FEBRUARY 29 2020
Private markets pivot around the fulcrum of voluntary exchange and mutual benefit. As they pivot about this fulcrum, exerting output forces and lifting loads, they generate allocative efficiency, enabling societies to produce the right combination of goods they most pine for.
But voluntary exchange may do more than benefit willing partners – it may also impose costs on or confer benefit to third parties who neither play the purchasing nor selling role. “Externalities” is the fancy word which economists have reserved for this form of market failure.
With the rising visibility of environmental issues on the global agenda, the torch continues to be shone on pollution as a major negative externality. But in markets where environmental regulation is lax, prices expressed on the demand and supply curves only capture the private costs of production, but not those of environmental externalities, even when the social costs exceed private ones and the externalities are negative.
Put differently, because the costs of negative externalities are not priced in such markets, firms appropriate the private costs of their production but leave society holding the can for environmental destruction. Inspired by Elkington’s Cannibals with Forks however, the narrative against the observed market failure has begun shifting from the bottom-line to the triple bottom-line.
Consequently, the ESG (Environmental, Social, and Governance) criterion, as a filter for the pursuit of superior risk-adjusted returns, continues to grow in stature, and capital markets have responded by innovating climate or green bonds as a means of internalising environmental externalities.
Since the primary issue in 2007, the global green market for climate bonds has grown by giant strides, topping a value of $185.6bn (£141.7bn) by 2019. But Kenya is catching up 12 years later, with the first green bond valued at 4.3 billion shillings ($41.45 million), having just been issued. This is not only the first in the NSE’s 65-year history (it has also been cross-listed at the LSE), but is also the first in the East and Central African region.
The issue of this bond has come hot on the heels of new regulations that free investors from the withholding tax burden associated with bond earnings. Motivated by its voracious appetite for cash, the Kenyan government is already casting a longing eye on the green bond, providing promise of fast growth in this asset class. Nevertheless, interest in such bonds is particularly likely to be pronounced among institutional investors out to enhance their ESG performance by investing in climate bonds and impact investors in pursuit of ESG options to satisfy their client needs.
This is likely to have various implications. Theoretically, climate bonds are expected to have a positive impact on the environment by cutting back on pollution and greenhouse gas emissions. Therefore, climate stands to win. Since climate bonds cater to the taste of green investors by internalising the costs of negative environmental externalities (e.g. pollution), green bonds are expected to generate positive signalling effects, and to give a lift to issuer’s stock prices.
But if past performance determines future behaviour, tipping climate bonds to enjoy high oversubscription is not a stretch. High oversubscription increases bond price and reduces debt costs, which are expected, in turn, to enhance the issuer’s appeal and stock performance. There is also evidence that in enhancing media coverage, climate bonds elevate firm visibility and signal strong fundamentals based on the firm’s long-term commitment to sustainability.
These should potentially stir more consideration form investors and enlarge the firm’s investor base. Moreover, investors are likely to benefit from the downside-risk-reducing potential of assets with higher ESG. Nonetheless, the issuance, certification, and regular disclosure requirements of climate bonds require substantial time and costs, on the basis of which aspersions regarding the real value to shareholders of this asset class may be cast.