THIS PAPER IS THE WINNER OF THE 2024 E-AXES FORUM RESEARCH PRIZE
From the Abstract: We develop a theory of optimal security design for financing green investments in the presence of greenwashing (i.e., when reported green outcomes can be manipulated). The model embeds key features of green investments, such as the uncertain nature of green outcomes and the variation in the strategies to deliver them (i.e., tangible projects vs. behavioural changes) into a principal-agent setup in which an investor with green preferences employs a profit-maximizing firm to produce a green outcome. We show that the optimal contract includes a compensation component that depends on the implementation of tangible green projects (i.e., a project-contingency), and a compensation that depends on reported green outcomes (i.e., an outcome-contingency). The more severe the level of greenwashing, the more relevant is the project-contingency component to ensure efficient project implementation, and in the limit where manipulation is highly likely, only contracting on projects is possible. The optimal contract nests the two categories of contracts currently present in the market, namely green bonds (GBs) that focus only on pledging proceeds to specific green projects, and sustainability- linked bonds (SLBs) that do not impose restrictions on the use of proceeds but instead make the payoff entirely dependent on reported green outcomes. Our model is able to rationalize several SLBs and GBs issuance patterns.
