The Optimal Design of Green Securities

Abstract

We develop a model of green project financing which incorporates investors with green preferences into an otherwise standard framework of corporate financing with asymmetric information. Firms seek to finance green projects whose outcomes embed an uncertain component that is revealed only to the firm and which can be manipulated. Firms can raise funds using non-contingent green debt contracts, such as green bonds, that specify ex-ante the projects to be financed using the proceeds, but make no commitment to green outcomes. Alternatively, they can use outcome-based contingent contracts, such as sustainability-linked bonds, that do not impose restrictions on the use of proceeds but embed contingencies which incentivize commitment to outcomes. We demonstrate that the co-existence of the two green debt contracts is an equilibrium result when reported green outcomes are manipulable and firm types differ in their ability to manipulate. In the presence of asymmetric information about firms' type, non-contingent debt can be used as an expensive signalling device, and we find empirically that contingent green debt securities have lower credit ratings, higher yields and are issued by more emissions intensive firms.

Keywords: Security Design, Financial Innovation, Corporate Debt, Green Bonds, Sustainability-Linked Bonds, Carbon Emissions

JEL Classification: G23, G32, D62, Q56