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ENERGY

Environmental Impact Bonds May Not Bear Fruit for Green Investors

Environmental Impact Bonds

In September 2016, D.C. Water and Sewer Authority issued a new financial instrument called an environmental impact bond to finance a portion of its green infrastructure project aimed at reducing pollution flowing into local waterways.

In July 2017, the Environmental Defense Fund, together with The Nature Conservancy and the Coastal Protection and Restoration Authority of Louisiana, announced plans to develop a second environmental impact bond to finance coastal restoration. These two cases are receiving considerable attention among both the environmental community and the finance community.

Although it would seem that environmental impact bonds are a leap forward in environmental infrastructure finance, the incentives of the bond issuer and the investor need to be considered. They also need to be compared to other instruments, such as green bonds, in order to make an informed decision about their future use.

There are two main reasons that environmental impact bonds—which pay investors bonuses when projects are successful—have been touted as a potentially significant advance in environmental infrastructure finance.

First, there has been a movement within the investing community toward social impact investing. That is, investors are demanding more and more that they not only want to make a return on investment, but also to make the world a better place. Environmental impact bonds, as well as green bonds, meet this demand.

Second, many of the green infrastructure solutions to climate change and natural disasters are untested. As such, project implementers would like to transform the project outcome risk to financial risk. That is, if the project is a success, investors receive a bonus since the implementer received more benefits than they thought they were going to.

Similarly, if the project fails to meet expectations, the project implementer receives a reduction in the debt obligations—in other words, the investor receives a reduced return. This is the pay-for-success approach that distinguishes environmental impact bonds from green bonds, which are simply bonds issued by businesses and municipalities for environmentally friendly projects.

Some believe environmental impact bonds could be the next big thing for ethical investment. Investors get another option to meet their needs for social responsibility, and project implementers can spread risk within an adaptive management framework whereby implementers experiment in the early phases of a large-scale project in order to learn what works best.

Bang for Buck

But there are two important pieces that are often not considered with environmental impact bonds. Compared to a green bond, there is considerably more monitoring and evaluation needed to meet the demands of contracts used to finance these projects. That is, more money needs to be set aside by the implementer to verify the results than would be the case with a green bond.

Thus, less project work is actually done if a project is financed through an environmental impact bond, as opposed to a green bond. From a social responsibility investment perspective, green bonds could be preferable since the scale of the project, with the same money, would be greater.

Additionally, the interest rate attached to environmental impact bonds has not necessarily reflected the additional risk to investors. The D.C. Water bond, for example, offered an interest rate that was the same as the interest rate for all other bonds D.C. Water issued.

The return on investment for green bonds and environmental impact bonds are likely to be the same as they are tied to the same underlying risk of repayment. But because the bond issuer is transforming the project risk to financial risk, the environmental impact bond is a riskier investment than a green bond.

For an investor to have an incentive to invest in an environmental impact bond, they must be compensated with higher interest rates. This, however, increases the cost of borrowing for the bond issuer—which could discourage them from using environmental impact bonds over green bonds.

Given the widespread increase in green bond issuance over the past few years, it seems likely that they will continue to be the dominant instrument for environmental infrastructure finance. Investors may be willing to accept a lower return on investment for socially responsible investments, but environmental impact bonds may not turn out to be the best instrument to leverage these investment possibilities.

Moving forward with non-traditional instruments, we need to consider the transaction costs and the incentives of both the debt issuer and potential investors, in order to develop instruments that are viable in a market setting.

-Aaron Strong and Benjamin Lee Preston

 

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