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Bringing Social Impact Bonds to the Environment

Is the social impact bond model better suited to environmental issues?

Social impact bonds (SIBs), or pay-for-success contracts, are designed to help governments finance social outcomes by way of outside investment and have gained significant attention over the past few years. In the United States, two initial SIBs, signed in New York and Utah, aim to reduce recidivism and increase kindergarten readiness, respectively. These efforts are building on work started by Social Finance in the UK, McKinsey's 2012 SIB report, the Nonprofit Finance Fund's information hub, Harvard’s Social Impact Bond Labs program, and the many other pay-for-success contracts signed around the globe. Taken together, a tremendous amount of brainpower, multi-sector collaboration, and financial innovation has gone into building new ways to finance the long-term social outcomes that society seeks. But what about the environmental outcomes we seek? Is the pay-for-success model even better suited to financing sustainability?

This is the question we set out to explore last year, by considering factors that would justify the creation of environmental impact bonds (EIBs). When you consider a social impact bond, there are several essential steps (as defined in Social Finance’s "A Technical Guide to Developing Social Impact Bonds"). These include defining the outcomes you seek and determining the "value for money case"—or the potential savings that could result from the intervention. You then define the program, decide on metrics and who will track them, and convince different parties to make payments if the program meets target initiatives (so far, philanthropists and investors have paid up front, government agencies later).

For environmental issues such as water quality improvement, environmental financing has three distinct advantages over social financing:

  1. Many standardized EIB metrics already exist, and we can develop new ones more quickly than SIB metrics. In the SIB ecosystem, metrics and measurement techniques often are developed from scratch, or are costly to collect and track because they are “people” metrics—that is, they measure behavioral change over time. In the EIB ecosystem, however, many standardized metrics already exist, and thanks to scientific knowledge and rigorous environmental monitoring already underway, we can readily develop new ones. The City of Philadelphia, for example, is revamping its system of measuring (and taxing) stormwater runoff, which has been shown to adversely impact the city's water quality. The city could easily adapt this metric for use in an EIB that focuses on improving local water quality.
  2. Natural resources are commonly associated with revenue streams. Apart from government funding, social service agencies and SIBs often have few established revenue streams. In the environmental sphere, however, natural resources are frequently linked to revenue streams, potentially reducing reliance on government funding for EIBs. If regular cash flow payments are available during the life of EIBs, we could structure bonds in a way that would entice more conservative investors. We created two scenarios for this: 1) the investor gets annual coupon payments over the life of the bond (we call this "Return at Risk - standard"), or 2) investors get coupon payments plus a potential annual bonus (called " Return at Risk - annual bonus"). A steady cash flow during the life of the bond would provide lower-risk instruments to impact investors and perhaps obviate the need for the first-loss guarantee layers (foundation or government subsidies to cover potential losses) present in most SIBs to date.
  3. Future EIBs may not depend on new government regulation. Government regulation is not always required to develop a consistent cash flow from natural resource assets. As a result, there is great potential to use EIB financing to expand investment in environmental markets that already exist. In The Freshwater Trust's Water Quality Trading program, for example, the critical metric is in-stream water temperature; colder water helps promote healthy salmon and trout fisheries. The Oregon Department of Environmental Quality publishes standards that relate streamside restoration efforts to cooling benefits in the water. A third party verifies this data, and the water trading program uses it to manage the trading of "stream temperature" offset credits. Someone wanting to expand this program to other states or regions could, in theory, use Oregon’s existing system to create an EIB for outside investors interested in these outcomes.

One of our conclusions is that some environmental trade and credit programs, such as The Freshwater Trust program, work well enough that EIBs are not needed. Our new CASE i3 white paper, "Environmental Impact Bonds," is an initial exploration of the criteria needed to determine where an EIB would become an appropriate and effective part of the environmental finance toolkit.

We welcome feedback and comments on the paper.

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COMMENTS

  • Like the paper and the concept. Wondering how you incorporate ongoing scientific progress into the bond. For many EIB indicators it is very easy to imagine that over a number of years the indicators would evolve- become more accurate, change in relative importance, etc. For instance, measurements of water quality are constantly being refined. I believe in your paper you referred to this, in part, as “measurement risk”. How would you build that into an EIB? Or do you think the market could price that risk on its own?

  • BY Michael Eddy

    ON November 26, 2013 06:06 PM

    Cathy and David, Thank you for this worthwhile contribution. A few people have approached us about applying SIBs to environment and to be honest it’s an area in which I’m not as familiar.

    My major question when I saw this report is whether this is just a new name for something that’s been going on for a while? Carbon markets pay based on averted carbon emissions. The REDD+ scheme pays based on averted deforestation, and your own example of the Water Quality Training Program pay based on water temperature.

    Where’s the conceptual distinction between EIBs and existing outcome-based environmental financing schemes? How does applying what (little so far) has been learned in SIBs help environmental financing mechanisms or should really the SIB people be learning about the much longer experience of the environmental finance initiatives?

  • David Nicola's avatar

    BY David Nicola

    ON November 27, 2013 01:58 PM

    REPLY TO DAN:
    Thank you for reading the blog and paper.  We appreciate your comments and questions. 
    You raise an interesting point, in our paper we had thought of “measurement risk” as the “noise” associated with trying to link cause and effect of certain environmental improvements.  For instance, if a Land Trust restores streamside habitat to prevent erosion, it would be difficult to link specific restoration efforts to sediment levels measured in the water, particularly if there were significant activities upstream that disturb sediment levels in the water.  Your point seems to be slightly different than how we envisioned “measurement risk” but certainly a measurement risk nonetheless and one we can now incorporate into our thinking.

    In my view, there are two main ways of avoiding the potential risks you cite above (evolving measurement technology) in future EIB contracts: 1) using a proxy for measurement (third-party verified environmental improvement activities) instead of taking physical measurements of the environmental improvement, and 2) agreeing to specific measurement techniques or technologies in the EIB contract.

    For the first point (proxy measurement) The Freshwater Trust’s Water Quality Trading program does this.  The benefit of this approach is that investors have more certainty to project their returns based on undertaking specific environmental improvements.  For the second point (contractual measurement techniques), in the event that physical measurement must take place in an EIB, the contracting parties can agree to specific measurement techniques or technologies.  This will allow for more certainty in establishing future payouts to the EIB players.

    Both of these approaches would serve to help maintain more legal discipline in an individual EIB contract.  As technologies and environmental measurement techniques advance, new EIB contracts (based on the updated technology) would be established and the older EIB contracts (based on older techniques) would be phased out.  I tend to view this as a relatively low risk for investors and don’t think that new technologies will dramatically affect price (i.e., discount for older EIBs vs newer EIBs) unless the contracts leave room for legal maneuvering (also, we have a long way to go before there is a market for these types of instruments).  What the two points above do not address is: are we still having a positive effect on the environmental if updated measurement technologies demonstrate otherwise?  That seems to be a larger, philosophical issue that may not be best addressed via legal contracts.  In our view, getting more individuals and organizations to dedicate money to environmental causes via EIBs or other similar structures is a great first step.  Happy to discuss further and hear your thoughts on this response.  Thanks.

  • David Nicola's avatar

    BY David Nicola

    ON November 27, 2013 03:56 PM

    REPLY TO MICHAEL:
    Thanks for your comments and questions.  Yes, the term “Environmental Impact Bond” may be an artificial distinction from some of the environmental initiatives you mention.  Labeling certain environmental outcome-based initiatives as EIBs is similar to the label of “impact investing” – which is a new name for certain types of investing activities that have been occurring for well over 30 years.

    At the same time, EIBs are also different than some of the more established environmental markets that you mention.  We see EIBs playing a role in environmental issues that are less established than carbon markets or other trading programs.  Also, EIBs can help spread environmental improvement to regions or jurisdictions where the political capital is not available for establishing official credit or trading markets.  This is where we see a possible distinction.

    To your last point - should the SIB community be learning from the long history of environmental investing initiatives - this is one of my main reason for writing the paper!  Environmental outcome-based investors have been accruing knowledge for many years, knowledge the that SIB community would do well to embrace.  Thanks for your thoughts.  - Dave

  • HefesseeJoseph's avatar

    BY HefesseeJoseph

    ON December 3, 2013 04:04 AM

    I am not getting that how Social impact bonds will help to solve environmental problem.Please give any example as I am not finding it any helpful for environment.
    http://www.aerofixcycles.com

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