Bringing Social Impact Bonds to the Environment

Social impact bonds (SIBs), or pay-for-success contracts, are designed to help governments finance social outcomes by way of outside investment and have gained significant attention over the past few years. In the United States, two initial SIBs, signed in New York and Utah, aim to reduce recidivism and increase kindergarten readiness, respectively. These efforts are building on work started by Social Finance in the UK, McKinsey's 2012 SIB report, the Nonprofit Finance Fund's information hub, Harvard’s Social Impact Bond Labs program, and the many other pay-for-success contracts signed around the globe. Taken together, a tremendous amount of brainpower, multi-sector collaboration, and financial innovation has gone into building new ways to finance the long-term social outcomes that society seeks. But what about the environmental outcomes we seek? Is the pay-for-success model even better suited to financing sustainability?

This is the question we set out to explore last year, by considering factors that would justify the creation of environmental impact bonds (EIBs). When you consider a social impact bond, there are several essential steps (as defined in Social Finance’s "A Technical Guide to Developing Social Impact Bonds"). These include defining the outcomes you seek and determining the "value for money case"—or the potential savings that could result from the intervention. You then define the program, decide on metrics and who will track them, and convince different parties to make payments if the program meets target initiatives (so far, philanthropists and investors have paid up front, government agencies later).

For environmental issues such as water quality improvement, environmental financing has three distinct advantages over social financing:

1. Many standardized EIB metrics already exist, and we can develop new ones more quickly than SIB metrics. In the SIB ecosystem, metrics and measurement techniques often are developed from scratch, or are costly to collect and track because they are “people” metrics—that is, they measure behavioral change over time. In the EIB ecosystem, however, many standardized metrics already exist, and thanks to scientific knowledge and rigorous environmental monitoring already underway, we can readily develop new ones. The City of Philadelphia, for example, is revamping its system of measuring (and taxing) stormwater runoff, which has been shown to adversely impact the city's water quality. The city could easily adapt this metric for use in an EIB that focuses on improving local water quality.
2. Natural resources are commonly associated with revenue streams. Apart from government funding, social service agencies and SIBs often have few established revenue streams. In the environmental sphere, however, natural resources are frequently linked to revenue streams, potentially reducing reliance on government funding for EIBs. If regular cash flow payments are available during the life of EIBs, we could structure bonds in a way that would entice more conservative investors. We created two scenarios for this: 1) the investor gets annual coupon payments over the life of the bond (we call this "Return at Risk - standard"), or 2) investors get coupon payments plus a potential annual bonus (called " Return at Risk - annual bonus"). A steady cash flow during the life of the bond would provide lower-risk instruments to impact investors and perhaps obviate the need for the first-loss guarantee layers (foundation or government subsidies to cover potential losses) present in most SIBs to date.
3. Future EIBs may not depend on new government regulation. Government regulation is not always required to develop a consistent cash flow from natural resource assets. As a result, there is great potential to use EIB financing to expand investment in environmental markets that already exist. In The Freshwater Trust's Water Quality Trading program, for example, the critical metric is in-stream water temperature; colder water helps promote healthy salmon and trout fisheries. The Oregon Department of Environmental Quality publishes standards that relate streamside restoration efforts to cooling benefits in the water. A third party verifies this data, and the water trading program uses it to manage the trading of "stream temperature" offset credits. Someone wanting to expand this program to other states or regions could, in theory, use Oregon’s existing system to create an EIB for outside investors interested in these outcomes.

One of our conclusions is that some environmental trade and credit programs, such as The Freshwater Trust program, work well enough that EIBs are not needed. Our new CASE i3 white paper, "Environmental Impact Bonds," is an initial exploration of the criteria needed to determine where an EIB would become an appropriate and effective part of the environmental finance toolkit.

We welcome feedback and comments on the paper.

Read more stories by David Nicola & Cathy Clark.