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The Environmental Bonds Mechanism Report

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Updated: Jul 9th, 2020

Introduction

Bonding has been deemed an effective financial assurance mechanism in promoting environmental conservation. It helps reduce the devastating effects of economic activities by fostering long-term risk management of potentially destructive goings-on that can have adverse effects on nature. Environmental bonds (EB) seek to deter potentially damaging practices, particularly industrial activities, by imposing costs that the pollutant companies incur through the purchase of assurances. This paper provides an insight into the utilization of environmental bonds as a mechanism for addressing environmental issue risks.

Environmental Challenges addressed by Environmental Bonds

Different industrial activities have damaging impacts on the environment. Some of the adverse effects have been empirically shown to have large-scale and long-term global effects. Environmental bonds serve as a proactive tool utilized to regulate the activities of pollutants with a view of reducing or eliminating the adverse effects they have on the environment (Gerard & Wilson 2009). Polluters are required to demonstrate commitment to the placement of funds as a surety that their actions will not cause damage to the environmental ecosystems. This financial responsibility or bonding requirements restricts polluters to sustainable economic activities (Hagendorff et al. 2014). The funds serve as a compensation scheme towards any damages that can arise shortly. The environmental bonds focus on the activities that pose large-scale threats to the global ecosystem. Both scientific and regulatory interests of the financial assurance mechanisms seek to ensure that the creators of industrial pollutants take full responsibility for their actions by monitoring dangerous emissions. The dominating problems addressed by the EB include greenhouse gas emissions such as carbon dioxide, oil spills, solid landfills, hard rock mining, and nuclear emissions (Gerard & Wilson 2009).

Examples of Environmental Bonds

Assurance Bonds

One of the most actively utilized approaches to reducing adverse environmental impacts is the assurance bonds. This form of bond applies to cases where environmental risks can be completely eluded. They are also essential where the restoration of the environment to its original condition following a destructive economic activity is possible (Costanza & Perrings 1990). A notable example of an assurance bond is the rehabilitation financial mechanisms utilized by most contractors in the United States. The surety bond ensures that the existing contract progresses even after the servicer breaches the agreement. In the US, such bonds are offered under the Small Business Administration (SBA) initiative that aims at promoting small and/or emerging firms (Hagendorff et al. 2014). Before the commencement of work, the DPI requires the operators to provide the rehabilitation bonds. In that case, the department undertakes the reinstatement tasks if the operators fail to meet the agreed obligations ((DPI 2010). For instance, operators conducting a resource activity are required to pay financial assurance to cover the risks that can occur to prevent or minimize the harm by rehabilitating the original state of the environment after the completion of the activity. It is worth noting that the full amount of the assurance bonds is refundable by the DPI given that the operator meets the stipulated rehabilitation requirements (DPI 2010).

Insurance Bonds

This approach, sometimes called the CAT Bonds, encompasses a risk-sharing strategy with the insurance firm (Hagendorff et al. 2014). The operator pays a premium to the assurance firm that in turn reinsures it at a Special Purpose Insurance (SPI) company. The SPI firm in turn issues publicly traded CAT bonds that, just like the assurance bonds, are refundable to the operator only if the harm does not occur before the maturity date of the bonds. CAT Bonds are appropriate for spreading the investor’s risks (Hagendorff et al. 2014). According to Coval, Jurek, and Stafford (2009), public trading attracts higher than the average returns. Furthermore, with the CAT bonds direct access to the capital markets, costs can go far beyond the financial capacity of both the operating and insurer firms. For this reason, CAT bond systems have been on a rigorously growing trend since 2005 (Hagendorff et al. 2014). They have been applied in covering pollution that is triggered by natural disasters such as landslides, tornadoes, and earthquakes.

Incentive Bonds

Environmental Incentive Bonds (EIB) offer monetary-related incentives to operators for causing a lesser amount of environmental pollution (US Environmental Protection Agency 2001). The approach is meant to motivate the polluters to reduce the harmful activities that affect the environment adversely. The operators who cause more pollution are obliged to pay more. The costs imposed on the polluters include those involved in the tradable permits and pollution charges. Incentive-based instruments can also be easily applied to control household polluters that are less controlled in most cases (US Environmental Protection Agency 2001). The incentive bonds are more effective as compared to the traditional environment regulations. This approach is mostly utilized in developing countries that are deemed more effective.

Substitute Market-Oriented Mechanisms

Various substitute market-oriented initiatives seek to alleviate risks that investors pose to the environment. Hacket (2011) reveals that the most common mechanisms based on the market are the Property Rights Systems (PRS) and Allowance-Trading System among others.

Marketable Tradable Allowance System (MTAS)

The Marketable Tradable Allowance System (MTAS) is a suitable alternative approach to the financial assurance mechanisms that can deal with the menace of polluters. They are a form of MBIs that are aimed at reducing the overall level of emissions (Hackett 2001). Policymakers aim at maximizing the growth of the economy by managing the environment to reduce costs. The MTAS help in evaluating the accrued level of harmful releases to the environment (Jaffe, Ranson, & Stavins 2009). A good example is the Acid Rain Programme (ARP) that has established systems to monitor the amount of pollutants released with a view of imposing equivalent penalties to companies that surpass the minimum thresholds of harmful emissions. The MTAS provides the operators with incentives to install environmentally friendly technologies that can help minimize the emission levels (US Environmental Protection Agency 2009). Nevertheless, the MTAS has one important limitation. Steven Hackett (2001) reveals that whilst the allowance program seeks to reduce the quantity of emissions in its endeavors to reduce the overall compliance costs, it fails to offer the best type of technologies that operators can use to achieve the desired results.

Subsidies, Loans, and Grants

The MTAS plays an active role in the mitigation of environmental risks through offering subsidies, loans, and grants to the operators of green investments. This role of the government can be extended to motivate the operators to invest in environmentally friendly technologies. Additionally, it can promote voluntary compliance with the regulations (Hackett 2001). For instance, the US government funds of up to fifteen million dollars at affordable interest rates to investors in an attempt to encourage property owners to initiate clean-up operations in pollution sites. It can also offer grants to meet the clean-up costs of the operators. The US government covers approximately 75% of the aggregate clean-up costs (US Environmental Protection Agency 2001).

Benefits and Shortcomings of the Environmental Bonds

Benefits of the Environmental Bonds

The EB has notable benefits over other approaches. Given that the firms cannot cause any environmental damage, the EB has been deemed more appropriate than other approaches such as tax collection and quantity restriction.

Increased Efficiency

The EB strategy augments the efficiency of the organization’s operations. According to Shogren, Herriges, and Govindasamy (1992), perfect and close monitoring of the environmental bonds can result in desirable results regarding pollution of the environment. Given the monetary value of the bonds that the firms incur when their activities result in pollution, they will undoubtedly put the necessary efforts to evade such costs. The ultimate effect of such efforts is observable in a cleaner environment. In most cases, the assurance bonds are forfeited if the firm faults by causing pollution (Shogren, Herriges, & Govindasamy 1992).

Promoting Research Incentives

The environmental bonds initiatives offer research incentives in a bid to determine the value of the environmental damages that their activities cause. This notion not only shifts the burden of the valued proof of the environmental damage from the public to the firm but also acts as an incentive for the firm to indulge in deeper research and development. The firm looks for alternative technology that can elude the pollution of the environment in an attempt to evade the costs associated with the environmental bonds. Besides, the EB is a tool that motivates the firms to research the value of environmental degradation. The value registration obtained through the R&D can serve as a framework for evaluating aggregate effects on the environment to forecast suitable alleviation methods shortly. Indeed, Gerard and Wilson (2009) reveal that the EB is an effective tool that intensifies the responsibilities, awareness, and innovation of the involved organizations.

Disadvantages of Environmental Bonds

Despite the aforementioned benefits, the EB is associated with some disadvantages. According to Gerard and Wilson (2009), the main drawbacks of the EB include liquidity constraints and moral hazards.

Liquidity Constraints

According to Gerard and Wilson (2009), a liquidity constraint is a major limitation of the EB. Firms do not always have enough capital to post bonds that sometimes attract exorbitant costs. Given the escalating value of the environmental bonds in the past decade, most firms are faced with financial challenges that can constrain their assets. This situation is likely to force the firms unable to post bonds to drop the intended projects despite their beneficial potentials. This notion can hinder investment; hence, it can lead to the closure of the firm. Also, the concern for liquidity constraints can restrict new entry into a market due to the high costs of the environmental bonds (Shogren, Herriges, & Govindasamy 1992).

Moral Hazard Issue

The chief seller of bonds in every country is the government that is also the regulatory agency for the environment. While bonds can act as incentives for firms to participate in more research and development, they can also deter firms from investing. This case applies to multinationals (MNCs) that seek to invest in foreign countries. The regulator of bonds can sometimes tend to pursue self-interests such as taking away partial or complete part of the pledges even when the firms have not damaged the environment. This deviation of the government agency from the social welfare can scare away potential foreign direct investments (FDIs) as they fear losing a part or all the bonds posted.

Conclusion

The Environmental Bonds (EB) is a mechanism utilized by government agencies to help mitigate the risks posed by polluters. The paper demonstrates how the environmental bonds can be applied in creating environmental awareness by making the creators of pollutants take responsibility in the form of costs. In the light of this knowledge, various types of EB including assurance, insurance, and incentive bonds have been used to mitigate environmental pollution. The financial mechanisms can achieve notable results in environmental awareness and sustainable economic activities. However, they can cause undesirable effects in situations where they hinder investment through liquidity constraints and hazard issues to the firms and countries involved.

References

Costanza, R & Perrings, C 1990, ‘A Flexible Assurance Bonding System for Improved Environmental Management’, Ecological Economics, vol. 2 no. 1, pp. 57-75.

Coval, J, Jurek, J & Stafford, E 2009, ‘Economic Catastrophe Bonds’, American Economic Review, vol. 99 no. 1, pp. 628-666.

DPI 2010, Establishment and Management of Rehabilitation Bonds, Web.

Gerard, D & Wilson, E 2009, ‘Environmental Bonds And The Challenge Of Long-Term Carbon Sequestration’, J Environ Manage, vol. 90 no. 2, 1097-105.

Hackett, S 2001, Environmental and Natural Resources Economics: Theory, Policy and the Sustainable Society, M.E. Sharpe, New York, NY.

Hagendorff, B, Hagendorff, J, Keasey, K & Gonzalez, A 2014, ‘The risk implications of insurance securitization: The case of catastrophe bonds’, Journal of Corporate Finance, vol. 25 no. 1, pp. 387-402.

US Environmental Protection Agency 2001, The US Experience With Economic Incentives For Protecting The Environment, US EPA, Web.

US Environmental Protection Agency 2009, , Web.

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