More on free riding

My previous posts have discussed points raised at an OECD meeting in Paris when the environmental application of the Social Policy Bond concept was discussed. I am collating these criticisms and my responses, and uploading them onto a Criticism page on my website. I will now go into more detail about free riding, often cited as a reason not to consider the concept further.

Free riding

Much of the criticism of Social Policy Bonds has centred on the free rider problem. I should make clear at the outset is that Social Policy Bonds are intended to be the best possible way of achieving many of our complex, long-term social and environmental goals for which there are currently no successful, efficient policies, and many of which are thought to be intractable. This is the over-arching aim of the bonds: the aim of the bonds is not to eliminate the possibility of free riding. 

The goals that Social Policy Bonds are best suited for are those that are:

•    long term;
•    broad;
•    require diverse, adaptive approaches and, quite likely, a mix of these; and
•    resistant to any current or envisaged efforts by policymakers to their achievement.

If Social Policy Bonds are to be of value, then, they need not be elegant in an economic sense. They just need to better than alternative approaches, including the approach of not doing anything. Which is all to say that, even if free riding does occur under a bond regime, it need not be so significant as to detract from the bonds' ability to tackle some of our most challenging social and environmental problems.

The first thing is to note that free riders gain only if the value of their bonds rises; that is, if the goal is seen to be more likely to be reached, which usually means that something is being done to achieve the goal. The real problem arises if so many bonds are owned by passive investors (would-be free riders) that nobody does anything or, rather, that the goal remains unachieved as a result of their passivity. 

The more bonds in the hands of would-be free riders, the less likely that the targeted goal will be achieved quickly. The market value of all the bonds will therefore fall. As it falls, so the potential rewards from holding the bonds rises, so that more people would become interested in buying the bonds. If the price keeps falling, the would-be free riders will be tempted to sell their bonds to these buyers. Some might be tempted to become active investors themselves, rather than sell to such investors. The bonds are worth most to those prepared to do something to help advance the targeted goal. Nevertheless, there will certainly be some who will hang on to their bonds, and it is likely that, yes, there will be an irreducible number of bonds in the hands of free riders, who will profit as the targeted goal comes closer to achievement. The question is whether these holdings would be sufficiently large to make Social Policy Bonds less efficient than alternative policies. 

Because large quantities of the bonds held by a single passive investor would be big enough to devalue the bonds, it's unlikely that a passive holder will want large quantities of the bonds. More likely the bonds held by would-be free riders will be distributed amongst a large number of people with small holdings. It's possible that would-be active investors, if the bonds are falling in value, eyeing the total number of these bonds, would make offers greater than the current value to these small, passive, investors, and that the result would be aggregation of holdings into a holding sufficiently large, and bought at sufficiently low cost, to encourage the holder to be an active investor.

The goal is not to minimise free-riding, or to create policies that generate no free-riding. Indeed, most policies can be interpreted as rewarding free riders, in the sense of people taking advantage of the efforts others have made to supply some collective good without actually contributing themselves. Society accepts even spectacularly egregious cases of free riding, such as the rewards reaped by property owners when transport infrastructure is extended to their locale.

But to repeat, the over-arching goal of Social Policy Bonds is to set in place the most efficient practical way of solving humanity's social and environmental problems. Free riding is problematic only if it so blights the Social Policy Bond concept that it becomes less efficient or less effective that any other policy, including the policy of doing nothing. 

Writing in this year, 2023, when global tensions are high and there is a non-negligble chance of nuclear conflict, I feel certain that most people would accept the price of a few passive investors benefiting from holding the bonds in exchange for a new approach to reducing the probability of say, nuclear conflict; especially given the obvious and frightening inadequacy of current efforts.

One other point

In chapter 5 of my book I discuss issues of bonds that are failing to achieve their intended purpose. That could be because of insufficient funding. If progress is obviously too slow, the funders (government, usually) could simply increase the size of the redemption funds. But that would have the effect of immediately raising the value of all existing bonds, which would lead to 'moral hazard' in that free riding would be rewarded: people could hold a large number bonds hoping that by doing nothing to achieve the issuers could increase the redemption value of each bond, or issue more bonds, which would have the effect of raising the value of these passive investors' holdings. My thinking now is that the issuers might be better invalidating existing bond issues, perhaps stating in advance that if no significant progress is made toward goal achievement within, say, ten years, then that bond issue will be invalidated. They could then issue new bonds targeting the same goal, with greater funding.

Futures, options and perverse incentives

I continue to look at concerns raised by delegates at an OECD meeting that discussed a paper I presented on the environmental application of Social Policy Bonds. My previous post was the first; this is the second. 

Perverse incentives could arise from trading of Environmental Policy Bond derivatives. For example, one could make financial killing by selling bonds short (or by purchasing put options) and then dumping a million tons of manure in the Chesapeake Bay, or simply by not following through with promised abatement activities.

Futures and options markets in Social Policy Bonds would enable people to benefit from a falling bond price, so giving them an incentive to delay achievement of the targeted goal.

It is quite likely that there would be futures and options markets for large bond issues, and it is almost certain that the price of any particular Social Policy Bond would not always be rising monotonically from its float price to its redemption value. It would be justifiable, as well as efficient, if bondholders could hedge against consequent falls in the value of their assets. People who do not hold bonds might want to participate in markets for derivatives of bonds, some of which would rise in value as the targeted goal became more remote. This in turn means that speculators and short sellers could certainly profit from short-term bond price falls, and the question is whether these people would then take steps to impede progress towards any targeted goal.

There are two main reasons why they would probably not. The first is that, in the long term, the weight of money would be against them. Provided sufficient funds were allocated to achieving the targeted objective, there would be a net positive sum of money payable if the targeted objective were to be achieved, and a net zero sum paid as long as the goal were not achieved. All the long-term incentive would be to achieve the targeted objective. Those who, for whatever reason, would suffer from achievement of the objective could be compensated by bondholders, or bribed to change their ideas. Note also that for every buyer of a ‘put’ option there would be a seller, and that for every futures contract bought on the expectation that the bond price would fall, there would be an equivalent futures contract sold on that basis, so that the net incentive generated by derivatives would be in line with the incentive created by the underlying financial instrument, the Social Policy Bond: in the long run, this would favour achievement of the targeted objective.

The other reason that short sellers, or holders of ‘put’ options, in Social Policy Bonds might not take actions aimed at interfering with achievement of the goal is that such actions might well already be illegal or, again given the incentives that the bonds would generate, be made illegal – or have their provenance more enthusiastically investigated – once the bonds had been issued. Some miscreants might be tempted to sell bonds targeting water pollution short (or buy ‘put’ options) then dump a million tons of manure into Chesapeake Bay. But they would know that such an act is illegal – and that there will be people at the other end of their transactions who will be highly motivated to see the law enforced to its fullest extent.

Environmental Policy Bonds would not obviate the need for governmental regulators to monitor pollution levels and abatement activities of individual firms. Just like financial market need accountants, auditors and regulations to ensure Enron-like episodes remain an exception rather than the norm, Environmental Policy Bond markets will require similar oversight. The costs of this would reduce the efficiency of the bonds.

Government would need to monitor aggregate pollution levels under a bond regime, as these would be the measures targeted by the bonds. They would not need to monitor the pollution or abatement activities of individual firms. Bondholders would have incentives to monitor the activities of the largest polluters and either bring them to the attention of the authorities if they are breaking the law, or to find ways in which they would reduce their polluting activities. Bondholders would act as efficient enforcers of the government’s regulations by bringing the worst cases to the government’s attention. 

Arguing for and against Social Policy Bonds

Over the years Social Policy Bonds have discussed in many forums. I tried to address some concerns raised in these forums in my book, but that is several years old, so I am now going into more detail. This post looks at some concerns that delegates raised at a meeting of the OECD during which I presented a paper on the Social Policy Bond idea applied to the environment. I will eventually collate these arguments and responses and upload them onto the Social Policy Bond website. 

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If the polluters are few enough to overcome the free rider problem, then why are they not enough to collude in the bond market and thereby pay too cheap a price for the bonds issued?

The question is not about numbers of polluters. It’s about the number of bonds. Bidders for the bonds will compete to buy the bonds, then collude to achieve the goal that the bonds target.

The free rider problem arises when people own the bonds and do nothing to help achieve the goal. The more bonds in the hands of would-be free riders (passive bondholders), the lower the incentive for active bondholders to do anything. The value of the bonds on the market would keep falling. At some stage most bonds will end up in the hands of active investors. There might be few or many such investors, but they have every incentive to collude when they own bonds. They will, though, not necessarily collude to buy the bonds: the bonds will be sold on an open market, and, because anyone can buy them, collusion won’t be possible at that stage. So, there is always competition to buy the bonds, which maximises the returns to the issuing body. And there is always collusion between the shifting cast of bondholders, which maximises efficiency.

A more careful analysis is required about how governments would regulate information signals stemming from bondholders’ pollution abatement efforts and environmental measures on which bond payments are indexed.

The ‘environmental measures on which bond payments are indexed’ would be chosen to be, or to be inextricably and strongly correlated with the targeted goal. They would also be chosen to minimise the need for governments to regulate the associated information signals.

The idea needs a more careful analysis of the pros and cons of bond payment structures. Why do bonds simply pay a lump sum upon attainment of a fixed goal? Why not issue bonds that yield regular payments commensurate with pollution levels? If the bonds an all-or-nothing deal, the risk associated with the return could limit trading.

I agree. But the Social Policy Bond concept remains untried. Refinements can come later. Of course, separate ‘all-or-nothing’ bonds could be issued with targets of varying magnitude along the same scale.