Investing for the future: Environmental Policy Bonds

This article was originally published by the [UK] CEED Bulletin [number 35, September 1991], published by the Centre for Economic and Environmental Development. It also appeared as OECD Room Document 3 at a meeting of the Joint Working Party of the OECD Committee for Agriculture and the Environment Policy Committee, held in Paris on 13 December 1994. A link to a longer paper on Environmental Policy Bonds appears near the end of this page.

A novel way of injecting self-interest into the solution of environmental problems is the Environmental Policy Bond [EPB]. EPBs would be issued by the government on the open market and would become redeemable for a fixed sum only when pollution has been reduced to a target level. In this way the achievement - but not the setting - of the pollution objective is contracted out to the private sector via a free market in EPBs. Normal bonds are redeemable for a fixed sum, at a fixed date, and they yield a fixed rate of interest. EPBs would not bear interest; holders gain by ensuring that the targeted objective is achieved quickly.

For example, consider the objective of halving some broadly-based measure of current air pollution levels. Assume that a fixed number of bonds is issued, redeemable for five pounds each but only when this reduction in pollution has been achieved, as certified by an independent scientific body. The bonds are sold by open tender as at an auction; those who bid the highest price for the limited number of bonds will be successful in buying them.

What will determine the price of the bonds? Most obviously the market's assessment of how likely, and when, the targeted level of air pollution will be reached. Interest rates on alternative investments will also be a factor. The bonds might sell for as little as one penny if people thought there were virtually no chance of air pollution being halved in their lifetime. People will differ in their valuation of the bonds, and their views will change as events occur that make achievement of the targeted objective a more or less distant prospect. But the bonds, once issued, would be publicly quoted just like those of ordinary bonds or shares.

Assume that the bonds targeting air pollution have been issued, and that they sold for one pount. People, or institutions, now hold an asset that can quintuple in value once air pollution is halved. The bondholders therefore have a strong interest in seeing air pollution reduced.

The most important purchasers of EPBs are likely to be those who finance initiatives aimed at reducing air pollution. They could use their own capital, or borrow on the strength of the redemption value of their bonds, [or on the strength of any increase in the value of their bonds], to support projects targeting air pollution. Other purchasers might be polluting firms, whose bondholding would directly offset the cost of any programmes aimed at reducing their pollution output.

The first category of purchasers has an incentive to undertake these types of initiatives:

helping to defray the costs of firms' air pollution reduction programmes;

bribing firms to stop production of pollution-generating goods or services;

subsidising production, or consumption, of less polluting alternatives to existing products or services; and

subsidising research into alternatives to existing, pollution-generating, goods or services.

Bondholders can also be expected to discover and finance other pollution-reducing initiatives, the precise nature of which need not be known in advance.

Currently, many of these initiatives are taken by government, regional or local authorities. However, there is a crucial difference: under an EPB regime the motivation arises from the self-interest of bondholders, who have the incentive to seek out those ways of reducing pollution that will give them the best return on their outlay. Without government planning, bondholders finance the most cost-effective ways of reducing pollution.

For the EPB regime to be effective, three processes would need to be carefully carried out:

Quantification

The environmental objective must be capable of being quantified. 'Air pollution' for example, could be calculated as an average of reading as measured at many sites around the country.

Definition

Thought would need to be given to the definition of the objective to be targeted by the bonds. In the case of air pollution, it would be unsatisfactory to redeem the bonds when pollution levels had fallen below the target level for only a short time. The objective is a sustained cut in air pollution, and that is how it would have to be defined when thebonds are issued. Air pollution itself could be defined in terms of the concentrations of all significant pollutants, weighted according to their threat to the environment.

Monitoring

Progress toward the attainment of the environmental objective would need to be regularly and reliably assessed by bodies independent of investors in EPBs.

Many bondholders will want to sell their bonds before redemption; that is, before the environmental objective has been achieved. A secondary market for the bonds is necessary to ensure that these holders will be able to realise any capital appreciation experienced by their bonds. This is important, because many investors may be able to help speed up only one, or a few, of the processes necessary for the targeted objective to be achieved. Once these investors have done their bit, they may have no wish to speculate on the speed at which the remaining processes will be carried out.

Comparison with other market-based incentives

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Environmental Policy Bonds make policy objectives more transparent. By focusing on ends, rather than means, environmental objectives are explicitly identified, while indirect, as well as direct, means of achieving them are encouraged - but only if bondholders think them more efficient.
EPBS have informational advantages, especially when targeting broad objectives. Water pollution, for example, results from many sources and from many different processes. Immense quantitites of information would be needed to establish and monitor a comprehensive system of pollution control using taxes or tradeable permits to pollute. By contrast, EPBs would target society's objective - less water pollution - rather than each of the numerous activities that generate water pollution. They would therefore require comparatively few data: regular measurements of aggregate pollution need only be taken at selected sites.
Tradeable permits and taxes can work well with intrinsically large-scale processes, or for substances that have no polluting substitutes. Such processes and substances can be monitored quite effectively, because there would be no fear that doing so would lead to offsetting increasesin pollution via the setting up of small-scale processes, or the production of unregulated substitutes. But technological and ecological complexity mean that these processes and substances are in a minority.
The environment needs cleaning up on all fronts, and broadly-based EPBs can target this objective. It would even be possible to target both air and water pollution, for example, by a single bond issue. This would further reduce the possibility that targeted cuts in one pollutant would lead to increases in another.
Those charged with monitoring and enforcing tradeable permits or tax regimes may have little incentive to be diligent; typically they would be government agents whose rewards would not correlate with their efficiency. With EPBs it would be in the bondholders' interest to see, for example, that bribes to firms to cut their pollution do, in fact, result in such cuts.
EPBs generate more palatable money flows. Taxes and tradeable permits inflict immediate losses on identifiable groups of producers or consumers. EPBs, however, reward people and - another advantage - are paid only when the targeted objective has been achieved. The bonds would, of course, be redeemed using funds from the government's taxation revenue, and taxes might rise to provide these funds, but there is, nevertheless, a presentational advantage.

Politics

The EPB concept involves the surrendering of policy instruments to the private sector, and this may be difficult for politicians to swallow, even though, under an EPB regime, they would continue to set and finance society's environmental goals. But the bonds need initially play only a small role: a small number of bonds could be issued for any one objective and work in tandem with other regulatory mechanisms. In such a way the concept could gain gradual acceptance.

Once established at the national level Environmental Policy Bonds would readily lend themselves to global application. Bonds targeting the planet's wellbeing could be issued by the developed countries, to encourage developing countries to cut their pollution. This form of encouragement, by appealing to financial self-interest, could be more effective than any other.

If you are particularly interested in applications of the bond concept to environmental concerns, you may like to read this longer paper on Environmental Policy Bonds, which I presented to a meeting at OECD in April 2002.