12 May 2009

Costing large objectives

When it comes to large social or environmental goals, such as reducing a (carefully defined) crime rate, one advantage of Social Policy Bonds is that they can defuse controversy about how much government should spend. Issuers of Social Policy Bonds, though they would have to decide on the maximum amount they want to spend on achieving their objective, would not have to work out how much the actual cost would be with any accuracy. That would be done by bidders for the bonds in the open market. Assume that bonds are to be used exclusively in pursuit of a 50 percent reduction in the crime rate, and that an urban authority issues one million bonds, of redemption value $10.00. If the market valued these bonds on flotation at $1.00 each, the net cost to the issuers of achieving the targeted objective (ignoring administration costs) would be $9 million. In other words, the market at the time of issue believes that the cost of achieving the objective, including its profit margin and after taking into account risk, would be $9 million.

Now suppose the bond issuers are completely in the dark about how much it will cost to achieve the targeted objective and instead of issuing one million bonds they issue ten million with the same redemption value, $10.00. They would then be liable for a maximum cost of $100 million. However, the market would still reckon that it could achieve the objective for around $9 million. So instead of valuing the bonds at $1.00 competition between potential investors would bid up the issue price of the bonds to around $9.10. (Social Policy Bonds would be an unusual financial instrument, in that the more that were issued, the higher would be their value!) The issuers therefore would not have to estimate with any accuracy how much a targeted objective might cost to achieve, and they would put a cap on their total liability by limiting the number of bonds issued. The costing of achieving the targeted goal has, in effect, been contracted out to the market, and the market bears the costs if it gets it wrong - not the taxpayer!

This could be a huge advantage in dealing with climate change, for example, where there are sufficient uncertainties to explain, if not justify, politicians' reluctance to do anything meaningful until, quite probably, it's too late.

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