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.
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