Bonds 101: Climate Change Edition
How are state and local governments using bonds to finance critical climate projects?
The Fourth National Climate Assessment was quietly released last Friday and presents some sobering details about the impacts of climate change across the United States. One key takeaway is the need to adapt to climate change now as the impacts predicted in earlier reports are becoming a present-day reality.
Although more communities are beginning to adapt, the report states that “the scale of adaptation implementation for some effects and locations seems incommensurate with the projected scale of climate threats.” One reason for this disparity? Money. (Or lack thereof). According to the report, the costs of adaptation can range from the tens to hundreds of billions of dollars, a steep price tag for governments with tight budgets. Still, the benefits of adaptation are expected to be several times that over the long run.
State and local governments realize this and are turning to bonds to cover the upfront costs associated with expensive, large-scale projects. Below we’ll explore how bonds work and which types can be used to fund the projects needed to adapt to climate change.
What are bonds?
Bonds are an IOU with interest. Let’s say you’re short on cash and borrow $100 from a friend. You’ll pay them back in a month, but promise to buy them a cup of coffee every week until you pay the full amount. Bonds work in a similar way, but on a much larger scale.
Bonds can get a bit more complicated. For instance, their face value shifts with the market. But for the purpose of this piece, all we need to know is that bonds provide upfront capital that will have to be paid back (with interest, of course!) at an agreed time.
What bonds can be used to finance climate projects?
Bonds that can be used to finance adaptation projects come in various shapes and sizes and can provide investors a way to earn steady income while knowing that their dollars are being put to an environmentally positive use.
Municipal Bonds — municipal bonds are issued by state and local governments with interest rates that are generally exempt from federal income taxes. The two most common types of municipal bonds are General Obligation (GO) Bonds and Revenue Bonds. GO bonds must be approved by a majority of voters, and governments have the power to tax residents in order to pay back bondholders. Revenue Bonds do not require voter approval and are supported by a specific revenue stream (think toll fees from a fancy new bridge).
- Further Reading: Check out this GO bond passed in San Francisco in November that will put $425 million toward fixing the Embarcadero Seawall
Green Bonds — Green Bonds can be issued by public and private entities. Green Bonds issued by state and local governments are similar to Municipal Bonds, in that they are generally exempt from federal tax collection. Proceeds from Green Bonds pay specifically for “green” projects. Green Bonds are still quite new, and there currently isn’t a reliable standardization of what it means to be “green.”
- Further Reading: Here are some examples (though not directly related to climate) of how Green Bonds have been used to improve water quality in the state of Massachusetts
Insurance-Linked Securities — Unlike the bonds above, Insurance-Linked Securities (ILS) are typically issued by insurance and (re)insurance companies as a means to transfer risks. Two segments of ILS relevant to climate projects are Catastrophe Bonds (Cat Bonds) and Resilience Bonds. Cat Bonds raise money in case of a catastrophic event such as a hurricane or an earthquake. Investors agree to pay damages if a triggering event (i.e. the agreed upon disaster event) occurs. If no trigger strikes by the time of the maturity date, the investors get their principal back, plus interest. Because its value is tied to an insured loss event, Cat Bonds are not closely tied to the wider financial market. Resilience bonds are similar to Cat Bonds, but also include premium discounts and rebates for actions that reduce climate risk.
- Further Reading: RE.bound, a Resilience Bond program that “applies the insurance mechanism of a Catastrophe Bond for a city or public utility, and generates savings in the form of a rebate that can apply to projects, like seawalls or flood barriers, that reduce economic losses from disasters.”
Pay-For-Success Financing — Pay-For-Success Financing, a model used by Environmental Impact Bonds (EIB), is structured a little differently than standard bonds. An investor is matched with a municipality and provides the up-front capital needed to kick start a large-scale resiliency project. After the project is implemented, it is assessed by a third-party evaluator. The amount the municipality repays investors is contingent on the success of the program.
- Further reading: Read a recent report published by the Environmental Defense Fund and Quantified Ventures evaluating the feasibility of an EIB to support wetland restoration in Louisiana
As with any investment, there comes some risk. Bonds are generally less risky because they are issued by an established entity, like a public agency, and are unlikely to default. This steady and reliable (although lower yielding) stream of income may be interesting to investors that not only want to diversify their portfolios, but also invest in projects that result in environmental and social benefits.