Green bonds are making a splash on the national and international financing scene—over $150 billion of green bonds were issued in 2017 alone, representing a 5000% increase from the $3 billion issued just five years ago. As green bonds continue to attract private capital and prove their value in funding large-scale environmental projects, it is critical that they are optimally designed to incentivize environmental outcomes while still acting as an attractive investment model.
How do Green Bonds Work?
A green bond is a debt instrument just like a regular bond that specifically funds environmentally-friendly or sustainable initiatives—energy efficiency upgrades, green infrastructure, water management, biodiversity, and more. At its most basic, green bonds work by taking a loan from investors to develop an environmental project, and then paying back those investors with interest.
- A water utility could issue green bonds to fund capital improvements such as green infrastructure to reduce flooding and improve water quality. A stormwater utility fee repays the bonds over 20 years, or in the case of DC Water, 100 years.
- A municipality could use a green bond to upgrade heating and lighting in all city buildings. This creates both prolonged cost savings (which are linked to bond repayment), and a reduction in their carbon footprint to meet sustainability goals.
Why Paying for Performance Matters
While green bonds can be an important tool to obtain funding for environmental projects, they can miss a big opportunity if they are not paired with pay for performance contracting. Green bonds will have greater success when the risk of achieving performance outcomes lies with the party with the greatest ability to control project outcomes – the producer who implements the project.
During environmental improvement projects, third-party contractors are the ones who build infrastructure, install technology, and restore habitat. These producers have the power to ensure projects meet performance expectations, more so than the entity who administers the bond.
Instead of standard contracts, where payment is based on actions defined in a specific schedule or budget, public entities issuing green bonds should consider performance-based contracting. Linking producers’ financial incentives to the achievement of environmental goals will inspire the use of innovative approaches, new technologies, and extra effort to ensure the success of the project.
By driving the behavior of producers, public entities can increase the likelihood of their green bond funded projects achieving successful outcomes, passing that success along to investors and the public.
Environmental Impact Bonds
Performance contracts can also enable new private partnerships that include investors that share project performance risk. An Environmental Impact Bond (EIB) is a form of project financing that ties bond payments to investors to defined performance milestones. In this way, the capital provider is paid more or less depending on the quantity of environmental outcomes verified. If the project under-performs the investor is paid less, and they are paid more if the project exceeds expectations.
Similar to green bonds, environmental impact bonds will be more effective if they use a pay for performance contract with the producers who implement the project.
Environmental impact bonds that incorporate pay for performance link payments to both the producer and investors based on environmental outcomes achieved. This further reduces risk to the bond issuer, and incentivizes producers to hit performance milestones.