Environmental Impact Bonds offer governments, investors and non-government participants the opportunity to focus on outcomes rather than activities.
The market for Green Bonds continues to build momentum. The Victorian Government has announced plans to finance low-carbon infrastructure and public transport through the issuance of $300 million in triple-A rated bonds. These Victorian Green Bonds are the first of their kind to be issued by a government in Australia and reinforce the growing prevalence of the Climate Bonds Standards. They will provide further impetus for future market growth in this area.
But there is an alternative to Green Bonds - an alternative driven by one thing: results
A growing impact investment market is developing and with it the opportunity to drive material change in environmental practices. Environmental Impact Bonds (EIBs) are financing instruments that provide returns based on outcomes. Just as with Green Bonds, EIBs can be used to finance environmentally sustainable initiatives. However, unlike their Green Bond counterparts, they tie the financial return of the investment to the success of that initiative, so that participants can lay claim to financing a demonstrable difference to the environment.
Typically, an environmental project or initiative will be selected with the intent of improving environmental outcomes, gaining efficiencies, or both. For example, there may be a project that seeks to improve the water quality in a particular area, the key lies in quantifying the outcomes in financial terms through increased (or improved) quality or quantity, as well as reduced costs.
Growing recognition of Impact Bonds in Australia
Social Impact Bonds (SIBs) have gained prominence as a method of impact investment since the NSW Government’s issuance of two sets of bonds in 2013. These pioneering developments have caused successive State governments to explore SIBs as a way of facilitating non-government investment and monetising performance outcomes in social reform to repay investors.
in Queensland, the State government has recently received responses to its request for proposal in relation to SIBs addressing re-offending, homelessness and issues affecting Aboriginal and Torres Strait Islander people.
in Victoria, the State government is currently undertaking market testing and research into how SIBs can be used to fund alcohol and other drug treatment initiatives and programs to aid young people transitioning from out of home care.
Relative to SIBs, EIBs offer the advantage of a somewhat easier scientific measurement of improvement. This in turn underpins transparency in the payment mechanism from the Government. EIBs convert success in environmental initiatives into a coupon or return for investors, either by way of regular payments or bonuses paid on maturity.
Structuring EIBs to reward risk
Let’s say a project seeks to reduce soil erosion to improve agricultural production. Once the project is selected, an intermediary with the requisite environmental expertise designs performance objectives and evaluation processes, serving to provide benchmarks around which the project’s success will be measured. Investors are called on to make an upfront capital investment to establish the program, with returns paid to them based on whether the project meets the objectives set. These can be verified by an independent external agency, if required.
If such objectives are met or exceeded, the investors should receive their principal plus a return on investment that can be structured through regular payments (to match particular performance hurdles, i.e. annually) or with final repayment of the principal (similar to a zero coupon bond). Failure to meet the environmental outcomes sought may mean a reduced return.
It’s possible there could be no repayment (akin to default by the bond issuer).
As a result, the performance metric factored into the EIB will be crucial in allocating an appropriate level of risk between issuer and investor. A benchmark that is too low runs the risk of achieving mediocre environmental results and a sub-optimal ‘value for money’ outcome for Government, whilst one that is too high exposes investors to a disproportionate risk of loss (relative to the proposed gain). However, because the measurement of environmental outcomes has the capacity for rigorous and objective analysis, there is potential for more verifiable results. This should, in theory, provide greater transparency to investors.
What kind of investor?
Because the returns to investors are dependent on outcomes of the environmental project, EIBs may involve an increased level of risk beyond those of traditional corporate debt instruments (which rely solely on the creditworthiness of the borrower). In that respect, EIBs share some characteristics with equities or hybrid investments, in that returns depend not only on the capacity of the borrower to repay but the attainment of specific project goals. Because of this heightened risk, additional governance arrangements may be required to ensure independent monitoring. In the early stages of market development, some level of government guarantee or support may also be required to reduce the level of capital loss to which investors are exposed.
However, provided that measurement of deliverables is transparent, not overly complex, and includes appropriate reward relative to the risk, an EIB offers an attractive option to a socially responsible mandate seeking to make a demonstrable difference to the Australian environment.
For philanthropic investors, it also offers an alternative to providing grants or making donations, as an EIB offers a return on investment that can be recycled (rather than a one-off capital outlay). Because environmental gains can take some time to realise, they may also be suited to investors with a long-term (5-10 years) investment horizon. Those willing to do so can play a significant role in developing sustainable frameworks with lasting outcomes, and reap the benefits from not only a financial reward, but a cleaner, more sustainable, environment.