21 July 2017

Social Policy Bonds and free riders

Let’s say that the bonds have been floated, and that a high proportion of them have been sold to people or bodies have no intention of doing anything to achieve our targeted goal. These are would-be free riders, hoping to benefit from other bondholders’ efforts to achieve the goal, or a drift toward the goal that happens regardless of anybody’s efforts. (An example of this would be a holder of Climate Stability Bonds benefiting from new scientific evidence showing that the climate isn’t changing as quickly as the market thought it was when the bonds were issued.)

If too many Social Policy Bonds were held by would-be free riders who had no intention of doing anything to help achieve the targeted social objective, then the value of all the bonds would fall. At that point it becomes worthwhile for active bondholders to buy those bonds that are traded, do something to achieve the goal, and see the value of their bonds rise. This would benefit any remaining free riders of course, but not as much as the new bondholders, because these new bondholders would have paid less for their bonds. Most likely, we'd see aggregation of bond holdings as it becomes worthwhile for passive bondholders to sell their bonds. The resulting small group of large bondholders would then have incentives to cooperate with each other. This would mean, amongst other things, that they would all benefit by agreeing on how the specified social problem could best be targeted. One element of the optimal strategy will be to decide who will be responsible for what activities, and how they shall be compensated. Major bondholders will certainly have incentives to share information with each other. Many of the bonds would be traded between bondholders.

If the proportion of bonds held by free riders is small, then their passivity would have little effect on the market value of the bonds, and they might benefit by hanging on to their holdings if active bondholders are successful in their efforts to move towards the goal’s achievement. Such behaviour would, to a limited degree, undermine the Social Policy Bond concept, but keep in mind that:
  • The true standard of comparison is not perfection: just something significantly better than any alternative, and

  • Our goal is to achieve social goals as efficiently and quickly as possible; not to ensure that everyone is rewarded strictly in accordance with their efforts.
There is more about Social Policy Bonds and free riding in my book, chapter 4.

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