This paper was
presented to delegates of the Organisation of Economic Cooperation and
Development (OECD) at a meeting in Paris in April 2002 of the Joint Working
Party on Agriculture and the Environment.
The impacts of
agriculture on the environment are of major public concern. This paper
introduces a new financial instrument, intended to channel market forces into
the achievement of environmental goals. Agriculture, of course, is not the only
source of environmental degradation. In our ever more populated and complex
world solutions to environmental problems are needed that transcend sectors,
and even nation states. Environmental Policy Bonds, unlike many other policy
instruments, would not prejudge the origins of environmentally damaging
behaviour. Instead, they would focus on desirable outcomes.
In economic
theory, and on the evidence of recent history, it seems clear that a market
economy is essential for prosperity. Markets are the most efficient means yet
discovered of allocating society’s limited resources, but many believe that
market forces inevitably accentuate extremes of wealth and poverty. So it is
important to remind ourselves that a market economy is consistent with many
different outcomes and that market forces can serve public, as well as private,
goals. Environmental Policy Bonds would be an entirely new financial
instrument, intended to channel the market’s incentives and efficiencies into
the achievement of society’s environmental
objectives.
The first
chapter of this paper outlines the Environmental Policy Bond concept using the
example of nitrate pollution. Chapter 2 compares Environmental Policy Bonds
with other more-market approaches to policy.
Chapter 3 discusses characteristics of policy areas in which
Environmental Policy Bonds may have advantages, and looks in detail at how they
could be used to address climate change. Chapter 4 discusses some of the
practical aspects of the bonds, including potential problems and how these
might be mitigated. The fifth and final chapter briefly discusses when the
bonds might best be deployed, then looks in more detail at the use of the
concept to stabilise the world’s climate. It closes by setting the scene for
further discussion and trials of the bond concept.
Environmental
Policy Bonds are a new, and as yet unused, financial instrument that could be
deployed to help inject market incentives into the achievement of environmental
goals.
Central or local
government would auction Environmental Policy Bonds on the open market.
Government would undertake to redeem the Bonds for a fixed sum only when a specified environmental objective
had been achieved.
Normal bonds are
redeemable for a fixed sum, at a fixed date, and they yield a fixed rate of
interest. Environmental Policy Bonds would be entirely different. They would
have an uncertain redemption date, which, in combination with a fixed
redemption value, implies an uncertain yield. Unlike conventional bonds,
Environmental Policy Bonds would not bear interest: holders gain by ensuring
that the targeted objective is achieved quickly.[*]
As with conventional bonds, Environmental Policy Bonds would be issued by
government and redeemed by government. But they would differ from conventional
bonds in that all returns to their holders would take the form of capital
appreciation.
Once issued,
Environmental Policy Bonds would be freely tradable on the open market. Owning
such Bonds, whose value would rise when an environmental objective became
closer, would give bondholders an incentive to try to achieve that objective.
Under a Bond regime bondholders would have every motivation to choose and
invent ways of solving environmental problems that are cost-effective and
efficient. Environmental Policy Bonds would have the effect of contracting out
the achievement of environmental
objectives to the private sector, while government would continue to set these
objectives, and to be the ultimate source of finance for their achievement.
An example can
elaborate the principles involved.
The OECD has
carried out a stocktaking of the environmental performance of agriculture in
its member countries (OECD, 2001). While in recent years there have been some
positive developments, there have also been cases of environmental degradation.
This has been a result partly of the intensification of farm production in some
areas, and the regional concentration of activities such as livestock farming.
These have generated higher levels of nutrient surpluses, ammonia and
greenhouse gas emissions, with consequent increases in water and air pollution.
There is also growing competition for scarce water resources both between
agriculture and other users, and in meeting the water needs of aquatic
ecosystems for recreational and environmental purposes.
One of the
indicators the OECD uses to measure the environmental impact of agriculture on
water quality is the water quality state indicator. This can be defined as “the
proportion of surface water and groundwater above a national threshold value of
nitrate concentration (NO3 mg/l)” at various measuring points (OECD
2001). Agriculture accounts for more than 40 per cent of nitrogen emissions,
and many OECD countries are trying to reduce the concentration of nitrates in
their water. Let us assume that a particular government wishes to reduce the
existing level of nitrates, calculated as an average of the level in its rivers
and groundwater, from 50 mg/l to 40 mg/l.
The government
decides to target this level by issuing Environmental Policy Bonds that become
redeemable for, say $10 only when the average nitrate water concentration has
fallen to 40 mg/l as certified by an independent scientific body. It calculates
that achievement of this target level is worth a maximum of, say, $10 million.
By issuing 1 000 000 Bonds it therefore ensures that the net cost of achieving
the objective will not exceed this figure. These Bonds would be floated at an
auction. Those who bid the highest price for the limited number of Bonds will
be successful in buying them.
What will
determine the float price of the Bonds? Most obviously the market's assessment
of how likely, and when, the targeted level of nitrate concentration will be
reached. People will differ in their valuation of the Bonds, and their views
will change as events occur that make achievement of the targeted objective a
more or less distant prospect. The Bonds might sell for as little as a fraction
of a cent if people thought there were virtually no chance of the nitrate
concentration reaching the target level in their lifetime. However, let us
assume that the Bonds fetch an average price of $5. The Bondholders now hold an
asset that can appreciate by 100 per cent once nitrate pollution levels have
fallen to the target level. They therefore have a powerful incentive to do what
they can to help bring about such a reduction. The Bonds, once issued would be
freely tradable, and their price publicly quoted just like those of ordinary
bonds or shares.
Who would buy
the Bonds, and what would they do? Some
people might buy the Bonds as they would a lottery ticket, or a publicly quoted
company share. They would think that the Bonds’ value will rise, even if they
do nothing. Such passive investors would want to become ‘free-riders’ hoping to
benefit from any increase in the Bond price without actually participating in
any pollution reduction activities. But the way the market works would limit
the opportunities for such speculation. The more Bonds they collectively own,
the more remote the targeted pollution will become, and so the more they stand
to lose as the aggregate value of their Bond holdings fall. At some point,
then, it would become worthwhile for these passive investors either to become,
or to sell their Bonds to, active investors. (Chapter 4 will look at this, and
other potential pitfalls arising from perverse incentives, in more detail.)
Active investors
would finance initiatives aimed at reducing nitrate pollution. They could use
their own capital, or borrow on the strength of the redemption value of their
Bonds, or on the strength of any increase in the value of their Bonds, to
support projects that help reduce the level of nitrates in water. They would
have every incentive to co-operate with each other, to help achieve the
targeted objective, and to do so as cost-effectively as possible. Their
motivation arises from the expected capital gain they will experience as the
value of their Bonds rises in line with the enhanced probability of the
objective being achieved quickly.
Such active
investors in the Bonds are likely to undertake a range of initiatives,
including:
·
helping to
finance farms’ water pollution reduction programmes;
·
paying
farmers to reduce their pollution-generating output,
·
defraying
the costs of production, or consumption, of less polluting alternatives to
existing products or services; and
·
contributing
to research into ways in which the same agricultural output can be produced
with less pollution.
Bondholders can
also be expected to discover and finance other pollution-reducing initiatives, the precise nature of which need not be
known in advance.
Note that large
polluters might buy Bonds themselves. They would do so knowing that their
holdings would rise in value and help to offset the cost of any measures –
whether compulsory or voluntary – that they take to reduce their pollution.
In some
countries, central, regional or local government bodies might already be
involved in some way with some of these initiatives. However, there is a
crucial difference: under an Environmental Policy Bond regime participants
(bondholders) have the incentive to seek out those ways of reducing pollution
that will give them the best return on their outlay. Without government
planning, therefore, bondholders finance
the most cost-effective ways of reducing pollution.
Environmental
Policy Bonds, once floated, must be readily tradable at any time until
redemption. The operation of such a ‘secondary market’ is critical to the way
the Bonds work. Many Bond purchasers will want, or need, to sell their Bonds
before redemption—which may be a long time in the future. With a secondary market,
these holders will be able to realise any capital appreciation experienced by
their holdings of Environmental Policy Bonds, whenever they choose to do so.
Tradability would make the Bonds a more attractive investment in the first
place.
As the Bonds are
traded, they would tend to flow towards those who are most able to help solve
the targeted problem. In fact, though, it is not necessary for there to be any
actual flow of Bonds. Large bondholders might simply decide to subcontract out
the required work to many different agents, while they themselves hold the
Bonds from issue to redemption. The important point is that the Bond mechanism
ensures that the people who allocate the finance have an incentive to do so
efficiently and to reward successful outcomes, rather than merely to pay people
for undertaking an activity. At the limit we can conceive of just one single
buyer of all the Bonds. If this buyer were determined to hold on to the Bonds
until redemption, then the Bonds would function as a sort of performance-related
contract, with the government paying only when the objective has been achieved.
The buyer could contract out most, or all, of the work required to achieve the
objective, with the incentives given by the Bonds for speedy accomplishment cascading
down from the bondholder to those subcontracted to do the work.
Too large a
number of small bondholders would probably do little to help solve targeted
environmental problems by themselves. If there were many small holders, it is
likely that the value of their Bonds would fall until there were aggregation of
holdings by people or institutions large enough to initiate effective
problem-solving projects. As with shares in newly privatised companies the
world over, Bonds would mainly end up in the hands of large holders—individuals
or institutions. Between them, these large holders would probably account for
the majority of Bond holding. Even these bodies might not be big enough, on
their own, to achieve much without the co-operation of other bondholders. They
might also resist initiating projects until they were assured that other
holders would not be free riders. So there would be a powerful incentive for
all bondholders to co-operate with each
other to help solve the targeted problem. They share the same interest in
seeing targeted objectives achieved quickly. So they would share information,
trade Bonds with each other and collaborate on objective-achieving projects.
They would also set up payment systems to ensure that people, bondholders or
not, were mobilised to help achieve targeted objectives in ways that stimulate
success. Bondholders would either trade Bonds, or make incentive payments to
ensure that any proceeds from higher Bond prices, or from redemption, would be
channelled in ways most likely to stimulate speedy achievement of the targeted
objective. Large bondholders, in co-operation with each other, would be able to
set up such systems cost-effectively.
Regardless of
who actually owns the Bonds, aggregation of holdings, and the co-operation of
large bondholders, would ensure that those who help achieve targeted goals are
rewarded in ways
that maximise
society’s environmental benefit per unit outlay.
Once an objective
is close to achievement, the issuing body can float a new set of Environmental
Policy Bonds aimed at maintaining the achieved outcome, or at further
improvements. Sustaining the outcome beyond the period specified in the
original Bond issue is likely to be cheaper than achieving it, while further
improvements targeted by a second Bond issue are likely to cost less, in terms
of benefit per unit outlay, than those achieved by the first issue. Assume
again that a Bond issue aims to reduce nitrate levels from 50 to 40 mg/l, and
to sustain this lower level for, say three years. It is very likely that
sustaining this lower level for an extended three-year period would cost less
than whatever was the net cost of the initial Bond issue. There are three main
reasons for this, the first two of which are linked:
1.
Bondholders
may have invested in systems or capital assets that cost less, per unit
benefit, to keep running than they did to set up.
2.
Bondholders,
in a similar fashion, would have learned from their experience of achieving the
objective targeted by the first Bond issue. They would have looked for, and
experimented with, different methods of solving the targeted problem, and be
able to choose the most efficient ones for subsequent Bond issues. If water quality
were targeted, is likely that any know-how about monitoring systems or
equipment installation would be more cheaply available once an initial targeted
lower level had already been achieved.
3.
Less
specifically, it is probable that general improvements in productivity, mainly
arising from technology (including information technology), will continue to
occur in our economies, and that bondholders will continue to adopt and adapt
them.
New issues of
Environmental Policy Bonds might not be the most cost-effective way of
maintaining the achieved outcome. Instead alternative government actions, such
as legislation or institutional monitoring, could be preferable.
The main
advantage of Environmental Policy Bonds is that, because they would inject self-interest
into all stages necessary for solving environmental problems, they would be
more cost-effective than current, activity-based programmes. And because they
target outcomes rather than activities or institutions, they do not embody
fixed assumptions about the best ways of achieving society’s environmental
objectives.
This chapter briefly looks at three ‘more-market’ approaches to environmental policy, in relation to an Environmental Policy Bond regime.
A tradable
permit regime specifies the maximum amount of pollutant that can be discharged.
It then issues tradable permits to emit amounts of pollutant making up this
total. In the US, markets for permits to emit sulphur dioxide have been in
operation for several years. Markets decide the price and allocation of these
permits. Tradable permits are especially useful in allocating unpriced
resources, such as the assimilative capacity of the environment, and also for
targeting pollutants that have marked thresholds.
Tradable permits
can work well with intrinsically large-scale processes, or for controlling
emissions that have no polluting substitutes. Such processes and substances can
be monitored quite easily, because there would be no fear that doing so would
lead to offsetting increases in pollution via the setting up of
difficult-to-monitor small-scale processes, or the emission of polluting
substitutes that are not being monitored. But technological and ecological
complexities mean that these processes and substances are a minority. Air
pollution, for example, results from many sources and many different processes.
Immense quantities of information would be needed to establish, monitor and
enforce a comprehensive system of pollution control using tradable permits to
pollute. An Environmental Policy Bond regime, however could be more flexible.
It could target an index of, say ‘air pollution’, embodying many pollutants,
whose weights in the index would differ according to their adverse effects on
the environment. In general, it is air or water pollution as a whole, or the
adverse effects of such pollution, that need control, not the concentration of
single pollutants. Tradable permits to pollute can therefore play only a
limited role in environmental protection.
Contracting out usually involves government specifying the outputs it requires, in terms of the nature and level of service required, and inviting the private sector to bid for the contract to supply these outputs. Specifying outputs in this way can be helpful when there is a definite and fixed relationship between a small number of outputs and the desired outcome. But for most environmental objectives such relationships are many and obscure. Contracting out of output-supplying services generally means that the required output must be specified to a high degree. This imposes its own costs, and means that contracting out tends:
· to be limited to particular stages of outcome-delivery; and
· to reinforce established ways of doing things.
Of course,
government could contract out outcome-supplying
services. (In the late 1980s the New Zealand Government did in fact contemplate
this: see Schick (1996).) Doing so would stimulate some of the advantages of
Environmental Policy Bonds, but not all. An important feature of Environmental
Policy Bonds is their tradability. This makes them more attractive to potential
purchasers, and enables active investors to benefit from involvement in only
one, or a few, of the processes necessary for the targeted objective to be
achieved. Tradability differentiates Environmental Policy Bonds from the
contracting out of environmental services to private operators in other ways.
It
o transfers risk of breach of contract from the taxpayer to bondholders. If, under a contract system, the successful bidders fail to do what they were legally obliged to do, then it is up to the aggrieved party—the central or local government agency—to take proceedings against them. Even if such actions are successful, they can be protracted and costly. Under an Environmental Policy Bond regime, underperforming bondholders will find a ready market for their Bonds in people who believe they can be more efficient.
What if contracts were made tradable, so that the winner of a tendered contract could sell the right to supply an environmental service? This would be helpful if a company, having been successful in bidding for the right to supply this service, has done what it can to achieve a targeted objective. If it has done so efficiently and quickly, the value of the contract rises, and being tradable, can be sold at a profit. The new contractor has the same incentive as the original to perform efficiently.
Such tradable contracts would be similar to Environmental Policy Bonds, as long as the terms of the contract stipulated not that a certain output be supplied, but that a specified outcome be achieved. There would be some small differences though. Ownership of Environmental Policy Bonds would be more fluid, which means more market liquidity, more transparency and an enhanced ability for the government to fine tune its priorities after the outcome has been specified and the Bonds issued. The market prices of the Bonds are extremely helpful in telling the government, and any potential supplier of objective-achieving services: how close the objective is to being achieved, the potential rewards from buying the Bonds and participating in objective-achieving projects, and the likely costs of marginal improvements beyond those already targeted. This is discussed in the next chapter.
Another significant difference is that the Bond concept makes more feasible the targeting of remote objectives; ones that might take years or decades to achieve. Many businesses would be reluctant to take on such goals without the possibility that they could benefit in the shorter term. The Bonds allow them to do what they can to achieve a target, and then benefit from selling their Bonds at a higher price, so letting the new bondholders continue the advance toward the goal.
When governments target remote objectives, it is possible that the winners of a contract to supply a service underestimate their costs, and so fail to deliver. This often takes a long time to become apparent either to government or to other potential suppliers of the service. Under an Environmental Policy Bond regime, however, prices of the relevant Bonds would fall, enabling others to buy them earlier and continue to try to achieve the objective.
Tradable pollution permits can work well with inherently large-scale processes, which can be monitored relatively easily, but suffer from informational disadvantages when there are large numbers of polluters. Similarly, contractual arrangements between government ministers and government agencies, or between government and private suppliers of environmental services, suffer because of the need for government to specify in detail what is required. Another problem is that the most efficient suppliers of environmental services will not always be identifiable at the outset of an environmental improvement programme, nor will their identity remain constant, especially during the lifetime of a long-term programme. Tradable contracts mitigate some of these deficiencies, but the enhanced marketability of Environmental Policy Bonds might supply still more advantages, especially when targeting broad, long-term environmental goals.
Environmental
Policy Bonds could have informational advantages over other forms of control
when there are many sources of
pollution. In this respect, regulation suffers from the same weaknesses as
tradable permits: both can work efficiently when dealing with intrinsically
large-scale processes. But in agriculture there are typically large numbers of
polluters, which can make enforcement of environmental regulations expensive
and intrusive. Establishing and monitoring a fully comprehensive water
pollution regime, for example, would require immense quantities of information.
The Bonds,
focused as they are on outcomes rather than activities, would target society's
overall objective – less water pollution – rather than each of the numerous
activities that generate water pollution. They would therefore require
government to monitor comparatively few data: regular measurements of aggregate
pollution, or of indicators or pollution, or of the adverse effects of
pollution, need only be taken at selected sites.
Environmental
Policy Bonds might have particular advantages too when a multiplicity of solutions is required. The Bonds specify and
reward outcomes; they do not prejudge how these outcomes should be achieved.
For broad objectives applicable to large areas, it may be preferable to encourage
a full range of activities, adapted to local circumstances, than to specify how
environmental outcomes are to be met. And, ideally, policies should not
discourage research into, and application of, new, more efficient solutions
than those that can currently be envisaged by policymakers. Policies that seek
to constrain certain prescribed activities, or reward certain prescribed
processes, may not be optimally efficient.
A related
concern is that the adverse impacts of a particular agricultural activity on
the environment will vary with natural
circumstances. The composition of groundwater or river water, for example,
varies according to natural climatic and geochemical conditions. In consecutive
seasons, with the same intensity of production, nitrate levels, for example,
may vary widely and inversely with rainfall, approaching dangerous levels when,
say, rainfall is very low. Regulation mainly concerns itself with activities,
rather than the results of these activities on the environment. When, as happens
frequently in agriculture, the effects of production systems on the environment
vary with (say) the weather, it may be more efficient to target outcomes rather
than systems or activities. Environmental Policy Bonds transfer the risk of
failing to meet environmental objectives from society to the polluter.
The same
reasoning applies where there are uncertain
relationships between processes and their effects on the environment. We
may, for example, be concerned about the health of a river, say, as exhibited
by the number and variety of fish within it. Perhaps species have been dying,
for reasons that are not clear, and not obviously related to identified water
pollutant levels. An Environmental Policy Bond issue targeting an increase in
the fish population directly may be more efficient than one targeting a
reduction in pollutants such as nitrates or phosphates. Bondholders may find it
more worthwhile to investigate the causes of the decline of the fish population
than to pursue pollution reduction schemes on lines envisaged by policymakers.
Or they may decide on a combination of these and other measures. Their research
may even lead them to conclude that the decline in the fish population results
from a combination of circumstances that will resolve itself without any need
for intervention. Whatever bondholders do, they will be motivated to restore
the health of the river using the most cost-effective combination of measures
possible.
For most environmental problems, not all the alternative solutions are known in advance. The optimal range of approaches is seldom a one-size fits all, government-dictated, inflexible, policy suite. More often, it is a matter for investigation and experimentation, and a wide variety of approaches is essential. Under an Environmental Policy Bond regime, diverse activities would be rewarded in proportion to their success. And once applied they, or an optimal combination of them, would become the new standard for future projects.
Environmental Policy Bonds targeting national goals would encourage investigation of local circumstances, on the basis that it could lead to more efficient solution of the environmental problem affecting a much larger region, or the whole country. In similar fashion they would stimulate diverse responses to a particular problem. Bondholders might find, after a bit of experimenting with different approaches, that certain activities work better than others under certain conditions. They would take the best of these approaches, and apply them where their contribution to achieving the targeted environmental outcome would be greatest, and they would recognise that, for certain objectives, a mosaic of diverse activities is most efficient.
Government policy tends to be uniform. It is often obliged to impose similar policies across whole sectors or large regions, regardless of whether such an approach is cost-effective. It focuses on pollution standards, rather than on the impacts of pollution, which can vary greatly over space and time. All this is not to say that government cannot be both innovative and adaptive in formulating environmental policy. But too often its response is ‘too much, too late’, being absent when longstanding environmental degradation accumulates, and overly prescriptive when, for instance, the same impacts attract media attention. Bondholders, having a financial incentive to do so, could help shape government policy, making it more responsible and effective. They could act as a counterweight to those whose self-interest impels them to lobby against effective environmental policy.
Environmental
Policy Bonds would help make environmental policy objectives more transparent.
Under an Environmental Policy Bond regime, environmental goals would be
explicitly identified, while indirect, as well as direct, means of achieving
them would be encouraged – so long as bondholders think them more efficient.
Focusing on identifiable outcomes would encourage constructive participation in
the political process, and means that measures taken to achieve them would be
more likely to attract public support. At least as important, all outcomes
would have to be costed. This means that the maximum value that society wishes
to place on an outcome would have to be decided and publicly known before any
programmes have begun. Once that has been determined, the issuing body would be
able to decide on the Bonds’ redemption value and the number of Bonds to be
issued. Costing outcomes in this way would make the tradeoffs between
environmental outcomes more transparent, and make people's expectations of what
government can do for the environment more realistic.
A
clear expression of desired environmental outcomes would also mean that
progress toward them could be accurately monitored.
Many
environmental goals have a necessarily long lead-time. Under an Environmental
Policy Bond regime bondholders would aim to achieve environmental goals as
cost-effectively as possible. They would be free to choose how to achieve the
targeted objective. Environmental goals can be expressed transparently, rather
than in terms of technical indicators that embody assumed links between them,
and the desired outcome. Society’s environmental goals are likely to be more
stable than these links. For example, our ultimate objective in reducing
nitrate levels in rivers and groundwater is likely to be one of maintaining or
restoring wildlife habitats. Environmental Policy Bonds would allow this
outcome to be targeted, rather than each of the many possible influences on
such an objective. Of course, it would be unsatisfactory to redeem such Bonds
as soon as a targeted improvement in water quality, however specified, had been
achieved. The objective would be a sustained
improvement in water quality, and this is how it would have to be defined when
the Bonds are issued.
Stability
of desired outcome makes it unlikely that investors will be deterred from
taking measures to achieve them by fears of a reversal of government policy—or,
indeed, a change of government. Environmental objectives will have to be
carefully defined, so that future governments would be unlikely to repudiate
them, even if the associated Environmental Policy Bonds had been issued by a
ruling party with a different political outlook. The risk of that happening would
be not much greater than that of a government refusing to redeem fixed interest
stock issued by any of its predecessors. This risk, always present, is factored
into ordinary bond prices, and in no way impedes the operation of bond markets.
Importantly,
for the Bonds to be as successful as possible, governments would have to give
some assurances as to their future behaviour. For maximum success, therefore,
they would also have to choose their objectives in consultation with opposition
political parties, as well as with the electorate.
Many
environmental objectives are difficult to value. Environmental Policy Bonds
share with conventional policy instruments the need for some estimate of the
value to society of a specified objective. But they have an advantage over most
other instruments in that the cost of achieving the targeted outcome is
minimised and capped. And if bondholders fail to perform, the cost to the
taxpayer is zero. In maximising the efficiency with which the outcome is
achieved, the market for the Bonds is elegantly efficient in conveying
information about the cost of achieving objectives and, crucially for
policymakers, how this cost varies with time and circumstances.
Take our example of lowering the nitrate concentration in groundwater from 50 mg/l to 40 mg/l.
Let us assume that the government issues 1 million ‘Nitrate Reduction Bonds’ (NRBs) redeemable for $10 each once this lower level has been attained. The maximum cost to the government of achieving this objective is then $10 million. But if the Bonds, when issued, fetch $5 each, then the market is saying that it thinks it can achieve this objective for just $5 million. It doesn't say when it thinks it can achieve that objective, but that can be inferred from market behaviour, and the market value of the Bonds compared with other financial indicators. But what if the Bonds sell for virtually nothing, and the market value of the Bonds fails to move from that floor? That would mean that the government had miscalculated: in the market's view there is no realistic chance of the objective being achieved for an outlay of $10 million in the foreseeable future. The government could respond in different ways:
·
It can wait
for new technology to arrive, or for circumstances to change in other ways,
such that the market sees the objective as becoming more easily achievable, and
the value of the Bonds consequently rises. Or
·
It can
issue more Bonds, with the same specification, also redeemable for $10. It can
do this in stages, gauging the market reaction to each new tranche of Bonds,
which will tell government the maximum cost of achieving the objective.
Either way, the government can be reasonably sure that it is getting a good deal, expressed as nitrate reduction per unit outlay. This important benefit is worth spelling out in some detail. Valuing the benefit of achieving an environmental outcome is bound to be an uncertain, and to some extent, subjective task, whichever policy instrument is used. But minimising the cost of whatever outcome is targeted is a different matter. Under an Environmental Policy Bond regime, it is the collective wisdom of those in the market for Bonds that determines how much the government (that is, taxpayers) will pay to achieve the targeted outcome. An issuing government can determine the maximum cost of achieving the objective because that would simply be the total number of Bonds issued multiplied by the redemption value plus administration costs minus any revenues gained on floating the Bonds.
But while it has to decide on the maximum cost to society of achieving the objective, a government wouldn't have to work out how much the actual cost will be with any accuracy. Potential bondholders would do that for the Bonds in the open market. Assume again that a government issues 1 million Nitrate Reduction Bonds of redemption value $10. If the market decides that the issue value of these Bonds is $1 each, the net cost of achieving the targeted objective (neglecting administration costs) would be $9 million. In other words, the market at the time of issue believes that the cost, including a profit margin, of achieving the objective will be $9 million.
But suppose the government is totally in the dark about how much it will cost to achieve the targeted reduction in nitrates, and instead of issuing one million Bonds, it issues 10 million with the same redemption value, $10. It would then be liable for a maximum cost of $100 million. However, the market will still reckon that it could achieve the objective for $9 million. So instead of valuing the Bonds at $1.00 it would bid up the issue price of the Bonds to $9.10. (Environmental Policy Bonds would be an unusual financial instrument, in that the more that are issued, the higher would be their market value!)
The Environmental Policy Bond
mechanism ensures that people other
than government employees decide roughly how much a targeted objective will
cost to achieve. Potential investors do this when they bid for the Bonds at
issue, and afterwards. This fact, and the would-be bondholders' incentive to
minimise their costs, contrast with the current system, in which the costs of
achieving particular outcomes, if they are calculated at all, are not widely
known, nor subject to competitive bidding. Under the current system, in fact,
many of the people employed or contracted by government to supply social or
environmental services have every incentive to inflate their projected costs.
Note that the government could add to the number of Bonds in
circulation after floating, at any time, if it wanted to boost the efforts
going into achieving a particular environmental goal. If it wanted, for
whatever reason, to reduce such
efforts, the situation is a little more complicated. The government could buy
Bonds back from holders, but doing so would reduce the total funds to be spent
on achieving the targeted objective, and so would lower the value of all Bonds
in circulation. People might therefore be unwilling to buy Bonds in the first
place, if they thought there were a high probability of the government’s buying
some of them back in this way. They would demand some sort of premium for
taking that risk. Or the government could undertake either that it would never
buy Environmental Policy Bonds back or, that if it did, it would buy them all
back at the market value ruling before it announced its purchase intentions. This unlikely sequence of events should
not obscure the fact that under a Bond regime competitive bidding would work to
minimise the cost to taxpayers of achieving environmental goals.
But the Bond mechanism does not merely minimise the total cost of achieving a specified objective. It also indicates the marginal cost of achieving further improvements. Say the one million NRBs initially issued do actually sell for $5. This tells the government that the present value of the expected maximum cost of reducing groundwater nitrogen concentration from 50 mg/l by 10 mg/l is $5 million. The government may therefore judge that it is well worth being more ambitious, and aim for a further fall in nitrate pollution of 10 mg/l to 30 mg/l. It could issue a million additional NRBs redeemable when this new lower concentration is reached. These would (probably) have an initial market value of less than $5, reflecting the (probably) diminishing returns involved in lowering the nitrate concentration. The point is that, by letting the market do the pricing of the Bonds, the government is getting an informed view of the marginal cost of its objectives. So if the NRBs targeting the new level of 30 mg/l sell for $4, then the maximum cost of achieving that objective is $11 million, being equal to: $5 million (paid out when the level fell from 50 to 40 mg/l) plus $6 million (paid out when the level fell from 40 to 30 mg/l). The marginal cost of a 10 mg/l drop in the nitrate concentration is revealed to have risen from $5 million to $6 million. Should the government aim for a further fall to 20 mg/l? Under a NRB regime it would have robust information about the cost of doing so.
Of course, this
is a simplified example. In fact, the Bond market will continuously update this
sort of information. Say that improvements in technology, of the sort that
might be stimulated by an initial nitrate-targeting Bond issue, mean that it
becomes much cheaper to reduce nitrate levels. Bondholders may, for example,
have financed successful research into new varieties of grasses that exhibit
better fertiliser uptake. How would the market react to such a development?
Once the new varieties’ effectiveness was revealed, the value of all the
nitrate-targeting Bonds would rise. Instead of being priced at $5 and $4, the
two NRB issues of our example might sell for $8 and $7. The total cost to the
government of redeeming these Bonds will not change: it will remain $11 million
(though redemption will occur earlier). But the market is providing new
information as to the likely cost of future improvements in water quality. The
market now expects reductions of 10 mg/l in nitrate concentration to cost $2
million (from 50 to 40 mg/l), and $3 million (from 40 to 30 mg/l). The new
grass varieties have reduced the costs from $5 million and $6 million
(respectively). So the cost of any further nitrate reductions will also fall,
and by following market price movements we can gauge approximately by how
much.
These figures are made-up and simplified, but they do
indicate the role that an Environmental Policy Bond market could play in
helping the government, and taxpayers, decide on their spending priorities. The
importance of this sort of market information can hardly be exaggerated. The
failure in history of central planning can plausibly be attributed to the
absence of market-generated information (Hayek, 1978). Market prices reflect
all of the information used by all who transact, or choose not to transact, in
the market. Central planning fails in comparison with a market economy because
it encounters the limits of human beings’ calculating capacity: no individual
or group of individual planners knows or feasibly can know all the dispersed
information that is embodied in prices. Even with a sound incentive system in
place—and the centrally planned economies had some fearsome systems—without the
information that only markets can generate the computational task of organising
an efficient allocation of resources is too great. Prices incorporate and
simplify all of the dispersed information implicit in getting a product or
service to the marketplace. Markets for Environmental Policy Bonds would
continually generate and reveal this information to policymakers and all those
involved in achieving social and environmental outcomes—probably for the first
time on a systematic basis. In solving society’s environmental problems
this combination could prove potent.
A
further advantage of Environmental Policy Bonds is that, in many cases, they
will have more politically appealing money flows. Many current methods of
pollution control inflict identifiable losses on certain people in pursuit of
vague objectives. Environmental Policy Bonds, however, would reward people for
achieving successful outcomes. The Bonds would of course be redeemed by funds
from the government's general taxation revenue and taxes would still have to be
levied to provide this, but there is, nevertheless, a presentational advantage.
The
other money flow advantage of Environmental Policy Bonds is that the government
would incur expenditure only when definite outcomes had actually been achieved.
For this reason, the Bonds may attract greater political support for certain
goals than agency- or activity- based programmes.
Environmental
Policy Bonds would represent a radical change in the way in which our society
does things. At first sight, a Bond regime might seem outlandish: it appears to
mean that government hands over responsibility for achieving environmental
goals to the private sector. It also allows private companies to profit from
work done to achieve public goals. But it is important to realise that there is
no necessary conflict between public and private goals. Under an Environmental
Policy Bond regime government would merely contract out the achievement of
environmental objectives. Government would still set these goals and, by undertaking
to redeem the Bonds, would still be the ultimate source of finance for the
projects that achieve them. Moreover, competitive bidding for Bonds would bid
away excessive company profits. Nevertheless, the concept does raise some
important questions. One such is whether a Bond regime would generate perverse
financial incentives.
What if, following a Bond issue, polluters spurn
bondholders’ blandishments and refuse to reduce their pollution? Bond prices
might therefore fall, and polluters could collude to buy them at a lower price.
They would then profit by reducing pollution and redeeming the Bonds. If a
pattern of such behaviour were established, would not polluters then be the
only investors in future issues of Environmental Policy Bonds? A quick answer
would point out that the targeted objective would still have been achieved for
a sum equal to, or less than, the maximum cost for which the issuers have
allowed. True, the cost would be lower if there were no such collusion. But another
answer is that Bonds are only one weapon in a government’s armoury. Regulation
of pollution, or the threat of it, would work to raise the market value of the
Bonds, and make such behaviour risky. This type of behaviour would be a threat
only when there were a few big polluters who could collude. In such circumstances
Environmental Policy Bonds might anyway not be the best pollution control
mechanism, because their informational advantages over tradable permits for
example (see Chapter 2) might not be so significant.
But what if, following a Bond issue, businesses
pollute more than they otherwise would, and gain from bondholders paying them
to stop? In effect they would pollute more on the expectation they will receive
enhanced payment for reducing pollution in the future. This would also,
however, have some risk attached, because bondholders may calculate that the most
cost-effective reductions can be achieved by businesses other than such
anti-social polluters, or that the objective can be achieved in other ways
(such as, for example, removing air pollutants from the atmosphere). If
pollution were a bye-product of production, then the output of these polluters
would be at an above-optimal quantity, so their pollution increase would not be
costless.
But the possibility still arises that these businesses could profit from such behaviour. Or even that people who previously generated no pollution whatsoever might begin to pollute so that they could benefit either from bondholders’ paying them to pollute less, or from buying the Bonds cheaply, and then reducing their pollution and selling their Bonds at a higher price. In all these cases there need be no collusion amongst bondholders. For ‘market fundamentalists’ contemplating using Environmental Policy Bonds as the sole means of achieving environmental goals, this might constitute a fatal flaw. But, again, Environmental Policy Bonds would almost certainly complement a government’s regulatory powers, including its powers to apply the Polluter Pays Principle. There is probably enough existing legal, as well as moral, sanction against cynical polluters to ensure that it need not happen. Governments would certainly retain its powers to tax or regulate in ways that would make perverse increases in pollution more risky, or criminal. And it bears repeating that, in a Bond regime, holders have powerful incentives to see that existing rules against pollution are enforced, or that new regulations on polluters are imposed.
Another possible source of perverse incentives could arise from the development of futures and options markets in Environmental Policy Bonds. These would enable people to benefit from a falling Bond price, so giving them an incentive to delay achievement of the targeted goal.
It is quite likely that
there would be futures and options markets for the Bonds, and it is almost
certain that the price of any particular Environmental Policy Bond would not
always be increasing along an upward trend from its float price to its
redemption value. It is right too that bondholders should be able to hedge
against the consequent falls in the value of their asset, and it follows that
people who do not hold Bonds will also participate in markets for derivatives
of Bonds, some of which would rise in value as the targeted goal became more
remote. This in turn means that speculators and short sellers could certainly
profit by short-term Bond price falls, and the question is whether these
people would then take steps to reduce climate stability. There are two main
reasons why they would not. The first is that, in the long term, the weight of
money would be against them. Provided sufficient funds are allocated to
achieving the targeted objective, there would be a very large net positive sum
of money payable if the climate is stabilised, and a net zero sum being paid if
the climate is not stabilised. All the long-term incentive is to achieve the
environmental objective. Those who, for whatever reason, would suffer from
achievement of this goal could be compensated by bondholders, or bribed to
change their ideas. Note also that for every buyer of a ‘put’ option there
would be a seller, and that for every futures contract bought on the
expectation that the Bond price would fall, there would be an equivalent
futures contract sold on that basis, so that the net incentive generated by
derivatives would be in line with the incentive created by the underlying
financial instrument, the Environmental Policy Bond: in the long run, this
would be in favour of achieving the targeted objective.
The other reason that short sellers, or holders of put options, in Environmental Policy Bonds might not take actions aimed at interfering with achievement of the goal is that such actions might well already be illegal or, again given the incentives that the Bonds would generate, be made illegal once the Bonds have been issued.
Might issuing governments themselves try to avoid expenditure by failing to redeem the Bonds, either by reneging on their commitment, or by doing what they can to stop the goal being achieved? If governments issue Bonds they would be doing so as representatives of their citizens. They would therefore be under strong moral pressure to comply with their commitment to supply funds for Bond redemption, and not to take actions impeding progress toward the targeted goal. But it is also in governments’ own interest to fulfil their obligation. If they did not, they would be discrediting the entire Bond principle, which they might well want to deploy again, either domestically or as participants in efforts to solve global social or environmental problems.
Could ‘free
riders’ undermine the workings of the Environmental Policy Bond mechanism? If
purchasers of a significant number of the Bonds hold them with no intention of
doing anything to help reduce solve the targeted environmental problem that
would undermine the potential of a Bond regime.
There are,
though, grounds to believe that free riding would not be a serious problem,
mainly because it is unlikely much free riding would occur, and partly because
even if it did occur, it would not impede the operation of the Bonds mechanism.
Free-riding would be a self-cancelling activity: if most of the Bonds were held
by would-be free riders, then little would be done to help achieve the targeted
objective. As the objective becomes more remote, the value of the Bonds would
fall. And as the Bonds lose value, they would make a more attractive purchase
for people who would be prepared to reduce water pollution. So free-riders
would be tempted to sell, even at a loss, rather than see the value of their
Bonds continue to fall. Some history of falling Bond prices would tend to make
free riding on Environmental Policy Bonds less appealing with future issues.
There are other reasons why passive bondholding would be unattractive to
potential free riders:
· As with other financial instruments, small players would have to pay higher transaction costs than the bigger institutions – the ones that can initiate objective-achieving projects.
Note also that
even if free riders were to gain from holding Environmental Policy Bonds, they
would do be doing so only because their Bonds rise in value when the targeted
objective becomes closer to being achieved. Attempted free riding would have
positive effects: it would add liquidity to the Environmental Policy Bond
market.
Environmental
Policy Bonds would work by giving financial incentives for people to achieve
particular environmental goals. Realistically, however, they could also
encourage people to break the law to do so.
Examples of acts
that would be illegal, but that particular Bond issues might encourage, are:
·
emitting
pollutants that, while unspecified by Bonds targeting pollution, are still
controlled or banned; and
·
falsifying
pollution data.
Most such acts
are already illegal but before issuing Environmental Policy Bonds, governments
should be aware that there would be greater inducements to commit them.
The Bonds could
also induce people to modify behaviour in ways that, while not illegal, would
undermine what society is trying to achieve. So, for example, if Bonds aiming
to reduce the area of intensively farmed land were issued, bondholders might
lobby for changes in the definition of what constitutes an intensive farm. Or
they might finance projects that shift production from some intensive farms
onto others, thereby reducing the actual area intensively farmed, but
increasing the pollution generated on that reduced area.
In this case
judicious specification of the targeted objective would help: the Bonds could
define precisely what shall be deemed an intensive farm for the purpose of the
Bond issue. And they include a proviso making the Bonds redeemable on the
condition that the maximum pollution level from farming did not exceed a
specified level. In general, objectives
that are complementary, and that if not pursued jointly are likely to conflict,
should be targeted by a single Bond issue. (See box: “What to
target?”)
It is likely
though, that even carefully specified objectives would not always eliminate or
mitigate the kind of illegal, or negative-but-legal, activities that the Bonds
may stimulate. So how can this potential problem be solved? The solutions have
to do with the way in which the Bonds are introduced, and with the role of
government.
A cautious,
gradual, introduction of Environmental Policy Bonds is one means by which
adjustment problems can be minimised. If, despite such an approach, bondholders
behaved illegally, government could prosecute the perpetrators. If bondholders
behaved in negative, but legal ways, government has other options. In ascending
order of severity, government could:
·
persuade or
cajole bondholders into toeing the line. It could do this publicly or privately
- initially, at least, bondholdings couuld be registered in the same way as
shares;
·
buy back as
many of the Bonds as is necessary to eliminate the incentive to holders to take
any action;
·
legislate
against the unforeseen activity; or
·
declare the
Bonds null and void, and offer compensation related to the Bonds’ issue price,
or their current market price.
Targeted objectives should, in principle, be as broad as possible. It would probably be unsatisfactory to make nitrates, for example, the sole target of an Environmental Policy Bond issue if it were likely that farmers would respond by increasing the use of phosphates. Instead, both could be made the target of a single Bond issue. Environmental Policy Bonds lend themselves to targeting combinations of objectives. They could, for example, target indices encompassing a range of pollutants, weighted according to their contribution to environmental degradation.
In principle ends, rather
than means to ends, make better targets for Environmental Policy Bonds. Thus it
may be preferable to target not pollution, but such indicators of environmental
status as wildlife biodiversity, landscape features, perhaps in conjunction
with more subjective indicators like the views people have about the
quality of the rural environment, as measured by questionnaire responses. Bonds
could be issued whose redemption value is on a sliding scale, reflecting the
perceived adverse environmental impacts of the targeted range of pollutants.
Bonds aimed at improving national averages of such measures as water quality would be adequate sole policy instruments only if society is unconcerned about the distribution of pollution. Otherwise water pollution targets should be used in conjunction with existing sanctions against polluters. Or Bonds targeting pollution could be made redeemable only on the condition that minimum pollution thresholds shall not be breached anywhere in the country concerned.
Bond issues could provide bonus payments for achievement of the targeted goal by a specified date. Or issuers could stipulate that Bonds would not be redeemed unless the targeted objective were achieved by a certain date, or that they would be redeemed for a sum that diminishes over the time it takes for the objective to be achieved. The market would factor all such penalties or bonuses into the Bond price.
Another
possible problem arising from the integration of Environmental Policy Bonds
into the current policy-making system concerns the government's role as creator
of statutes. Government can pass laws affecting the Bond price, or its actions
could influence the Bond price in other ways. For instance: government could
come under great pressure to increase any taxes it imposes on nitrogen
fertiliser from holders of Bonds targeting nitrate levels. Note, though, that
the source of the pressure, and the motivation for it, would be easy to
identify. And lobbying is a legitimate activity. There is no reason why
bondholders, in common with other pressure groups, should not lobby
politicians. They would be doing so mainly out of financial self-interest of
course. But other pressure groups are also self-interested, and in the case of
bondholders their self-interest is, or should be, congruent with society's
interests. Bondholders will lobby for legislative change, and they will benefit
in obvious, financial ways. In assessing the Bonds’ value potential investors
will take into account the likely influence of bondholders on legislation, and
the potential influence of changes in legislation on the speed at which the
targeted objective is achieved.
These
influences make it important for there to be some element of consultation when
defining targeted objectives. People do become rich by using their influence on
politicians under the current system, but they are less identifiable, and they
do so in ways that are not always easy to identify. Politicians will always
have to weigh the evidence for and against any course of action promoted by
lobbyists, with due regard to the lobbyists’ motivation. In the end, though, it
is up to potential investors in Environmental Policy Bonds to take into account
likely or possible changes in the legislative environment when bidding for the
Bonds.
The
threat of bondholders lobbying governments for legislative changes can have a
positive aspect. For Bond issues to be as successful as possible, governments
would ideally give assurances as to their future behaviour. So, for example,
prospective purchasers of Bonds targeting water pollution would want to know,
for instance, the government’s fertiliser taxation (or subsidy), plans.
Government would maximise interest in the Bonds by being as open as possible
about its legislative and spending intentions as soon as possible. Government
could also undertake not to do such things as eliminate taxes on fertiliser.
Of
course, if the Bonds target only small changes in, say, pollution, the
government’s long-range plans will not be so significant to prospective
bondholders. It might emerge after trials of the Bond concept that targeting
incremental improvements in environmental indicators would be the best way of
dealing with any uncertainties over future government behaviour. Or it might be
that these uncertainties turn out to be relatively insignificant when compared
to the uncertainty involved in this, or any other, sort of investment. Markets
routinely deal with low levels of risk and uncertainty by attaching lower
values to riskier instruments.
Governments
issuing Environmental Policy Bonds would have to organise reliable and accurate
monitoring of the targeted problem so that progress towards the attainment of
the environmental objective could be impartially assessed. This monitoring must
also be seen to be independent of bondholders, who could benefit unfairly from
dubious data collection. Naturally the information as to how close the
objective is to being achieved would have value. It is not difficult, for
instance, to imagine the latest water pollution figures being sought in advance
of official publication and used for ‘insider trading’ purposes. If too much
insider trading went on, it would increase the riskiness of the Bonds to those
without access to this information and so tarnish their value as an investment.
How could it be minimised?
·
In many
cases data gathering and collation would have to be more transparent. There
would be a ready market for this information, which would help to make these
processes more robust. There would be more interest in more frequently updated
information, so that progress toward achieving objectives could be more readily
charted. If large sums of money were at stake, there would be a great deal of private
information gathering: investors, bondholders, and financial commentators will
be taking their own soundings during the lifetime of each Bond issue. All this
would serve to keep the official information assessors honest.
·
Those
involved in gathering, collating and processing information would be bound by
contractual terms deterring or forbidding them from abusing privileged
information.
·
Indicators
for targeted objectives could be chosen with a view to minimising the
possibility of insider trading being an important factor. Combinations of
indicators could shorten the length of the information chain. The same effect
could be achieved by a national government stipulating that Bonds targeting
such objectives as water or air pollution would be redeemed on the basis of
data from a random sample of sites, rather than all sites or any pre-arranged
subset of sites.
·
The
objectives themselves could be chosen to minimise the possibility of insider
trading. Bonds targeting long range objectives such as cutting nitrate
pollution by 50 per cent rather than 20 per cent, would probably be less
sensitive to insider trading. With long range objectives, each datum illegally
withheld from the Bond market would probably represent a smaller proportion of
the total relevant information available to the Bond market, and so have a
lesser effect on the Bond’s market value.
None
of these ways of mitigating insider trading would always be fully effective.
That said, there are already sensitive indicators, such as unemployment or
retail sales figures, that are capable of moving markets, and so there are
already in place mechanisms to control access of such information until it is
time for publication. There are also sanctions against those who obtain, and
act on, such information illegally. These mechanisms and sanctions might need
to be strengthened under a Bond regime, but it remains to be seen how important
abuse of insider information will be. While insider trading means that
unscrupulous people benefit at the expense of the public, it does not generally
impede the operation of markets. Markets continue to function and the
possibility that a low level of insider trading goes on is generally discounted
by the broader market.
Government
agencies could, as competitive suppliers of objective-achieving services,
participate as active investors in Environmental Policy Bonds, under certain
conditions. Unlike in industry the private sector would be unlikely to cry
‘unfair competition’, even if the operations of these agencies were heavily
subsidised, because its own Bonds would appreciate as a result of the
government, or government-inspired, activity. If government agencies were to
participate in the Environmental Policy Bond market, they should not have
privileged access to information. Also, it is important that any profits or
losses they make as a result should accrue to that agency. The people who work
for the agency must have the same incentives as the private sector bodies to
perform efficiently. This would change the character of these agencies, and
would probably lead to their ultimate divorce from the public sector.
Few
bodies charged with achieving environmental goals are currently paid in ways
that correlate directly with their performance. Nevertheless these bodies are
the main repositories of expertise for solving environmental problems, and some
of them are bound to be efficient, or to be capable of becoming efficient. It
would be unwise as well as unfair and unnecessary to divert their funding at
short notice into funds allocated to redeem Environmental Policy Bonds. The
answer, at least for those goals currently the responsibility of major
government-funded institutions, is a gradual transition to an outcome-based,
rather than institution- or activity- based funding programme. This would mean
that funds from government allocated on an institutional basis would gradually
decline, while funds allocated via Environmental Policy Bonds to the outcomes
that these (and new) institutions are collectively trying to achieve – a
cleaner, safer environment – would gradually rise.
One
method would be for government to reduce its funding of environment agencies
and research institutes by 1 per cent a year, in real terms. It could allocate
the saved funding to the future redemption of the Environmental Policy Bonds it
has issued. After five years, each body would be receiving directly from
central government only 95 per cent of what it formerly received. But holders
of Bonds targeting environmental outcomes may choose to supplement the income
of some of these environmental bodies. They might judge some of them to be
especially effective at converting the funds they receive into measurable
environmental benefits, as defined by their Bonds’ redemption terms. It could
be that the most effective environmental bodies, in terms of achievement per
unit outlay, are working in especially polluted areas, where small outlays
would probably bring about larger improvements in the environment. Or
bondholders might judge that a particular research body is worthy of additional
funding, because they judge its research most likely to yield pollution control
measures, say, that would be most efficient in terms of converting funding to
better environmental outcomes. In such cases, bondholders would supplement
government funding. It might well be that these favoured bodies end up
receiving considerably more than 100 per cent of their former income,
throughout the lifetime of a Bond regime.
It
could also happen that investors in Bonds targeting environmental outcomes look
at completely new ways of achieving these objectives; ways that currently
receive no, or very little, funding. To give a not entirely unbelievable
example, they might be convinced that one of the best ways of achieving
society’s long-term environmental objectives is to increase women’s access to family
planning information. Following
this logic, they might find that one of the most efficient ways of doing this
is to support non-governmental organisations, including registered charities,
that already have this objective. It is difficult to imagine how our current
activity- or institution- based government fund allocation mechanisms could
take this sort of approach.
Could
Bonds targeting remote objectives be compatible with a gradual transition of
the type described above, where funding to existing government-funded
institutions reduces by 1 per cent annually? At first sight there is an
apparent mismatch between small reductions in government spending, and the
large sums that would be needed to motivate potential investors in Bonds that
target remote objectives. The critical point here is that bondholders will be
investing not on the basis of the annual reductions in government expenditure
on existing environmental bodies, but on the basis of the redemption value of
all the Bonds issued. To be more precise, it will be this total redemption
value, minus the Bonds’ existing market value, that will drive bondholders’
investment decisions. This sum could be many times each year’s incremental
reduction in government’s institution-based spending. One of the virtues of an
Environmental Policy Bond regime is that even in the short term bondholders
would begin to invest in projects with a long range objective, on the
expectation of capital gains that might arise only in the distant future.
The
accumulated reductions in spending to existing institutions would be one, but
not the only, factor influencing how much government decides to spend on
achieving a specified environmental goal. Also important would be the financial
savings (if any) that achieving the objective would bring about, and the value
society places on any nonfinancial benefits.
It
might be possible to expand spending allocated via the Bonds at a faster rate
than the 1 per cent suggested: expertise in the environment is still mobile,
relative to that in other areas of government spending, which would make it
easier quickly to establish new outcome-based institutions or to reorientate
existing ones.
Note that, while
changes in the source of funds would be gradual, those involved in existing
institutions might well react by quickly reviewing how all their
existing programmes and projects operate. If bondholders see existing
programmes as being particularly effective in achieving targeted outcomes they
would be inclined to invest in them. On the one hand, the switch in funding
would tell existing institutions that they could expect to see their relatively
ineffective operations receive diminishing funds in the future. On the other
hand, their effective operations could look forward to higher—possibly much
higher—funding. Even a gradual transition, involving 1 per cent annual cuts in
funds allocated to existing institutions, that was balanced by Environmental
Policy Bonds could bring about a rapid change in the way existing bodies
conduct all their programmes. They might have to devote some of their resources
into persuading bondholders of the cost-effectiveness of their activities; but
this would not represent a radical difference from the way these bodies lobby
for government funding nowadays. Under a Bond regime, though, they would do their
lobbying on a more transparent, outcome-oriented, basis.
It has to be said that some of today’s policies would not long survive the scrutiny of an Environmental Policy Bond regime, with its emphasis on clarity and transparency of outcomes. In agriculture, in particular, it would be difficult to imagine a wide and enthusiastic consensus in favour of the existing array of policies and their unstated, obscure or mutually contradictory objectives. Clarifying agricultural policy objectives could be expected to reduce costs to the consumers and taxpayers who, often unwittingly, pay for the panoply of current policies.
Environmental Policy Bonds are unlikely to be the optimal
solution to all environmental problems. This chapter begins by the
circumstances under which they are likely to be most beneficial in comparison
to other policy instruments. It then looks at one example of a global problem
perhaps ideally amenable to a Bond-based solution: climate change. The chapter
concludes with a brief discussion of the Bond concept, in the context of the
current policy environment.
We should expect a Bond regime to show the most marked improvement over current approaches when:
For some environmental problems these concerns would not apply. The third concern, indeed, would imply that the Bonds would not be especially helpful in achieving local goals, and would be better deployed to solve large-scale problems, perhaps of regional, national or even global dimensions. Many agri-environmental problems are local in nature. Even then, there might be some scope to apply the Bond concept, for example, to clean up a lake fed by rivers polluted by many different farms. However, the most significant advantages of a Bond regime are likely to arise when dealing with larger scale problems. One such is climate change.
Climate change
is an example of a process that might arise from many sources, natural and
man-made. It is going to require a full range of policy approaches and it
involves many scientific uncertainties. Globally backed Environmental Policy
Bonds rewarding climate stability may well have significant advantages over the
current suggested solution.
The evidence that the global climate is changing is large and growing. That said, scientists are divided as to (a) how fast climate is changing, (b) the effects of climate change (c) how much man can do about it, and (d) how much man should do about it. And there are still respectable scientists who argue that the climate is not changing at all in any meaningful way. Despite these uncertainties, climate change has the potential to inflict serious harm on many people, so there is a strong argument for doing what we can to minimise its adverse effects.
The December 1997 Kyoto Protocol (‘Kyoto’) saw 159 nations
reach the world's first legally binding commitments
to reduce the global output of carbon dioxide and five other gases thought to
contribute to the ‘greenhouse’ effect. Thirty-eight industrialised countries
agreed to reduce emissions by 2012 to an average of 5.2 per cent below their
1990 levels, and in July 2001 180 countries reached a broad political agreement
on the operational rules that will govern the Protocol.
The Kyoto targets are far lower than those that some environmentalists had hoped for, and that some countries, most notably the European Union, had been advocating. Kyoto will only slow, but not stop, the build-up of carbon dioxide and other greenhouse gases in the atmosphere. (Carbon dioxide, which is given off by fossil fuel combustion, is thought to be by far the most important of the man-made greenhouse gases that form an insulating blanket around Earth.) But subsequent evaluations by leading scientists indicate that the environmental effects may be so small as to be almost unnoticeable in the near term.
Kyoto embodies the assumption that controlling the targeted greenhouse gases is the best way of achieving climate stability. But with climate change, the biological and physical relationships involved are many and complex. Even specialists disagree about the degree to which the multitude of biological and physical variables influences climate change. Apart from the daunting uncertainties about the role of greenhouse gases in climate change, there is even less understanding of the role that agriculture and forestry can play as sinks for these gases.
Environmental Policy Bonds targeting climate stability would bypass these, and other, uncertainties, and encourage research into clarifying the relevant scientific relationships. Such Climate Stability Bonds (CSBs) would be issued by governments on the open market and would become redeemable for a fixed sum only when the climate had achieved an agreed and sustained level of stability. In this way there is no need for the targeting mechanism to make assumptions as to how to stabilise the world climate: that would be left to Bondholders.
Ideally, CSBs
would be internationally backed. They could be issued by a world body, perhaps
one supervised by the United Nations or World Bank. This body would undertake
to redeem the Bonds using funds that could perhaps be obtained from all
countries, in proportion to their Gross National Product. It would be up to
individual countries to decide how to raise funds, presumably from taxation
revenue. Importantly though, no Bonds would be redeemed until the objective of
a more stable climate has been achieved and sustained. Climate Stability Bonds
would be issued by open tender, as at an auction; those who bid the highest
price for the limited number of Bonds would be successful in buying them. A
fixed number of Bonds would be issued, redeemable for, say, $10, only when
climate stability, as certified by objective measurements made by independent
scientific bodies, has been achieved and sustained. Once issued, the Bonds will
be freely tradable on the free market.
People will
differ in their valuation of the Bonds, and their views will change as events
occur that make achievement of a stable climate a more or less remote prospect.
They would also change as new information about climate, and about the causes
of climate change, is discovered.
There are
obvious difficulties involved in defining what a stable climate actually is, but the same difficulties apply when
attempting to monitor the success or otherwise of Kyoto. Presumably
scientists will measure the effects of the cuts by monitoring such objectively
verifiable indicators as temperature, change in temperature, rate of change of
temperature, precipitation, and many others, at a wide range of locations.
Under a CSB regime, the Bonds would be redeemed only when climate stability, as defined by such a similar set of indicators, had been achieved. A Bond regime might also explicitly target less scientific measures, such as the frequency and severity of adverse climatic events, the numbers of people killed or made homeless by such events, or the insurance payouts to which they give rise.
A CSB regime would not dictate how to achieve a stable climate. Bondholders could undertake a wide range of projects including:
· helping countries or companies to set up and run greenhouse gas emission control programmes;
· helping countries or companies to set up carbon sequestration plantations;
· financing the production or consumption of energy that involves lower greenhouse gas emissions; or
· carrying out, or supporting, research into increasing the reflectiveness of the Earth or its atmosphere.
Bondholders can
also be expected to finance other research and initiatives, all aimed at stabilising
climate as cost-effectively as possible.
Some governments, research institutes and others are already carrying out these, or similar, activities. But under a Climate Stability Bond regime, the Bondholders will have the incentive to seek out those ways of achieving a stable climate that would give them the best return on what is, in effect, the taxpayers’ outlay. Only when the targeted degree of climate stability is achieved would governments have to pay for it by redeeming the Bonds. Until then, it is bondholders who have to finance the initiatives that they think will achieve climate stability. The body that issues the Bonds will, in effect, contract out the achievement of climate stability to the private sector – having defined the degree of stability it wants and undertaken to pay Bondholders when it has been achieved.
Climate
Stability Bonds have two critical advantages over Kyoto. One is that the Bonds
do not rely on the robustness of our existing scientific knowledge even as to
whether the climate is changing in the way that many scientists believe it is,
let alone as to how best to stabilise it. Kyoto aims to reduce emissions of a
small range of gases. But there may be other causes of climate change that are
far more important, of which we are currently unaware. And these need not be
man-made: natural variability of climate has had severe impacts on human life
in the past. Kyoto, responding to effects whose causes are uncertain, embodies
a limited number of fixed ideas about the nature of the relationships involved.
A CSB regime, targeting climate change directly, might well lead to cuts in
greenhouse gas emissions, but it would not assume that doing so is the best
solution. CSBs improve on Kyoto, because they encourage behaviour leading to
the desired outcome, rather than seeking to control activities whose effects on
the climate stability are not fully known.
The other major
advantage of a CSB regime is that Bondholders tackle whichever causes of climate
change give them the best return for their outlay, whether they are natural or
man-made. The more efficient Bondholders are in achieving climate stability the
more they will gain from appreciation of the value of their Bonds. This
efficiency maximises the degree of climate stability that can be achieved per
dollar outlay. Because of the colossal sums involved, the benefits that CSBs
offer in comparison activity-based regimes, such as Kyoto, are likely to be
huge.
Further
advantages of a CSB regime are:
·
The
informational advantages that apply when there are large numbers of polluters.
Greenhouse gases are emitted from many sources. About half of carbon dioxide
emissions, for instance, come from dispersed sources, such as cars and home
heating systems, and about 8.4 per cent of greenhouse gases (in the OECD) are
emitted by the agriculture sector (OECD 2001, ).
·
That
governments pay up only when a stable climate has been achieved: any risk of
failure or of undershooting the climate stability target is borne by
Bondholders, rather than taxpayers.
·
That funds
for climate stability need not be used for scientifically approved projects.
They could, for instance, be used to bribe corrupt or malicious governments.
Appealing to these governments’ financial self-interest could be the most
effective way of modifying their behaviour in favour of achieving climate
stability.
·
That
formulating the redemption terms for CSBs would entail clarifying of what is
actually wanted. In global terms, climate change—as distinct from climate
variability—could actually be a good thing. It could lead to longer growing
seasons and higher yields in some regions. Others point to the boost to crop
productivity given by higher levels of atmospheric carbon dioxide. ‘Climate
Stability’ as targeted by Climate Stability Bonds could be defined such that
Bondholders tackle only the negative effects of climate change.
Achieving a stable climate will probably require a huge range of different projects. Reducing greenhouse gas emissions or sequestering carbon might be helpful, but they are not necessarily going to be the most cost-effective. Other ways yet to be discovered could be far cheaper. Kyoto is deficient in that it offers no incentives to find out how to achieve a stable climate most cost-effectively. CSBs would encourage the most efficient solutions given the knowledge available at any time, and they would stimulate research into finding ever more cost-effective solutions. This occurs because of the nature of the Bond mechanism, and requires no presupposition as to the optimal set of solutions. The Bond issuers would dictate only the objective—climate stability—not the ways of achieving it. Crucially too, the objective would be one with which all shades of public opinion can support. Without such support no coherent policy addressing climate change is likely to succeed.
Environmental
Policy Bonds are one application of the principle of Social Policy Bonds,
devised to inject market incentives into the solution of social problems, such
as crime, unemployment, illiteracy and poor health standards (see
bibliography). The Bond principle might though be especially suited to the
environment, whose complexity means that it is difficult to identify and
specify the full range of non-natural processes that generate positive or
negative externalities, the degree to which they do so, and the relationships
between these processes, natural processes and desired outcomes. This applies
especially to larger-scale problems, including perhaps some agri-environmental
problems.
Targeting
outcomes rather than activities encourages diverse and untried solutions and
bypasses scientific uncertainties. As well, existing policy instruments do not
allocate resources rationally between controlling sources of environmental
problems, and rewarding measures that solve them. And Environmental Policy
Bonds need not be deployed in isolation: they can be used in conjunction with
existing policies. Under a Bond regime it will still be desirable to apply
existing regulatory sanctions against polluters, as well as the Polluter Pays
Principle. A Bond regime would not take away the initiative for solving
environmental problems from those with the expertise to solve them. The Bonds
would simply provide a way in which that expertise could be effectively
mobilised to achieve targeted outcomes. Environmental Policy Bonds can be used
to reinforce, rather than substitute for, existing environmental policy
instruments, by injecting incentives to make sure those instruments are used
optimally. For all these reasons Environmental Policy Bonds may have advantages
over conventional policy instruments.
Despite all
these theoretical advantages, however, and the fact that it has been in the
public arena for some years, governments have not yet applied the Bond concept
either in agriculture or, indeed, in any other sector. However there are, at
the time of writing, people outside government proposing to issue
privately-backed Bonds for projects as diverse as boosting voter registration,
raising literacy in developing countries, and developing open-source software.
Governments appear to be more wary. Perhaps this is because under a Bond
regime, they would surrender (within limits) their power to dictate how objectives shall be achieved, and
which institutions shall be charged with achieving them. Government, along with
those who administer current policies, might be reluctant to lose this power,
even though they would continue to set and rank objectives. And elements of
government, along with beneficiaries of some current policies would be likely
to oppose a shift toward more transparent policymaking.
In any case, as
an entirely new policy instrument, the Bonds will need to be introduced
cautiously. Initial goals should be relatively small scale and uncontroversial,
and the Bonds should complement, rather than replace, existing government or
local authority programmes. Local authorities could begin by issuing
Environmental Policy Bonds that target the water quality in particular rivers,
for instance; indicators of success could be the number and variety of fish
present. Such contained, easily identifiable, goals could help the Bonds gain
acceptability amongst the public, and encourage policymakers to discuss and
refine the concept. National governments could collate local experiences, and
apply any lessons learned before issuing Environmental Policy Bonds addressing
national concerns. Some deliberation would be essential, especially when Bonds
target particular indicators for the first time. Then they are especially
likely to encourage unanticipated negative behaviour by bondholders. Lessons
learned from such initial issues could be applied to later issues targeting the
same objective.
Trials of the
Bond concept would be necessary to answer such basic questions as:
As well, there
are technical aspects that need investigating; for example, which indicators
can most reliably be used to measure society’s water or air pollution
objectives?
The introduction
of an Environmental Policy Bond regime might be accompanied by operational
challenges and problems, not all of which can be anticipated. But these
potential problems should not be overstated: existing laws, careful choice and
specification of targeted objectives and perhaps more assurances as to how
government will behave would probably circumvent or remedy most of them.
And the question
of how well Environmental Policy Bonds would achieve society's environmental
goals needs to be considered alongside existing policy-making methods.
Currently policymakers, officials or lobbyists can escape or deflect censure
because the adverse results of their policies are difficult to relate to their
cause. If Environmental Policy Bonds were to lead to negative effects, the
relationship between these effects and their cause would be easier to identify,
and deterring such effects would be simpler, than doing so under current
activity- or institution- based funding arrangements.
Resources are always going to be limited and Environmental Policy Bonds will not change that fact. Priorities and choices will always have to be made: under the Bond principle, governments will still decide on which environmental problems to solve, and on the sums allocated to their solution. In economic theory, and on all the evidence, markets are the best way of allocating scarce resources to achieve prescribed ends. Environmental Policy Bonds would allow both democratic governments and markets to do what each is best at doing: respectively: prescribing ends, and allocating resources to meet these ends as efficiently as possible.
Efficiency, of
course, is not the only attribute of a successful policy instrument.
Environmental Policy Bonds make transparent not only the goals of environmental
policy, but also its returns, measured as environmental benefit per taxpayer
dollar. They would also clarify the inevitable trade-offs that society will
have to make between different environmental goals. In today’s complex
economies, many people feel alienated from decision making, which to outsiders
can appear remote and specialised. Such alienation can express itself in many
forms, including apathy, cynicism and even violence. Too often government
intervention in environmental matters is seen as bureaucratic, intrusive, and
unrelated to relevant outcomes. With their focus on identifiable goals,
Environmental Policy Bonds may, in a small way, help to bridge this gap, and
encourage public interest and participation in policy formation. That could
well prove to be as valuable to society as any efficiency gains.
--
Hayek, F A, ‘The Pretence of Knowledge’, New Studies in Philosophy, Politics, Economics and the History of Ideas, University of Chicago Press, Chicago, 1978.
OECD (2001) Environmental indicators for Agriculture, Volume 3: Methods and Results, OECD Paris, France.
Schick, Allen The spirit of reform: managing the New Zealand state sector in a time of change, State Services Commission, Wellington, 1996.
Tangermann, S (1990) “A Bond Scheme for Supporting Farm Incomes.” In The Changing Role of the CAP, Marsh, J, Green, B, Kearney, B, Mahé, L, Tangermann, S, and Tarditi, S, Belhaven Press, London, UK.
Investing for the future (September–October 1991), Ronnie Horesh, UK CEED Bulletin No 35, Centre for Economic and Environmental Development, Cambridge, UK. (Presented as Room Document 3 to the December 1994 meeting of the OECD Joint Working Party of the Committee for Agriculture and the Environment Policy Committee.)
Social Policy Bonds: Injecting market incentives into the solution of social problems (August 1992), Ronnie Horesh, AEU Occasional Papers, University of Cambridge, Cambridge, UK.
Injecting incentives into the solution of social problems: Social Policy Bonds (September 2000), Ronnie Horesh, Economic Affairs, 20 (3), Institute of Economic Affairs, London, UK.
Better than Kyoto: how Climate Stability Bonds can inject market incentives into the achievement of a stable climate, (December 2001), Ronnie Horesh, Writers Club Press, USA. ISBN: 0-595-21164-X
Better than Kyoto: Climate Stability Bonds (September 2002), Ronnie Horesh, Economic Affairs, 22 (3), Institute of Economic Affairs, London, UK.
Injecting Incentives Into the Achievement of Social and Environmental Outcomes: Social Policy Bonds, (September 2002), Ronnie Horesh, ISBN: 0-595-24823-3, Writers Club Press, USA, September 2002.
© Ronnie Horesh July 2002
[*] Nor have Environmental Policy Bonds anything to do with the bond idea associated with Professor S Tangermann, which involves one-off payments to farmers in compensation for reduced agricultural support payments. See Tangermann et al (1990).