At a Glance
- A put option gives its holder the right, but not the obligation, to sell future carbon credits to the Pilot Auction Facility.
- The investor pays a premium to purchase the options.
- The option will be materialized by a tradable, zero coupon bond.
What is a Put Option?
Put options give their holders the right, but not the obligation, to sell future carbon credits to the Pilot Auction Facility (PAF) at a price established through an auction (the strike price).
There is a cost involved purchasing the put options, known as their “premium.”
Put options are commonly used by commodity producers to lock in a floor price for their product without limiting any upside price gains, and can best be thought of as price insurance.
For example, a farmer buys put options at the beginning of the season to sell his grain in the event there is a market-wide bumper crop at harvest and the price for grain collapses. Given a low market price, the farmer exercises the option to sell his produce at the fixed price. The option acts as price insurance to guarantee a minimum return to the farmer and allows him to make the necessary investments in seed, fertilizer, equipment, etc. However, at harvest, if market price for grain is above the option-guaranteed price, the farmer can sell the grain on the market rather than exercising the option – and the option expires unused.
In a similar way to the farmer, the put options sold by the PAF will give its owners a guarantee that they can sell their carbon credits at a minimum price, giving them the confidence to invest in “clean” projects. The put options will be tradable which means, for example, that if the buyer of the put option has a project that is not generating the volume of carbon credits anticipated, the holder can sell the put option to another developer who thinks his project will generate eligible emission reductions and can make use of the put option. This tradability from one option holder to another maximizes the likelihood that the PAF will achieve its full potential to reduce emissions.
It is important to note that carbon credits issued in the past and currently trading on carbon markets will be ineligible for redemption with the put options.
Put materialized by a bond
In keeping with the PAF’s piloting objective, rather than creating a new market for specialized PAF put options, the World Bank will instead use a special type of bond, which when bought and sold will have the same properties as a put option. Specifically, the World Bank will issue zero-coupon puttable bonds to the auction winners. The bonds will be 100% backed by funds contributed from PAF donors. The purchase price of the World Bank bond will be the equivalent of the premium of the put option. The bond will not pay any interest (“zero-coupon”).
Again mimicking the put option, the bond owner will need to deliver the eligible carbon credits in order to receive payment of the strike price at the bond's redemption date. Using such a bond provides the same financial effect as a put option, but will be faster and less expensive to establish. Bonds will also be easier for holders to trade as they will trade on the same markets and use the same clearing systems as traditional World Bank bonds.
The PAF puttable bond draft terms can be requested through this webpage.