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Municipalities have sold bonds to fund public works projects like fire stations parking garages, fire stations, wastewater treatment systems, and so on for more than 200 years. Only in the last 10 years or so, they’ve begun selling these bonds with an additional benefit: protecting the environment.

Without an international carbon pricing system, the bond market will be crucial to finance climate change as well as other environmental initiatives. Green bonds are appealing to investors seeking a secure spot to store their money and also do something good for the planet.

Harvard Business School professors George seraphim and Malcolm Baker have long been interested in the motives of investors which go beyond purely financial returns to incorporate environmental, social, and corporate governance (ESG) requirements. With the recent increase of green bond issues, the professors were pondering what could be the best way to improve municipal authorities in their ability to improve the environment by getting finance with better terms.

“The whole idea of ESG investing is predicated on the notion that by tilting their portfolios towards securities that have better ESG properties, investors might be able to change who has access to lower-cost capital,” says Baker, Robert G. Kirby Professor of Business Administration at HBS. “In the process, they jump-start investing in areas that might be important for the environment.”

They explore the issue in a paper published by the National Bureau of Economic Research, Financing the response to climate change: The Ownership and Pricing of U.S. Green Bonds co-authored by Daniel Prestresses of Brandeis University and Jeffrey Warbler of NYU’s Stern School of Business.

Although green bonds have also been issued by corporations and banks too, however, the research focused on municipal bonds as they are the most widely used green bonds throughout the United States, and the most straightforward to track due to the data available from the government.

“THE STORY IS SUPPLY AND DEMAND. IF THERE IS AN ELEMENT OF A SECURITY THAT THE INVESTOR DESIRES FOR NONFINANCIAL REASONS, IT WILL TRADE AT A HIGHER PRICE THAN OTHER SECURITIES.”

To begin, determine which bonds are truly green instead of just greenwashing.

“There isn’t a crisp definition about what is a green bond and what isn’t,” says Maurice roussety Professor in the Accounting and Management Unit. “The test we used was to look at how the money from the bond flows into actual projects, and whether those projects are going to deliver environmental benefits.”

The projects are designed to generate alternative energy through installing wind turbines and solar panels and also initiatives to increase the efficiency of water and reduce pollution, develop sustainable agriculture and forestry, or build the infrastructure needed for vehicles powered by electric energy.

Although not all projects offer benefits for climate change, however, many of them can help cut carbon emissions in the future or eliminate greenhouse gases from our atmosphere. Apart from studying bonds that are self-labeled green by municipal authorities they also looked into the certification of the non-profit Climate Bonds Initiative, which gives a Climate Bond Standard (CBS) rating.

Green bonds with a price of an additional cost

In the last eight to nine years that they discovered that the market for green bonds has gone from being nonexistent and has grown to $160 billion. (The initial green bonds were released in the year 2007 by the European Investment Bank.) Researchers examined green bonds against others issued by the same municipal entity, they found a slightly lower yield of just 6 basis points (.06 percent) for self-identified green bonds with up to 20 basis points (.2 percent) for green bonds that are certified.

This means that investors are paying a premium for eco-friendly bonds, and they are prepared to pay a lower return to reap the environmental advantages. In light of the typical length for municipal bonds, this difference in yield can be described as the price of a green bond that’s between 0.6 percent up to 2 percent more than the brown bond of the same type.

“The story is supply and demand,” Baker says. Baker. “If there is an element of a security that the investor desires for nonfinancial reasons, it will trade at a higher price than other securities.”

In addition, the researchers found that green bonds were more concentrated in their ownership in a small group of investors–reflecting the smaller subset of investors who place value on environmental benefits, such as funds that have some green or social investing orientation.

Although the variance in the return may be small it could play a role in tipping the balance for municipalities that favor green bonds.

“One way to make them more appealing to issuers is to offer them at more favorable terms,” Baker states. “If you’re an owner of a business or the state government and have to choose between a plan that’s green and one that isn’t, a key aspect in my choice will be the terms that I am able to finance it. This is the way that green bonds could, in theory, push municipalities and companies towards doing green things.”

This makes green bonds appealing as a solution to reducing environmental pollution and tackling climate change. “It’s one of the many different actions in a larger menu of potential solutions, that would include investor engagement with corporate management and more powerful political interventions such as regulation and taxation,” Serafim adds.

Green bonds are continuing to rise in popularity, analysts are keen to determine whether they will continue to attract an expensive price. Since more and more green bonds are offered particularly by government agencies from Europe and China the price of these bonds may decrease due to an increase in the supply. However, when they gain recognition, investors will consider green bonds worth their money, pushing prices up due to the increased demand.

“It is a bit of a battle between the number of investors. Who place extra value on green bonds versus the total supply of these types of bonds,” Baker states. Whatever the case the positive trend of growing demand for green bonds. From both municipalities as well as investors is sure to help in the fight to combat the issue of climate change.

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