The Sovereign Authorization

Covenants underpin every institutional-grade financial instrument. A bond is a promise to pay wrapped in undertakings about what the borrower will and will not do (the covenant), and that covenant is what a buyer actually diligences. In carbon, the covenant is defined by Article 6 of the Paris Agreement, and it lives in a specific document: the Letter of Authorization, or LoA.

An LoA is a signed instrument issued by a host government under a published framework. It identifies the project that produces the units, commits the government to apply a corresponding adjustment to its NDC, and states what the units may be used for.

That is the part that matters to capital. Diplomacy cannot be diligenced. A document can. Counsel reads it, an underwriter prices it, a committee approves or declines it, each conducting the same evaluation they have conducted thousands of times on other instruments. The LoA moves the sovereign promise out of the realm of intention and into the realm of documentation, which is the only realm institutional capital operates in.

Without an LoA, a credit stays home and can be counted toward the host country’s own NDC target. The LoA opens the other use cases: toward another country’s national target, for other international mitigation purposes, which is where aviation sits under the CORSIA scheme, and for other purposes, the category covering a company retiring a credit against its own claims.

Critically, the authorized use travels with the unit. Whoever holds it, wherever it sits, the claim its final holder may assert is fixed by the document. That is what makes the unit a store of value: its worth does not depend on who holds it, so it can be held, financed, and transferred without the claim eroding.

The LoA also answers a question that has dogged carbon for a decade: how does a unit issued under one country’s authority mean anything in a global market? Because the covenant attaches to the unit rather than to a place. The accounting happens in the host country’s own books and is reported internationally, so the unit carries its status wherever it goes.

One thing the Paris Agreement does not supply is a courtroom. An LoA is an undertaking recorded and reviewed, not terms a holder can enforce. That changes when the authorization is carried into the wrapper, which is issued under a chosen law and whose terms are enforceable in it.

So a carbon unit becomes investable through the interaction of two documents. The LoA supplies the covenant and defines the claim; the wrapper supplies the law under which it is held and the terms are enforced. Neither does the job alone.

Assembled, the parts give us a standardized financial instrument that trades on the existing rails of the global capital markets. The rest of this series describes what that machinery fixes, one market failure at a time.

Next up: The Accounting Earthquake.

Part of No New Parts, a sixteen-part series by Andrew Gilmour.