By Michael Curley, Lawyer, Author, ‘Finance Policy for Renewable Energy and a Sustainable Environment
In 2008, the World Bank issued its first “green bond”. This security differed from other World Bank bonds in that the Bank pledged to bondholders that the proceeds of the bond would be invested in environmentally beneficial projects. Clean water. Clean air. Rapid transit that gets people out of thousands of polluting cars and motorbikes. These are the type of projects that the bank was going to invest the green bond buyers’ money in.
Now the rule of thumb in environmental finance is that the lower the payments, the more projects will get done. Is a farmer going to build a fence to keep his cattle from fouling a stream? If it costs $500, probably yes. If it costs $5,000, maybe. If it costs $50,000, definitely not. Are you going to put solar panels on your roof? If the payment is $20 a month, probably. If its $200 a month, maybe. If its $2,000 a month, definitely not.
So, in 2008, everybody thought that the World Bank’s green bonds would have a lower rate of interest than its traditional bonds. The bank would then pass the lower payments on to its developing country borrowers, who, in turn, would be more likely to do more environmentally beneficial projects. Socially Responsible Investors would be willing to accept a lower rate of interest in return for the satisfaction of knowing that their money was creating environmental benefits. What a neat system!
Only it didn’t work.
The World Bank’s green bonds carried the exact same interest rate as did the Bank’s other bonds. In other words, if investors wanted the Bank to invest in water pollution reduction projects, they could buy a green bond with, say, a 4% rate of interest. On the other hand, if they wanted to buy one of the Bank’s other bonds that were financing, say, a coalmine, an urban highway or some other environmentally atrocious project, they could buy a regular World Bank bond that was also paying 4%. So, what is different about green bonds? Well, they assuage the conscience of sensitive investors. They make them feel good. They are Feel Good Bonds.
This situation may be changing thanks to DC Water and its advisors at Quantified Ventures.
As even casual visitors to Washington D.C. can attest, there are no multi-thousand acre tracts of active farmland or forests in the Nation’s Capital. These features perform an invaluable environmental function in that they absorb rainwater and prevent it from gushing into - and polluting - lakes and streams. And so, rainwater, especially its virulent form, called stormwater, is a major nightmare for the District. So much so that the District, specifically its water/wastewater utility, called DC Water, has been working through a 25+ year solutioning process with the U.S. Environmental Protection Agency (EPA) over what to do with the billions of gallons of stormwater that the District must deal with whenever there is a major rainstorm.
The upshot of this struggle is a consent order under which DC Water must dig enormous caverns - right under downtown DC - to trap the stormwater before it can get to, and overwhelm, their sewage treatment plant. Over the last few years, DC Water has been looking at green infrastructure to see if it offers a cost-effective and more environmentally friendly alternative. Green infrastructure is basically vegetation that absorbs rain. Think of rain gardens instead of cement patios. Think green roofs instead of tiles or sheeting.
Concluding that it was definitely worth a shot, DC Water, the District, the US Department of Justice and the EPA agreed to amend their consent order. The agreement was that DC Water would build about 300 acres of green infrastructure. Before jumping into a massive 300+/- acre project that might cost hundreds of millions of dollars, DC Water decided to experiment with 25 acres first to see what the green infrastructure would actually cost and, second, how much water flow it would actually reduce. So, they picked out 25 acres and installed flow meters to see what the pre-project runoff was.
DC Water’s engineers told them that the project was likely to reduce flows between 18.6% and 41.3%. They said there was a 95% confidence interval that these goals would be reached. On the other hand, there was a 2.5% probability that the flow reduction would be below 18.6% AND a 2.5% probability that the flows would be reduced by more than 41.3%. The project was slated to cost about $25 million.
So, here’s what DC Water and its advisors at Quantified Ventures did.
They put together a tax-exempt municipal bond that DC Water would issue. They called it an “Environmental Impact Bond” (EIB). And it is, indeed just that: an environmental impact bond! Remember a few paragraphs above where we said that the goal of environmental finance was to produce the lowest cost. Well it was a stroke of genius on the part of Mark Kim, DC Water’s CFO, and Eric Letsinger, the CEO of Quantified Ventures, that they realized that “lowest cost” didn’t necessarily mean lowest interest rate. So they built into the EIB a unique and brilliant feature: if the flow reduction exceeds 41.3%, DC Water will pay the investors an additional $3.3 million. BUT, if the flow reduction is less than 18.6%, then the investors will get $3.3 million less interest.
This looks like it’s backwards. With this Environmental Impact Bond if more environmental benefits are created, the bondholders get MORE money, not less. Not only do they get the satisfaction of improving the environment, but they get an extra cash bonus too.
So, the question now arises: why would DC Water pay more for success? Well, let us say that the project exceeds its goals by 100%. That could mean that DC Water doesn’t need to spend a possible $300 million on 300 acres of green infrastructure. They might be able to spend half of that to achieve their targets. That’s could translate to enormous savings. So, why would DC Water pay its EIB investors an extra $3.3 million? The answer is simple: they are happy to pay out $3.3 million because they might save millions more!
In other words, DC Water and QV want to motivate investors to support investments that can develop environmentally positive results - motivating by paying for performance - encouraging environmentally minded investors to underwrite the likelihood of success for the project and get paid according to its riskiness - as one does with the rest of the investment market - thus mainstreaming environmentally beneficial projects into the investment community.
What did the investment world think of this Environmental Impact Bond? What did the market think about Quantified Ventures’ proven “Pay for Success” type of bond? Well, the venerable bible of the municipal bond industry, The Bond Buyer, named the issue the “2016 Non Traditional Deal Of The Year”!
Does this mean the end of the type of green bonds discussed above? No. They will still be issued. There may be no financial implications to such bonds, but they do, after all, create good will. They do let investors know that the bond issuers are doing the right thing for the environment with the investors’ money. As a matter of fact, DC Water is planning on issuing at least $100 million of green bonds in the near future. The proceeds of these bonds will go for stormwater reduction projects and other projects with direct environmental benefits, just like the World Bank bonds described above. And, soon DC Water will also issue a couple hundred million dollars of regular (non-green) bonds to pay for their other projects.
So, DC Water’s Environmental Impact Bond is, indeed, just that. It is having a major, positive environmental impact!