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The pros and cons of ethical debt instruments

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A man stands in front of a damaged house and a large fallen tree in the aftermath of Hurricane Irma in Dominican Republic.Ethical financing tools include "state-contingent" debt instruments that allow servicing payments to fall when times are bad, for example, when a natural disaster strikes. Photo: UNDP in Latin America and the Caribbean

In May, the World Bank issued the world’s first bond linked explicitly to the UN Sustainable Development Goals. Labelling them “SDG bonds”, the bank raised 163 million euros from institutional investors in France and Italy with the proceeds to be channelled into projects that aim to eliminate extreme poverty, in line with Goal 1 of the SDGs.

The initiative — which aims to capitalize on a rising number of investors interested in positive social and environmental impacts, in addition to financial returns — has been heralded an innovation in investment products and can be added to a growing list of innovative debt instruments that are marketed as “ethical” or socially and environmentally responsible.

Other examples include: green bonds, a multibillion dollar market in which the proceeds of a bond issue are tied to environmentally friendly investments such as renewable energy and clean transportation; blue bonds, a newer debt instrument championed by the Seychelles to fund investments in sustainable ocean industries; vaccine bonds, where funds are raised from international capital markets for immunization programs in developing countries with bondholders repaid by future streams of donor development aid; and social and development impact bonds, where impact investors provide upfront financing for social or development interventions and are repaid by governments and/or donors when specified results are achieved). Islamic bonds (or sukuk) are also sometimes marketed as more ethical than conventional bonds in that investment risks and rewards are shared between the parties, and certain investments are forbidden. GDP-linked bonds and state-contingent debt instruments can also be added since they allow debt service to fall when times are bad, for example, when a natural disaster strikes.

With the rise in debt instruments with an ethical slant, and as more countries, cities and municipalities seek to tap debt markets to raise funds for sustainable development, what are the pros and cons of such innovative debt instruments?

Proponents argue that ethical securities have the potential to shift substantial amounts of capital toward investments that address climate change and other sustainable development priorities.

Green bonds, for example, have helped sovereigns, cities and municipalities around the world raise much-needed finance at scale for investments in low-carbon transport (the most popular use of bond proceeds) and clean energy. 2016 marked the biggest year yet for growth in the green bond market, with more than $93 billion issued last year alone; Moody’s estimates that issuance may exceed $200 billion in 2017 with further expansion expected. While developed countries have been the largest sovereign issuers, more middle-income economies are joining the market, such as Colombia, Costa Rica, Mexico and the Philippines. Morocco and Nigeria are also planning green sovereign bonds.

Guarantees and other credit enhancement mechanisms from bilateral and multilateral financial institutions are also helping open up debt capital markets for countries that may not otherwise be able to issue innovative debt instruments on their own, thereby allowing for further expansion. For example, the Seychelles will aim to raise $15 million from its first blue bond in 2017 with financial support provided by the World Bank and Global Environment Facility. This is particularly important for emerging economies, where significant investment in sustainability is needed but little financing has been made available.

This finance can sometimes be obtained at lower cost, with some investors prepared to offer an interest discount where there is a commitment to use funds for a good cause. For many countries, especially middle-income nations, it has made sense to capitalize on globally low interest rates, which has further fuelled market expansion.

Ethical securities can also boost the image and reputation of issuers and investors, and can allow an issuer to diversify its funding profile by attracting new types of investors.

There are risks and challenges, however. First, and arguably most important, market participants decide for themselves what constitutes an ethical or green investment. Guidelines exist for the green bond market, but the sector still relies on voluntary reporting. In this context, is it little more than a PR exercise? As the market expands, transparency will emerge as an increasingly important issue.

Second, there are often heavy transaction costs associated with innovative debt instruments. Issuers must track, monitor and report on use of proceeds, for example. With social and development impact bonds, a complex set of verifiable performance indicators must be developed to indicate whether specific results have been achieved and when repayments to investors can be triggered. While there is much interest in blue bonds to finance the transition to sustainable ocean— especially among small island developing states — progress has been slow, in part because countries need to source technical expertise — which increases costs — and obtain co-financing/credit guarantees in some cases.

Third, while green bonds have successfully raised finance at scale, most other innovative debt instruments have been relatively small, such as vaccine bonds and social impact bonds. Some show potential, but have attracted little political interest. For example, many lenders seem reluctant to expand innovations such as hurricane or catastrophe clauses in loan contracts, partly because they lessen predictability. Grenada recently negotiated a hurricane clause with some of its creditors, but their use is not widespread.

Finally, borrowing always entails some risk and issuers must have the capacity to generate sufficient cash flow to repay capital and interest over time.

Innovative debt instruments help to harness the powerful role of capital markets and can connect more savings with international development priorities such as the SDGs. As investor interest continues to soar, they could help move the world from billions to trillions of dollars in financing for the SDGs. Yet it is also clear that some countries are better positioned than others to take advantage of these opportunities. For low-income countries in particular, development aid will continue to play a critical role in supporting development efforts, and must be increased.

This article was first published by Devex.

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