January 06, 2021

The Impact of Municipal Green Bonds on Mitigating the Impact of Climate Change

Carlos J. Micames

I. Introduction

If you’ve been paying attention to the news for nearly the past two decades, then it is likely that you would have heard about climate change, or global warming as it was originally known. Many countries, including the United States, have struggled to balance the environmental benefits of regulation with the negative externalities to the national economy, such as reduced productivity or overall investment.

While the federal government has taken steps to reduce environmental regulations, local regulation has been more efficient, with states and cities taking essential action to curb their emissions and incentivize development of renewable energy sources. Florida has invested in raising roads and installing flood pumps, California has imposed stricter emission requirements on vehicles, and New York City has invested billions to install solar panels on the rooftops of one million buildings. However, these efforts are costly and local governments require revenue to fund these ambitious projects. While congressional funding is generally a primary revenue source, states like Florida have been required to rely on their residents while others seek outside funding from environmental organizations. Given the time constraints of conducting economic analysis on environmental regulations and the natural political uncertainty characterizing federal regulators, solutions for climate change will likely arise from a bottom-up approach where states develop their own environmental protection projects through creative financing methods independent of the federal government. The application of green bonds in Europe demonstrates the efficiency of this financial instrument in raising capital for environmental purposes, and local governments should move quickly to implement this strategy.

Background

Bonds are debt instruments that are used in the public and private sector to raise capital to fund projects. The bondholder, or lender, purchases the bond from the bond issuer in exchange for a promise of repayment of principal plus interest on the loan. Cities generally issue municipal bonds (munis) to fund schools, highways, or other projects they are seeking to implement. Green bonds are bonds that are issued primarily for environmental, or “green” purposes.

In 2007, the European Investment Bank (EIB) established the market for green bonds by issuing a “Climate Awareness Bond” and has issued €23.5 billion ($24.98 billion) as of 2018. The World Bank then issued green bonds in November 2008 for the purpose of funding environmentally friendly projects. U.S. states and municipalities have also issued green bonds since the first municipal green bond (green munis) in 2013 and credit demand has only grown since. Further, the rise of ESG (Environmental, Social, and Governance) investing has also required money managers to seek environmentally friendly investments to attract a new generation of investors.

II. Government Policy for Green Bond Issuance

While green bonds are an alternative method for municipal governments to raise capital, it must also be structured within the existing capital raising framework for municipalities. Munis are unique in the credit market given that bondholders are exempt from paying federal taxes on the interest payments and most are exempt from paying state or local taxes. To account for the disparity, munis typically provide a lower interest rate than corporate bonds, which are not tax exempt. Currently, there are different tax incentives for green bond investors, ranging from tax credits to cash rebates to traditional tax exemption. Additionally, the interest rate on a bond is tied to the degree of risk the investment holds.

Bond investors will generally analyze these factors to determine whether the muni green bond is conducive to their risk-return expectations. As such, municipal issuers should conduct a third-party verified risk assessment of the project they are seeking to finance to provide the investor with an informed analysis of the degree of risk their investment holds. Such a risk assessment should include factors such as the issuer’s financial solvency, the underlying project risks, the environmental impact, and other factors a reasonable investor might consider prior to investing. For example, a risk assessment is likely to demonstrate that a New York City green muni carries less risk than a Miami green muni given the greater risk of flooding in Miami, therefore the Miami muni would likely carry a higher interest rate. Given the uncertain nature of the criteria rating agencies use to evaluate municipal bonds, investors are speculative on whether muni bond ratings correctly reflect the inherent risk of the security.

Additionally, local governments should take steps to incentivize green bond issuance in the form of taxes, or greater returns. By treating green bonds like munis, they are exempt from federal and state income taxes. However, municipalities can increase the attractivity of these securities by also exempting them from property/municipal taxes, thus creating a triple tax-exempt bond. This is likely to substantially impact demand in high-tax areas while also attracting wealthy investors. I’m sure Nebraska would love to see Mr. Buffett investing a fraction of Berkshire Hathaway’s $128 billion in cash to Nebraskan green bonds. Municipalities can also increase the spread, or the difference in interest rates, between green munis and traditional vanilla munis, to make green munis more financially attractive to investors. This strategy will likely incentivize sophisticated investors speculative of the risks associated with investing in environmentally specific projects by appealing to their financial propensities. More green bondholders equals a more liquid green bond market, which in turn attracts investors seeking safe, liquid markets.

Despite all the advantages green bonds provide, local governments must maintain an efficient regulatory environment to ensure that the capital is being allocated correctly to environmentally friendly projects. Further, municipalities will have to prepare a detailed analysis on the security in collaboration with third-party verifiers to ensure that the investor is receiving all the correct information prior to making the investment. Given the lack of a definition of what constitutes a “green” purpose, local governments will have to prepare detailed reports to assure investors that their capital is allocated toward the intended environmentally friendly purpose.

Conclusion

While climate change is a global issue, changes to resolving this issue should begin at the local level. Municipalities should consider issuing green bonds as an alternative method of financing to raise the capital required to construct environmentally friendly projects necessary to mitigate the impacts of climate change. Incentivizing investors through tax policy or greater interest rates is essential to creating a liquid market for these bonds that will attract larger, sophisticated investors. Finally, a well-established regulatory framework for green bonds will also help dissuade investor concerns and enhance the reputation of green bond financing for other U.S. regions interesting in implementing such a policy.

    Carlos J. Micames

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    Carlos J. Micames: The author received his JD from American University Washington College of Law in 2020 and BA in Political Science and Economics from the University of Puerto Rico-Mayaguez in 2017 and currently works for CIMA Financial LLC as a financial consultant.