bond was issued below par, giving investors a minimum guaranteed return of 0.52%. If the project generates the expected target number of VCUs, investors can expect to earn a total return of approximately 4.84%. In January 2024, WBG issued a seven-year $100 million, principal-protected Plastic Waste Reduction-Linked Bond. This bond offers a unique financial return opportunity, as it is linked to Plastic Waste Collection Credits, Plastic Waste Recycling Credits (collectively, plastic credits), and Verified Carbon Units (carbon credits) expected to be generated by two projects in Ghana and Indonesia. The coupon is linked to plastic collected credit and carbon credits . The bond holders will receive a guaranteed 1.75% interest, which is linked to Plastic Credits and carbon credits. The bond is set to sell at $19,468.25 per Specified Denomination, which is 100,000 units and has a cumulative ceiling of $532.99 for carbon-linked interest. According to our calculations, the maximum yield for the bond is 4.35%. 3.1 Forest carbon bonds In this section, we explain how different designs of financial instruments could support the development of JREDD+ markets. The focus is on forest carbon bonds, which help to mobilize early investment in JREDD+, how to use put options on ERs to de-risk bonds, and how call options facilitate fair distribution of the REDD+ benefits between buyer and seller while collecting additional resources to support early investment. The application of these instruments mitigates the global and regional climate policy uncertainty. 13 Issuing forest carbon bonds is a logical next step to mobilize private capital for carbon markets and channeling proceeds into building large-scale ERs production through avoided deforestation. A carbon bond here is to be understood as an instrument for collateralized future sales of ERs, which may or may not take the form of a classic bond (a tradable fixed-income debt security). Carbon bonds have already been issued in other contexts. In February 2023, the World Bank issued a US$50 million 5-year bond to support a water treatment facility in Viet Nam. 14 Verified carbon emissions reduction is a byproduct of the investment project finance by bond proceeds. The novelty of this issuance is monetizing this reduction in carbon emissions. Anticipated carbon emissions reduction is estimated at around 0.6 MtCO2/year or 6 MtCO2 over the 10 years. In January 2024, the World Bank issued a seven-year US$100 million, principal-protected Plastic Waste Reduction-Linked Bond. The bond provides investors with a financial return linked to Plastic Waste Collection Credits, Plastic Waste Recycling 13 Innovative insurance mechanisms, like those described in Chen et al. 2023 could also be used to reduce JREDD+ investment risk, guarantying performance, and ERs delivery. 14 https://www.worldbank.org/en/news/press-release/2023/02/14/emission-reduction-linked-bond-helps-provide-clean- drinking-water-to-two-million-children-in-vietnam 9 Credits (collectively, plastic credits), and Verified Carbon Units (carbon credits) expected to be generated by two projects in Ghana and Indonesia. The coupon is linked to plastic collected credit and carbon credits. 15 Forest carbon bonds would fall into a similar tradition. Golub et al. (2024) propose using forest carbon to secure the zero-coupon carbon bond principal. Proceeds could be invested in combating deforestation and diversification of the regional economy away from economic activities that result in deforestation or forest degradation. In contrast to the Viet Nam bond and plastic waste reduction linked bonds, carbon is the main product of investment supported by the bond issuance. Some activities, like the intensification of cattle ranching, may yield a positive return on investment (Golub et al., 2021), but collateralized future carbon revenues are the main asset to protect the principal and repay debt. In a JREDD+ program, a designated authority would issue forest bonds to the public, to raise funds for a large- scale jurisdictional conservation program, defined by a set of policies intended to reduce deforestation and degradation. The simplest version of a forest carbon bond would represent a legal commitment from the issuer to deliver to the bondholder a given quantity of ERs - or a monetary equivalent-, generated under the JREDD+ program. In other words, at the maturity date n, the bondholder would exchange the bond for a pre-agreed amount of emission reduction certificates previously produced by the JREDD+ program. In exchange for this, at issuance date, the bondholder would pay an initial amount to the issuer (the issuance price). Such a forest carbon bond is essentially a forward purchase of carbon emission reduction credits, where the bondholder takes the role of the buyer, and the issuer is the seller. In a zero-coupon bond, its price would be given by 16: () = , (1) (1+ )− Where: • P = is the price of the bond in monetary value at any given time • E(M) = is the expected monetary value of the emissions reduction credits at maturity • i = is the interest rate or yield of the bond • n = is the number of periods (or the tenure of the bond) Notice that in (1), () = denotes expected price of ERs and where stands for anticipated volume by maturity. This formulation highlights the risks that investors would take on a “pure ER convertible” bond. If the bond stipulates no guarantees or pre-agreed values for the price of ERs, the bondholder will be taking on carbon price risk. If the bond contemplates no mechanism to ensure that the bondholder will receive the agreed number of ERs even in the case where the JREDD+ program fails to produce those ERs, the bondholder bears credit risk as well. Depending on how it is structured, the proposed model can expose the bondholders to higher risk than the Viet Nam bonds to support a water treatment facility and Plastic Waste Reduction-Linked Bond: in a forest carbon bond, both principal and return are subjected to the carbon monetization risk. There are two major risk factors: delivery risk and price risk. Both risks could be mitigated by combining the high efficiency of interventions to mitigate deforestation risk and using innovative hedging instruments (Golub et al. 2018 and 2021) or guarantees. 15 https://www.worldbank.org/en/news/press-release/2024/01/24/world-bank-s-new-outcome-bond-helps- communities-remove-and-recycle-plastic-waste 16 The model below is highly stylized and not reflective of more realistic pricing models. 10 Under these conditions, given their exposure to price and quantity risks, investors would charge a risk premium. This is not a problem per se. In fact, under adequate conditions, this creates incentive mechanisms that are aligned with achieving deforestation reductions, in a similar way as government bond markets can create incentives for fiscal sustainability. The yield curve for such carbon bonds would fluctuate based on the credibility of emissions reduction targets in the JREDD+ scheme and the path towards its achievement, as well as on prospects for the price of carbon at which they could be exchanged. If the authority is off track in the avoidance of deforestation, the change in the expected value of the emissions reduction would lead its present value to fall. If, during the tenure of the bond, the government gets back on track, bond holders that bought the forest carbon bond below the initial price would see a gain from reduced credit risk. Yield curves would then behave just those of conventional government bonds. That dynamic is purposedly intended to mimic the dynamic of fiscal policy targets in mature economies, where a reduction of the government’s credibility to maintain debt sustainability would cause an immediate fall in asset prices, leading to political pressure to restore a credible fiscal path to bond holders. In that sense, forest preservation would be embedded into the government’s policy commitment, and its short- term effects would be aligned with long-term commitments of reducing deforestation. Figure 2 illustrates how the forest bond value depends on performance. The functioning of forest carbon bonds would be very similar to that of treasuries in other aspects. For example, the issuer would ensure there is enough liquidity in the open market and an authority to buy and sell bonds daily, based on their monitoring of carbon market prices (just as a central bank would do to regulate interests’ rates). A climate authority could even redeem all forest bonds after acknowledging poor performance, just to restore credibility in the next issuances. Moreover, while the government is building credibility on its performance, it would initially issue short term bonds, extending to longer term bonds as market assessment of issuer credibility allows. Figure 2: Visual representation of forest Bond values, based on environmental policy performance. Given the novelty of the product and the deep uncertainty associated with climate mitigation policies at the global scale, absorption of forest carbon bonds by private investors bearing the full credit and price risk is unlikely in the short-term. The creation of new and complex market for forest carbon bonds is likely to require 11 evolutionary steps, which could be supported by coalitions of different actors. A first relevant group are buyers for whom the future ER price is less critical. Organizations such as development agencies, multilateral financial institutions, ESG investors, impact investors, philanthropists, and other participants in pay-for-performance programs are more focused on the social value of ERs rather than their market value. Hence, they can efficiently achieve their goals by providing price insurance to bondholders of the first issuances of forest carbon bonds. Issuers, for their part, can strike a balance between pure ER products and sovereign debt-like products. For example, in the first issuances of carbon forest bonds, they could provide guarantees to return all or a fraction of the initial capital to investors in the event that not enough ERs can be delivered. Alternatively, they could provide a monetary amount that would match the value of the promised ERs given carbon prices at maturity. This would make the forest bonds more attractive for investors in the initial issuances, where the track record of JREDD+ programs may not be sufficiently deep to provide confidence. Development finance institutions can also play a role helping promote these products among investors and acting as “anchor investors” themselves. In the same vein, once a functioning scheme for JREDD+ is in place, a logical implementation for jurisdictions would be to issue regular debt instruments that are not directly convertible into ERs, but whose repayment is backed by the proceeds of ER sales from the JREDD+ program. 3.2 Put and call options to de-risk investment Beyond issuing ER backed bonds, forward monetization of ERs from a JREDD+ also opens opportunities to engage with private investors through call and put option (warrants) contracts. There is an essential difference between proposed instruments and financial derivatives. Initially, the optionality could be embedded in the ER purchase agreement. FCPF is currently using this provision. The Emissions Reduction Payment Agreement (ERPA) contains call options on additional ERs produced exceeding the contracted volume. For example, the ERPA between the Democratic Republic of Congo and the World Bank Group (Article V) outlines specific terms for two call options with different strike prices. In other words, initially, the options transactions will be conducted as over-the-counter transactions. Options on ERs offer several ways to improve the risk characteristics for parties involved in forest carbon transactions. A put option on ERs gives the holder the right, but not the obligation, to sell ERs at a specified strike price at a future point in time or within a certain timeframe. A call option gives its holder the right but not an obligation to purchase an underlying asset (in this case, ERs) at the negotiated strike price. The buyer of the call option pays the issuer an upfront premium in exchange for the options contract. The agreements of call and put option contracts specify the strike price, the premium or upfront payment, the expiration date, the number of ERs under the call/put contract and any special conditions if applicable. Negotiating terms on an option contract listed above, buyers and sellers manage the risk and returns of carbon investments and exposures. Asymmetric treatment of risks and returns by investors and issuers makes mutually beneficial agreements possible. In the next paragraphs, we analyze how call and put options support the formation of JREDD+ programs, as well as the benefits to all involved parties. A first relevant use would involve a forest country buying put options for the JREDD+ program. This would allow the JREDD+ program to manage the exposure of their future revenues to fluctuations in the price of carbon, which in turn can allow them to reduce their borrowing costs against future sales of ERs. For example, a JREDD+ issuer could take a loan or use other debt instruments with the expectation to use proceeds of a future sale of ERs to repay. However, there is always a risk that the sale may not happen or may not generate the expected 12 proceeds, leaving the issuer unable to repay the loan. In these conditions, buying put options ensure a minimum price (the strike price of the put option) for the future sale, reducing the cost of borrowing. Selling call options would allow a country to raise upfront finance without compromising future revenues from JREDD+. To see this, consider the following example. Assume a jurisdictional program is anticipated to prevent up to 690 million tCO2 by 2030. The current ER price on voluntary carbon markets is low, but in the future, REDD+ may be traded at compliance markets. Then in five years, one ton of CO2 of ERs may be worth more than the current price at voluntary carbon markets. For the sake of this example, let the anticipated carbon price on compliance markets in 2030 be US$40/tCO2 (Figure A1.1), but with probability of 0.2, this price could be higher than US$55/tCO2, and with the same probability, the price could be lower than US$20/tCO2. 17 The spot price on voluntary carbon markets (VCMs) is currently about US$5/tCO2 and is anticipated to reach US$11 by 2030. Selling one ton of CO2 at the spot market in 2024, the jurisdiction collects a US$5 and generates an upfront revenue to jump-start the JREDD+ program but is foreclosing the opportunity to get a higher price for ERs in the future. The call option offers an alternative. By writing call options, the JREDD+ collects an upfront premium. Although this premium is below the VCMs' spot price, in the future, the writer of the call will receive additional compensation that better reflects the intrinsic value of ERs. The JREDD+ either receives payment for ERs that equals the strike, presumably much higher than the spot VCMs price at issuance (say US$40/tCO2) or keeps ERs if the option contract expires. In the latter case, the program can decide how to manage ERs. It could sell some or all ERs (for example, if the price is US$30/tCO2) or bank them (the current price by the expiration time is still low, say US$10/tCO2) in anticipation of a rapid price increase in the future. Obviously, in a situation of permanently low prices for ERs, the worse-case scenario would be for the country to reverse deforestation efforts. The buyers of these call options will obtain risk management benefits. If a firm is subjected to climate policy and recognizes the risk of excessively high compliance costs in the future, it will use hedging instruments to contain the cost. The firm will be inclined to buy call options on JREDD+ to establish a price ceiling or gain a partial hedge against its own compliance costs if it believes the price of forest carbon offsets will be correlated with them. The JREDD program can improve its potential payoff by utilizing call and put options. Assume for example, that a country obtains put options with a strike price of US$10/tCO2 with an expiration in 2030. The options could be granted by international donors or philanthropists or bought from a firm in exchange for the call option. Annex 1 develops in more depth the calculations on the value of alternative option strategies. 3.3. Dealing with reversal risk and other key design features of carbon bonds A key consideration for forest-based ERs is reversal risk: the possibility that standing forests that have been credited as producing ER can be destroyed later. Importantly, this is not problem that is exclusive of jurisdictional approaches, it also affects individual deforestation or reforestation projects that are currently trading in voluntary carbon markets. In fact, the adoption of a jurisdictional approach, combined with the innovative instruments we present here would make management of reversal risk more feasible and effective. Because the instruments would be issued covering the entire jurisdiction, the supervision of standing forest 17 Carbon price computed for illustration purposes using a probabilistic model of the shadow price of carbon described above. 13 becomes simpler and important concerns related to leakage (the possibility that conserved forest in one area will simply mean that other areas are deforested instead) are much reduced. Publicly available data based on satellite images, with pre-agreed methodologies, would provide the transparency that is currently lacking in the forest carbon market. The instruments discussed in this could adopt mitigation measures explicitly as part of their design. For example, carbon bonds should include a reversal buffer, so that ERs are only allocated when permanent assurances have been obtained and can be reduced to offset materialized reversals. Call options could also be used to manage the reversal risk. 18 Forest carbon bonds are vital in raising resources to cover the upfront costs required by jurisdictional REDD+ programs and extending the participation of private investors is critical to its success. For the case of Brazil, our estimates indicate that by 2035 a national JREDD+ program could generate over 4 GtCO2 in ERs available for sale (see Annex 2). This figure is beyond the absorption capacity of donors and other official buyers. With appropriate policies, private businesses and corporations could become primary buyers of carbon bonds. To enhance JREDD+ and expand its capacity, the jurisdiction can utilize different types of bonds, with different design features depending on market appetite and evolution. The initial steps are likely to be more effective if based on ER convertible bonds, which are more suitable for specialized players that can manage the uncertainties related to the future evolution of the market (acceptance in compliance markets, etc.). Over time, the option to use bonds backed by ERs can be more efficient, and more suitable for the more advanced stages of JREDD+ expansion when perspectives for JREDD+ on the compliance market become clearer. Regarding options, corporations exposed to the risk of strengthening climate policy may write put options and exchange them for call options. This would reduce their exposure to future scenarios with a high price of carbon that can affect their profits. For firms, it is important to achieve the truncation of the right tail of the price distribution (see Golub et al. 2020 and Figure 3). They view call options as insurance policies, a hedge against climate policy shocks. Even if they lose the option premium, reducing the risk of exposure to climate policy shocks increases the firm's equity value and reduces its cost of capital. For JREDD+, the inverse position in the trade should provide value. The jurisdiction is exposed to the risk of experiencing delayed progress in climate policy, which can lead to low prices for carbon. A put option establishes a price floor and ensures an acceptable return on the initial investments in deforestation avoidance. Hence, for the jurisdiction, this swap would imply sacrificing upside potential in the value of its ERs in exchange for insuring a minimum value for them in the future. This last effect is presumably more relevant for the JREDD+ program, as ensuring a minimum value allows long-term planning with adequate resources. 18 The proceeds from an executed call contract could be held in an escrow account managed by the issuer (or trustees). Funds would be disbursed during an agreed time period (5-10 years), creating incentives to avoid reversal. 14 Figure 3: Call -put swap Source: Authors’ calculations Over time, JREDD+ programs may implement more sophisticated strategies. For example, they may issue some convertible bonds, combine long-term bonds with short-term bonds etc. Forward allocation of ERs to cover the forest carbon bonds hedged with put options can be used to eliminate market price risks, while performance risk could be hedged with other more specific products (akin to credit risk derivatives or policy risks insurances). 4. Value of JREDD+ innovative financial products In this section, we apply a probabilistic carbon price model, a modification of the carbon price model used by Golub et al. (2020) and Fuss et al. (2021), to estimate the potential resources that a host country could obtain (an example of how this analysis could be conducted is presented in Annex 2 using a hypothetical Brazil countrywide large-scale JREDD+ program). This is a complex exercise, so the figures should be interpreted with caution, but it illustrates the financial mechanisms that could be unlocked by the development of innovative carbon products for forest conservation. What it shows is that mobilization potential is very large, but realizing it depends on broader action across multiple fronts. The mark-to-model valuation calculates the expected value of different financial strategies considering alternative future scenarios for the price of ERs, which in turn hinge on the realization (or lack of) of different key turning points in global climate policy. Another important feature of our implementation of the model is that, to calculate the production of ERs, it calculates the baseline deforestation using a forward-looking analysis rather than relying solely on historical trends. To establish the baseline for deforestation and forest degradation, we use Busch et al. (2019) global findings on low-cost avoided deforestation and reforestation (removals). The authors employed a gridded dynamic land-cover-change model to produce spatially disaggregated MACCs. The model also calculates the emissions and removals for the BAU. As discussed by Wang et al. (2023) and Santos 15 Garcia et al. (2024), using a mark-to-model approach that focuses on the risk of deforestation instead of extrapolation of historical data is critical for the large-scale JREDD+ program aimed to deliver hundreds of millions of ERs. In this setting, the reference line is a counterfactual net deforestation scenario. However, the new approach to establishing the reference line will require an agreement on new crediting standards for ERs for NDC and additional ERs that could be traded or transferred, which is not still foreseen in the immediate future. Annex 2 provides additional details of the model implementation. Our numerical simulations for Brazil indicate that the country could obtain up to US$9 billion to US$18 billion in trading call options on future ERs vintages (2024-2030) and raise up to US$45 billion for upfront investment by issuing low risk forest carbon bonds. These amounts are far more than what is currently spent on conservation in the Brazilian Legal Amazon, and also exceed the estimates of the investments required to end all illegal deforestation in the Brazilian Amazon. These estimates, while tentative, indicate that successful development of innovative financial carbon instruments linked to deforestation has the potential to provide resources at the scale required by the challenge of conserving the Amazon in this decade. To be clear, the conditions for this to happen are not immediate and require deep transformations. A countrywide JREDD+ program that could issue these instruments should be developed in the context of a new development paradigm, as presented in Hanusch (2023). 5. Conclusions and recommendations Tropical forests have immense value for their socioeconomic benefits. Focusing on Brazil’s Legal Amazon, estimates indicate that the annual ecosystem services this forest provides, both public and private, are conservatively assessed at US$317 billion (Hanusch 2023). However, as of today, leveraging this value to promote the investments required to conserve forests has proven an impossible task. In this paper, we have first analyzed the potential of innovative financial instruments to scale up the monetization of tropical forests’ carbon value through JREDD+ programs. JREDD+ programs offer the best chance to support the institutional and structural transformations required to tackle deforestation. Importantly, well-functioning JREDD+ programs provide homogeneous, high integrity carbon credits which can allow the construction of financial instruments to leverage private finance and facilitate risk-management. Our analysis illustrates the potential of new financial instruments to leverage private capital in carbon markets for deforestation reduction. In the initial stages, sustainability-linked bonds with forest-at-risk baselines would support the extension of key concepts among the investor base, including the relevance of macroeconomic factors in driving deforestation processes and the importance of adopting a forward-looking baseline to measure deforestation risk. At later stages, JREDD+ programs would be able to tap a large pool of capital through the issuance of carbon bonds that allow for the borrowing of amounts against future delivery of emission reductions achieved by the program. According to our estimates, the amounts that could be obtained would be sufficient to pay for the investments required to transform the regions at the frontier of deforestation. Call and put options on emission reductions provide key risk management tools, which can facilitate value discovery and mutually beneficial risk hedging across issuing countries and buyers of emission outcomes. In view of our analysis, the potential that can be realized by developing the institutional and financial instruments we describe is significant. However, as with other innovation processes, achieving success will require coordination of different actors under a long-term strategic agenda. 16 Our results are broadly applicable. Undoubtedly, Brazil is at the forefront of the global efforts to tackle deforestation. With its responsibility over the majority of the largest carbon sink in the world, sophisticated financial markets, and track record of innovative policies, Brazil is uniquely placed to take the leadership in the creation of truly functioning carbon markets for curbing deforestation. However, other countries with large tropical forests (e.g., Colombia, Indonesia, and countries in the Congo Basin) are also key players in this process, and smaller countries can probably be the ones that gain the most from the development of deforestation carbon finance, as their alternative resources are more limited. Developed countries and investors would also stand to gain from these instruments, as they would facilitate access to an extremely efficient source of mitigation outcomes. 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REDD+ in theory and practice: how lessons from local projects can inform jurisdictional approaches. Frontiers in Forests and Global Change, 3, p.11. 20 Annex 1. Valuation of JREDD+ carbon instruments in the context of the Brazil: Methodology and detailed results The numerical analysis in this annex serves as an illustration and provides an initial estimate of the funds required to carry out the large-scale intervention in Brazil to achieve the net zero deforestation goal in the near future and encourage reforestation. This study uses the mark-to-model methodology to evaluate deforestation risk. This modeling approach allows us to establish a reference line based on forward-looking analysis rather than relying solely on historical trends. To establish the baseline for deforestation and forest degradation, we used the findings from Busch et al.’s (2019) global analysis on low-cost avoided deforestation and reforestation (removals). The authors employed a gridded dynamic land-cover-change model to produce spatially disaggregated MACCs. The model also calculates the emissions and removals for the BAU. Switching to the mark to model approach that focuses on the risk of deforestation instead of extrapolation of historical data is critical for the large-scale JREDD+ program aimed to deliver hundreds of millions of ERs. In this setting, the reference line is a counterfactual net deforestation scenario. The new approach to establishing the reference line will require an agreement on new crediting standards that clear distinct ERs for NDC and additional ERs that could be traded or transferred. Carbon price According to the World Bank report “State and Trends of Carbon Pricing 2022,” carbon pricing instruments cover about 23% of global climate emissions. Carbon prices are rising, and the free allocation of carbon allowances is reducing. Sixty-eight countries and jurisdictions use carbon pricing instruments worldwide; three more are in the latest implementation stage. The emerging global carbon pricing system is on the rise. As part of that, the carbon border adjustment mechanism is emerging as an important instrument for the transition to harmonized climate policies. However, carbon prices remain low and do not provide enough incentives to trigger convergence of the global carbon emissions to the net zero carbon emissions trajectory. The latest Emissions Gap Report, called “The Closing Window,” says that current climate policy commitments are insufficient to close the emissions gap and “…only an urgent system-wide transformation can deliver the enormous cuts needed to limit greenhouse gas emissions by 2030”. Implementing stricter climate policies will lead to a substantial rise in the carbon shadow price. In the global cooperation scenario (WBG 2021), the carbon price is expected to be around US$110/tCO2 by 2030 and approximately US$270 by 2050. REDD+ alleviates the cost of climate policy. For example, if REDD+ is accepted as a compliance instrument, carbon price in 2030 is about US$95 in 2030 and US$200/tCO2 in 2050 (Fuss et al. 2021). According to Fuss et al. (2021), the net global benefits from REDD+ are around US$33 trillion (net discounted benefits calculated with a 3 percent discount rate), while the cost of avoided deforestation is about US$6 trillion. This number includes consumer surplus and resource rent. Considering the significant cost savings, exploring the possibility of using REDD+ as a compliance instrument to achieve the global climate policy target is logical. This scenario is an essential precondition for the engagement of private capital in the large-scale JREDD+ programs. It is hard to imagine private buyers showing an increased interest in ERs without cost-saving incentives. It is unlikely that private investors will be motivated by ESG considerations to do more than just harvesting low-hanging fruits and trade ERs on the voluntary market for a price between $10/tCO2 and $20/tCO2. 21 Since this paper focuses on innovative financial instruments to engage private capital in the JREDD+ program, we focus on the scenario where JREDD+ is allowed on compliance markets or will be compensated at the level of a shadow price of carbon. We also examine the "voluntary markets forever" scenario, in which JREDD+ is not a compliance instrument and private buyers have a non-market incentive to back JREDD+ programs. Growing negative climate change impacts across the globe are a catalyst in triggering an acceleration of the transition to harmonized global climate policy that balances the benefits and costs of interventions to reduce GHG emissions. In this context, the social cost of carbon is a proxy for a shadow price of carbon. An alternative is an uncertain marginal abatement cost. The cost is uncertain due to climate policy uncertainty (uncertain emission target), uncertainty in the cost of abatement technologies, and an unknown quantity of offsets available and allowable on the carbon market (e.g., REDD+ supply), etc. This report applies a probabilistic carbon price model, which is a modification of the carbon price model used by Golub et al. (2020) and Fuss et al. (2021). In this model, the proxy for the carbon price is Social Cost of Carbon (SCC). However, suppose SCC is higher than the cost of backstop technology. In that case, the model uses backstop technology as an alternative proxy for the global carbon price. In Golub et al. (2020) and Fuss et al. (2021), the proxy for the global carbon price is the marginal abatement cost corresponding to a given climate policy (constrained on the GHG emissions stock). Figure A1.1: Carbon price at compliance and voluntary carbon markets in 2030 Source: Authors’ calculations The price model computes the probability distribution for a carbon price. It simulates convergence to the "equilibrium carbon price in 2050". As this price is uncertain, it is represented as a probability distribution of the carbon price in 2050. Another uncertainty relates to the unknown pattern of climate policy shocks. A current version of a probabilistic price model has a one-in-a-five-year sequence of policy shocks. The first shock is in 2025, the second shock is in 2030. Then shocks repeat every five years. After each shock, the mean value of the 22 price increases by 5% a year. Finally, there is no guarantee that JREDD+ will be fully accepted in compliance markets. Therefore, we also model a carbon price on voluntary carbon markets (VCMs). The probability distribution of carbon price in 2030 is presented in Figure A.1.1. We use the carbon price model to illustrate how call and put options help Brazil to generate upfront investment without compromising the future revenue stream from trading ERs. Mark to model valuation Brazil could obtain up to US$9 billion to US$18 billion in trading call options on the future ERs (2024-2030) vintages and rise up to US$45 billion upfront investment trading low risk forest carbon bonds. Although the intrinsic value of ERs is relatively high, it is still being determined what fraction of this value could be monetized in the foreseeable future. Therefore, estimating potential revenues from call options trading is a complex exercise. The low estimate of the revenues equals the opportunity cost of delayed deforestation for the duration of the expiration period (US$1.5 billion to US$3.5 billion), accounting for the scaling effect. The upper estimate equals the option value of ERs calculated using the carbon price distribution for the example above (Figure 1.1). Taking into account probability of JREDD+ acceptance on the compliance markets (1/3 in 2030 and ½ in 2035) the value of call options is US$3-US$6/tCO2. 19 If all 3 Gt CO2 is used to cover call options, the growth proceeds will be US$9 billion to US$18 billion. The expected value of 3 Gt ERs will be US$78 billion to -US$87 billion. The value is calculated as the sum of proceeds from trading call options (3 Gt CO2) with a strike price of US$50/tCO2 and revenues from trading 3 Gt ERs in 2030 (be US$9 billion to US$18 billion +US$69 billion). Since the PDF of the payoff function is truncated from both ends, the minimum price is US$15/tCO2, and the maximum price is US$50/tCO2. The maximum proceeds from trading ERs are US$150 billion, and the minimum proceeds are US$45 billion. As we said before, the expected value of ERs is US$69 billion. All numbers in this example are computed using a probabilistic model of the global carbon market, assuming Brazil implements the strategy described above and assuming it obtains enough put options to hedge risk for 3 GtCO2. Recall 660Mt CO2 was set aside and directed into the reversal buffer. If by 2035, the ERs are released from the buffer, Brazil additionally may receive US$31 billion. Considering price uncertainty and discounting this revenue back to 2030, the additional revenue is US$18.6 billion. More sophisticated ERs trading strategy may yield even higher revenues. Since ERs constitute a new source of wealth, the entity marketing Brazil’s JREDD+ program could play the role of a “carbon wealth” manager. Using the probabilistic carbon market model, the mean value of Brazil’s ERs is estimated at US$493 billion. 20 The corresponding PDF is presented in Figure A.1.2. The value in 90 percent confidence interval is US$153 billion to US$1,111 billion. Considering risk premium, the value of Brazil’s ERs is a minimum of US$615 billion. 21 If "The VCM forever scenario" actually occurs, then it is estimated that the mean value of Brazil’s ERs will be around US$155 billion. If climate policy adjustments and acceptance of JREDD+ as a compliance instrument are delayed, it can place a greater financial burden on public funds. 19 Using the Bachelier formula for at-the-money options Haug, 2007. 20 Mark to model valuation using computed carbon price in 2030, 2035, etc. The projected price was applied to cumulative ERs produced during the corresponding period (2024-2030; 2031-2035 etc)—a discount rate of 5%. 21 Estimated using the Bachelier options pricing formula that does not take into account skewness and kurtosis of PDF. 23 Figure A1.2: Value of Brazil’s ERs Source: Authors’ calculations Relative to other studies, our assumptions regarding carbon price (shadow price of carbon emissions) are conservative. For example, according to a recent study that applied the WITCH model, the carbon price that triggers the transition to low carbon development and achievement of the neat zero target is US$70/tCO2 in 2030 and US$153/tCO2 in 2050. 22 Using the WITCH price scenario, the value of Brazil’s ERs is about US$890 billion. Carbon price corresponding to well below 20C emissions scenario computed by ENVISAGE is even higher. The carbon price is about US$100/tCO2 in 2030 and about US$260/tCO2 in 2050, assuming global cooperation among nations to meet the emissions target. 23 In a unilateral scenario, by 2050, the carbon price will hit the US$400/tCO2 mark. Our conservative valuation reflects further delays in strengthening climate targets and uncertain perspectives for JREDD+ to be accepted as a compliance instrument. The program's cost, summarized in Table A.2.1, in Annex 2 represents the discounted opportunity cost of avoided deforestation, forest degradation, and reforestation over the "lifetime" of the program. The forgone income that is not necessary should be compensated right away. Depending on the incentive mechanism behind the JREDD+ program, compensation may be disbursed over time (like a reverse mortgage), and the program may create a revolving fund to support the transition to intensive cattle ranching like it was described in Golub et al. 2021. As discussed in this paper, the countrywide JREDD+ program should be considered in the context of a new development paradigm, presented in “A Balancing Act for Brazil’s Amazonian States: An Economic 22 https://www.adb.org/publications/ado-2023-thematic-report 23 See https://www.worldbank.org/en/publication/changing-wealth-of-nations p. 237 (Chapter 10). 24 Memorandum”. 24 Deforestation poses a significant risk to the climate and economy. Therefore, the prevention of deforestation is recognized in the Memorandum as an urgent priority. Brazil aims to prevent deforestation and allocate ERs strategically in order to mobilize significant resources toward transforming the economic development model. An increase of productivity and diversification to the economy away from activities that recure deforestation will suppress drivers of deforestation, reducing the risk of loss of tropical forests. A fundamental transformation of the regional economy (increased productivity and diversification) is an essential precondition of permanence and irreversibility of avoided deforestation and reforestation. Path dependency is important in determining future deforestation risk on a jurisdictional level. McCallister et al. 2022 It has been shown that if deforestation reduces from the expected trajectory, it is unlikely to return to that trajectory. The amount of rebounding that does occur will vary based on internal and external factors. Transformation of the economic development model reduces the impact of external factors making reversal less likely. The scale of intervention is an important condition of permanence. According to Schwartzman et al. 2021, jurisdictional REDD+ is less exposed to reversal risk than individual projects. Therefore, it is critical to mobilize a large pool of upfront investment and implement JREDD+ on a large scale. 24 https://openknowledge.worldbank.org/entities/publication/26dc1f44-f50e-4a71-b4b6-b5dc143f5dfb 25 Annex 2. Scenarios for ER production in a Brazil 25 The numerical analysis in this annex results from a preliminary assessment of the country-wide ERs potential. The assessment is based on mark-to-model methodology. Application of the Mark to Model methodology is necessary since the method accounts for the changing institutional environment and evolving global and regional climate policy. The methodology has clear advantages, but it also comes with some costs. It requires making assumptions about the key factors that affect the quantity and worth of ERs. The assumptions include the reference line, NDC commitments, marginal abatement cost, and carbon price. The results can vary based on these assumptions and should only be interpreted within the appropriate context. Reference line and marginal abatement cost In this study, the reference line for ERs crediting is based on a forward-looking assessment of deforestation risk. A model-based, forward-looking deforestation baseline outlined in recent studies is an essential instrument to quantify deforestation risks 26 in case of scaling up interventions and setting a jurisdiction-wide zero deforestation goal. Forward-looking models capture a complicated combination of different forces that create additional pressure on forested land (an increase in demand for agricultural products, increased scarcity of agricultural land, etc.) and factors that suppress deforestation drivers (increased productivity in agriculture as a result of the intensification of cattle ranching (Golub et al. 2021) or deployment new agricultural technologies less dependent on the expansion of agricultural land like for example, agroforestry, etc.). External factors like regional and national economy diversification with corresponding productivity increases (Hanusch et al. 2023, etc.) can also affect and alter deforestation patterns. As previously stated, we begin by using Busch et al.’s (2019) BAU scenario as a starting point to calculate the reference line for the countrywide JREDD+ program. The next step involves subtracting the net emissions reduction that corresponds to the NDCs target. Before benefiting from the countrywide JREDD+ program, Brazil must first achieve its NDC goal. This achievement qualifies them to produce and declare emissions reduction units for potential use in the future or to trade with international or domestic buyers. The seniority of NDC obligations follows the logic of UNFCCC and the Parise Agreement. This strict constraint affects ER supply to the compliance market. Voluntary markets may recognize ER produced according to a commonly accepted crediting mechanism like VERRA of ART TREE standards. Here, we do not argue for a particular accounting system of NDC obligations to determine eligibility for ER transfer to international or domestic buyers. We introduce this requirement to illustrate the JREDD+ ERs production on a numerical example. The cost of emission reduction by Busch et al. (2019) is specified per country per decade covering the period from 2020 to 2050. The unit for deforestation emissions, reduced emissions from deforestation, removals from reforestation, and increased removals from reforestation is tCO2. Figure 2 displays the annual Marginal 25 Jonah Busch’s valuable contribution to this section is acknowledged and highly appreciated. 26 In the models, it is important to distinguish between short-term, mid-term, and long-term risks. This numerical example focuses on the long-term risk as a foundation for reference deforestation scenarios. Understanding the short- term risk (see Wang et al. (2022), and Hanusch et al. (2023) proposed a novel methodology to quantify the short-term deforestation risk) is essential to building efficient mechanisms to combat deforestation. The JREDD+ program would implement extra incentives to address deforestation drivers when the risk is expected to be high. For a discussion of deforestation risk, see Ferreira et al. (2022), and Arcand et al. (2008). 26 abatement costs curves (MACCs) calculated for Brazil using decadal data. Figure A2.1 displays the MACCs for avoided deforestation, while Figure A2.2. shows the reforestation costs. Figure A2.1: Marginal abatement costs for avoided deforestation 120 100 80 $/tCO2 60 40 20 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 GtCO2/year MAC 2020-2030 MAC 2030-3040 MAC 2040-2050 Source: Authors’ calculations using data from Busch et al. 2019. Figure A2.2: Marginal abatement costs for reforestation 120 100 80 $/tCO2 60 40 20 0 0 30 60 90 120 150 180 210 240 270 300 330 MtCO2/year RMAC 2020-2030 RMAC 2030-3040 RMAC 2040-2050 Source: Authors’ calculations using data from Busch et al. 2019. The marginal abatement cost for avoided deforestation is approximated with a quadratic function, while the reforestation cost is approximated with a linear function. 27 Over time, the marginal cost shows a decreasing 27 We applied linear approximation for this study. While this approximation does not exactly replicate the original study by Busch et al. (2019), the deviation is insignificant and can be disregarded. 27 slope. Therefore, reducing 1Gt of CO2 in the second decade (2030-2040) is cheaper than in the first decade (2020-2030). Although there are some discrepancies among different sources regarding BAU emissions, estimates for 2020 are provided in Busch et al. 2019, IPAM 2021 28 and Global Forest Watch. 29 The Global Forest Watch estimates are higher than Busch et al. (2019), and the IPAM estimate (net emissions from deforestation) is slightly lower. We use Busch et al. (2019) BAU emissions data for further analysis as we rely on the MACCs from the same source. The BAU emissions in Busch et al. (2019) are higher than in the Brazil CCDR. 30 This means that the cost of the JREDD+ program may be slightly overestimated. We need annual MACCs to estimate the cost of the emissions reduction program. To build annual MACCs, we assume that the functions depicted in Figure A.2.1 represents the cost at the midpoint of each decade for avoided deforestation and the functions depicted in Figure A.2.2. for reforestation. Two constants describe each quadratic function (the marginal cost of avoided deforestation). Then we find an exponential function to describe a gradual reduction of these constants over time. The MACC for reforestation is a linear function described by one constant that sets its slope. The dynamics of the slope is also described by an exponential function. Brazil’s hypothetical ERs program As previously stated, the reference line for a nationwide JREDD+ program reflects the risk of deforestation rather than using historical emissions and is updated every five years depending on the reference line as in VERRA and ART-TREES JREDD+ crediting systems. Then we subtract a pledged NDC emissions reduction from the BAU. This creates a reference line for the hypothetical countrywide JREDD+ program. By switching from the ART or VERRA benchmark to the NDC creates better incentives to maximize emissions reductions in the long run. NDCs are exogenous, while the ART or VERRA benchmark is endogenous. The endogeneity of a reference line creates perverse incentives and complicates the maximization of emissions reduction. Transitioning to progressing NDCs creates an additional incentive to mobilize domestic and external finance and attract private capital to invest in Brazilian carbon bonds and options. Now we establish a stylized NDC scenario using the latest NDCs pages that are currently available. However, it is important to note that our stylized NDCs may not accurately represent the current status of Brazil’s NDCs. In March 2022, Brazil updated its NDC targets and pledged to decrease its GHG emissions by 37% by 2025 and 50% by 2030 compared to 2005. It also set the goal of achieving climate neutrality by 2050 31. The forward-looking estimate of a deforestation risk in Brazil for 2024-2040 is about 940 MtCO2 per year (based on Busch et al. 2019). The jurisdiction covers the entire country. To reach their long-term NDC targets for carbon neutrality by 2050, Brazil has to eliminate net emissions from deforestation by 2050 and potentially even surpass that by increasing removals to offset residual emissions from fossil fuel combustion and other remaining GHG emissions. 28 IPAM (2021) PROFOR/WB: Análise das Emissões Brasileiras de e Suas Implicações para as Metas Climáticas do Brasil 1970 – 2020. 29 https://www.globalforestwatch.org/ 30 https://openknowledge.worldbank.org/entities/publication/a713713d-0b47-4eb3-a162-be9a383c341b 31 We also use information from CCDR https://www.worldbank.org/en/news/infographic/2023/05/08/brazil-country- climate-and-development-report 28 Even though the NDC set a strict target for reducing emissions, there is still potential for further reduction that can be recognized through the JREDD+ program. This is based on the CCDR scenario, which assumes that Brazil will achieve net zero emissions by 2050. The CCDR scenario requires a significant increase in removals from forestry (almost 1GtCO2/year by 2050). According to our analysis, reforestation will result in negative emissions of 1.378 Gt CO2 by 2040, which will further increase to 1.849 Gt CO2 by 2050. Figure A2.3. demonstrates a hypothetical dynamic of the net avoided carbon emissions in the Legal Amazon. According to that scenario, JREDD+ ERs will increase from 700MtCO2/year in 2028 to 746MtCO2 by 2040. The JREDD+ program and NDC are both competing for ERs, resulting in a slow increase in the supply of ERs. As the NDC target becomes stricter over time, it leads to the stabilizing of the supply of JREDD+ ERs. Figure A2.3.: Scaling up JREDD+ in the Legal Amazon 1.60 1.40 1.20 1.00 GtCO2 0.80 0.60 0.40 0.20 0.00 ERs NDC ERs SJFA JREDD+ ERs Source: Authors’ calculations The future annual opportunity cost of avoided deforestation varies for different locations and types of land. For example, some lands are only suitable for extensive cattle ranching, implying a low opportunity cost of avoided deforestation. For a land plot of this kind, the appreciation of annual opportunity cost will be much slower than for the land plot suitable for soybean plantations. For lands suitable for soybeans cultivation, the risk of deforestation will increase dramatically during the accelerated expansion of the JREDD+ program (2024-2029) in the example illustrated in Figure A2.3. Program cost and sources of finance The first step is the cost attribution to domestic interventions to meet Brazil’s NDC targets and take actions to reduce emissions beyond NDCs. The costs of emission reduction attributed to NDC and to the JREDD+ program are proportional to emissions reduction counted against NDC pledges, and additional emission reductions can be marketed in international carbon markets. Table A1 provides a summary of the program's cost. To determine the cost of implementing the JREDD+, we calculate the present value of future costs across various time periods. 29 Table A1: Cost of emission reductions Cost USD Bn ERs GtCO2 Total Cost NDC Additional Total ERs NDC ERs Additional ERs PV cost and ERs 104.53 27.13 77.39 4.94 1.283 3.66 2024-2030 PV cost and ERs 215.48 65.69 149.79 10.49 3.20 7.30 2024-2035 PV cost and ERs 319.61 113.38 206.23 17.05 6.05 10.99 2024-2040 Source: Authors’ calculations. Note: the discount rate is 5%, and the costs are in 2014 US$ since MACCs were calculated in 2014 US$. Reducing emissions comes at a high cost. In our example, the average emission reduction cost between 2024 and 2030 is approximately US$21/tCO2. This cost is considerably higher than the current prices of offsets in voluntary markets and the price offered by the Norwegian government (payment for performance) or the LEAF coalition. While a relatively low cost of emission reduction could be observed in the initial stages of JREDD+ implementation, scaling up JREDD+ is associated with a significant increase in the marginal and average cost of emission reduction. The described above countrywide emission reduction program is unprecedented. The known JREDD+ program intends to supply tens of millions of tons CO2 at most, while Brazil's NDC and additional goals for reducing emissions from deforestation are measured in billions of tons of CO2. The high volume explains the high cost. Our estimates align with the cost estimates found in economic literature. Of course, potential REDD+ supply and the ERs cost vary across different studies. The average cost is US$30- US$50/tCO2. The literature suggests a massive global ERs supply at a price of US$100/tCO2. According to Griscom et al. (2020 and 2017), and Busch et al. (2019), Roe et al. 2020 cost-effective ERs potential for all land- based mitigation at 8–13.8 GtCO2/year could be achieved with a carbon price at $100/tCO2. According to Trove Research (2021), nature-based solutions can provide up to 2.5 GtCO2/year on average between 2020 and 2050. About half of this volume is available at US$50/tCO2. Nevertheless, JREDD+ provides a highly cost-effective contribution to closing the gap between current emissions trends and the net-zero emissions target (Fuss et al. 2021; Griscom et al. 2020; Rakatama et al. 2017). In addition to the direct economic benefits of reducing the cost of the global climate policy, the tropical forest provides vast collateral benefits. For example, the public and private annual ecosystem services provided by the 350 m hectares of the Brazilian Amazon are conservatively estimated at US$317 billion. Co-Benefits are spread out among multiple beneficiaries, and many of these benefits cannot be monetized until a later time. Unfortunately, the significant value of ecosystem services provided by tropical forests cannot currently be converted into economic incentives for their protection. JREDD+ is the only feasible mechanism to monetize some of these benefits. JREDD+ provides an opportunity not only to lower the cost of the global climate policy but also to secure these co-benefits, which further justifies the relatively high cost of forest carbon. 30 31 Summary of Bonds and options Instrument Issuer Use of funds Benefits Repayment Performance risk Risk sharing Comments Or source of return For ERs or For bonds or For ERs or bond For bonds or ERs on investment bond buyers ERs issuers buyers sellers Sovereign Federal Build The low-risk Raising capital The federal budget Failure to build Default risk Failure of the It allows JREDD+ integration in sustainability- government institutions for investment for green revenues from JREDD+ program supported the long-term development linked bonds JREDD+, invest that also transition and investment in the institutions and/or with proceeds from strategy. (Bonds linked in could be strengthening diversification of transform the bond sales to to performance diversification claimed as or building the economy. regional economy produce ERs but not to ER of the economy ESG institutions to alleviate production) to create investment for JREDD+ deforestation alternatives to drivers. deforestation, and make initial investment in ERs production. Bonds Federal Support initial Secure ERs Use ERs or proceeds ER production is ER production is Bonds could be There are several possible convertible in government JREDD+ supply buyer collateralized from ERs trading less than less than heavily discounted modifications to the rules of ERs or backed investment and has a choice ERs to back anticipated. anticipated. if ER production is conversion. entity scale up ER to convert convertible expected to be less It also could be issued as production bonds in ERs. bonds than anticipated. sovereign bonds. There is also a third-party insurance option. Bonds backed Federal Scale up A low-risk Low-cost Sale of ERs Jurisdiction failed Issuer default: the Delivery risk and Bonds backed by ERs work by ERs government JREDD+ investment borrowing allocated to cover to deliver ERs issuer cannot ERs price risk. best with put options that or backed that also without an bond issue allocated to cover deliver ERs, or ERs reduce the riskiness of bonds entity could be increase in bond issue. price is low, and (ER price risk). The scaling-up claimed as sovereign proceeds are stage occurs when the host ESG debt insufficient to repay country has a stable policy and investment debt, and the issuer regulatory environment for has no other means JREDD+ investment. to repay debt. Call options Federal Invest premium Protection Generate The difference Jurisdiction failed The seller is not Low strike price For buyers: The call option is government in scaling up agents spike immediate between market to deliver ERs. able to deliver ERs regrets an insurance policy against or backed JREDD+. If in carbon revenues and strike price (for Contracted price spike on the carbon entity executed – prices (premium). ERs buyer) vintages of forest market. invest proceeds (mitigation Preserves carbon are not For Sellers: it is a way to in ER risk of opportunity to fungible on generate funds immediately production and abatement get higher compliance while limiting regrets reversal risk short prices for ERs market. (compensation for ERs is too mitigation. squeeze) in the future. low). Writing call options with different strike price and expiration date facilitate price discovery. Put options International If executed, use If executed, De-risks Investment in put The jurisdiction Stranded ER assets Risk of delivery ERs For jurisdiction, the put option donors, proceeds to Claim the borrowing options could be failed to deliver if an actual ER value needed to execute is a tool to derisk early JREDD+ repay debt difference treated as ESG a put option investment. 32 corporations accrued in the between investment or ERs allocated to is much lower than , initial strike and charitable cover put options. the strike price philanthropis implementatio ERs market contribution. ts n stages. price as ESG investment. Call-put swap Call - Federal Transactions Reduce Reduces Asymmetric Inability to honor The jurisdiction is The corporation is Additional risk sharing and risk government are in-kind. No unknown exposure to hedging benefits. an option not able to honor not able to honor reduction mechanisms could or backed additional exposure to the risk of contract. the call contract. the put contract. be used to de-risk swap. entity funds from the price spikes unaffordable Put - transaction. in exchange losses due to corporations for the extremely low limited and ER prices in controllable exchange for risk of forgiving a slightly fraction of overpaying extreme for ERs— return on asymmetric ERs— value of asymmetric upside and value of downside upside and risk of downside risk exposure to of exposure to carbon carbon market market (Foster-Hart (Foster-Hart risk metrics). risk metrics). 33