Environmental impact bonds: Earning a bonus while doing good

Washington, D.C., has a problem.

Sanctioned by the Environmental Protection Agency for the pollution being caused by urban runoff into the streams that feed into the Potomac River, the district has launched a multi-billion-dollar storm drain program to collect and treat the water.

In 2016, however, DC Water, the district’s water utility, pioneered something different: the nation’s first environmental impact issue, a $25 million private-placement bond arranged by the Calvert Foundation and Goldman Sachs Urban Investment Group. This bond issue is funding new urban green spaces where water is absorbed naturally, saving the city the cost of building sewer lines.

In year five, if the project is found to have exceeded planned goals, investors will be rewarded with up to an extra year’s interest payment.

This first EIB has become a model for many more such issues nationwide dealing with environmental issues, according to Benjamin Cohen, a senior associate at Qualified Ventures in D.C., which is helping to conduct feasibility studies of EIBs and structure issues.

Other EIBs in the planning stage include one to fund barrier island restoration and moderate storm surges by the Louisiana Coastal Protection Authority, one to combat flooding in poor areas of Atlanta and a third dealing with flood issues in Baltimore, he says.

The goal is to develop EIB issues that are competitive in cost to conventional infrastructure bonds, offering investors similar returns but that would also include a performance bonus, Cohen says.

Typically, performance bonuses are paid after about five years, once an evaluation determines that project goals have been exceeded, he says.

The idea of social-impact investing with a performance bonus has been around for some time, but Cohen says applying it to bond issues is new.

He predicts that the model will catch on as potential investors see how it works.

Jeffrey Smith, co-principal of Bright Futures Wealth Management, an independent financial advisory firm based in Rockville, Maryland, says that many of his more conservative older clients could find the idea of investing in worthy EIBs attractive, particularly if the interest on those investments is competitive and there is a good chance of earning a bonus interest payment.

But he wonders about the risk of a disincentive for the issuer who may have to pay that bonus.

“Who is underwriting the bonus?” Smith asks. “Is it the issuer or the sponsor? And who determines whether the goal of the project has been exceeded?”

In the case of Washington, D.C.’s EIB and other bonds on the drawing board, an outside group makes the decision regarding payment of the bonus, while the issuer pays it, Cohen says.

But there would be no incentive for an issuer not to exceed a project’s goal, because exceeding the goal would save “vastly more money” in each case, for example reducing the need for building more costly sewer lines and expanding treatment facilities or reducing storm damage, he says.

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

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