Chapter 2. The efficiency case for environmental taxation
2.4. Interaction effects with green bonds
et al., 2014b; Newell, 2015). Environmental taxation can help fund these invest-ments but they may equally be financed through green bonds. Given the size of financing challenges for green transitions, both financing instruments might best be used jointly.
Another argument for combining green bonds with environmental taxation is that the instruments perform differently politically. A core problem of climate policy is to convince policymakers who are focused on short election cycles to implement policies that can imply short-term losses for long-term gains. Many policymakers doubt the short-term gains from carbon taxation even when they do agree that the policy will be beneficial in the long-run. Green bonds have the opposite pro-file: they allow policymakers to mitigate today and pay for this mitigation action tomorrow (or make their successors pay). Therefore, the two policy instruments have different inter-temporal cost profiles. The first-best policy may be to only use environmental taxation. But even if environmental taxation is the most efficient climate policy, if policymakers are not currently willing to roll out this policy at the scale needed, it is likely more cost-efficient to top-up whatever level of envir-onmental taxation is achievable today with some second-best policy instruments than to delay climate policy. Green bonds appear politically more achievable. Pre-cisely in situations in which policymakers shy away from incurring short-term costs for long-term gains, bonds could make climate policy incentive-compatible, because they shift some of the cost for repaying the bond to the next period (Sachs, 2015).
Another motivation for green bonds is intergenerational equity. Climate policy invariably involves intergenerational transfers, because the mitigation of emis-sions today causes benefits for future generations. The current generation may then wish to let future generations share in the cost of today’s efforts. Green bonds are an instrument for achieving such burden sharing when they are used to finance today’s mitigation actions and the bonds are repaid by the future gen-erations. Such burden sharing is Pareto-superior to a business-as-usual scenario with insufficient mitigation today (Orlov, 2017; Sachs, 2015).
Chapter 2. The efficiency case for environmental taxation
2.4.3 Relative efficiency of environmental taxes to ETS in interactions with green bonds
In this section, we compare how environmental taxes would perform in combin-ation with green bonds relative to how emissions trading systems (ETS) would perform in such a policy package. The analysis in this section is an addition to the literature on the relative efficiency of environmental taxes and ETS.
2.4.3.1 Effect of carbon prices on green bonds
It is known that green bonds perform better (in the sense of increasing demand in financial markets) when climate change mitigation projects have higher private returns (Flahertyet al., 2016). It is also known that the returns from climate change mitigation projects improve when countries implement carbon pricing as house-holds and firms substitute away from fossil fuels. These findings imply that a sufficiently high CO2price in ETS or taxes supports the successful market intro-duction of green bonds as well. Climate bonds are only partly an alternative to carbon pricing if they require carbon pricing for their market success. However, if carbon pricing takes off, we can expect green bonds to thrive as well.
Both carbon taxes and ETS would thus be expected to raise demand for green bonds, but that does not mean that their contribution would be equal. We know that ETS have much higher carbon price volatilities than carbon taxes. We also know that green investment projects can more easily attract green bond financing if their returns on investment are less volatile (Flahertyet al., 2016). Therefore, as the returns on investment for green investment projects depend on carbon prices, a more stable carbon price also creates a more stable return on investment and accordingly increases the demand for green bonds. As a result, emissions trading systems do not maximise the potential of green bonds to the same extent as carbon taxes of the same carbon price level.
2.4.3.2 Effect of green bonds on carbon prices
There is another negative interaction effect between ETS and green bonds which does not exist with carbon taxation. An ETS puts a cap on emissions, and emis-sions leakage can occur when green bonds finance climate change mitigation
pro-2.4. Interaction effects with green bonds jects for industries that are covered by the same emissions cap. The mitigation achieved through the bonds can reduce the scarcity of emissions permits under the cap, reducing the price of those permits and thereby allowing the displace-ment of emissions rather than their net reduction.14
To prevent this unwanted feedback loop, governments would need to tighten ETS caps when they introduce green bonds. However, those adjustments may be polit-ically impossible precisely in the situations where green bonds are sought. If green bonds are introduced as a second-best policy to fill the policy gap left by the political opposition to serious carbon pricing, the same political opposition would probably also prevent an adjustment in emissions caps.
Against this argument, optimists may point out that the introduction of green bonds might break the political gridlock because it creates new vested interests:
The holders of green bonds have an interest in the tightening of ETS caps.15 Cur-rent lobbying by industries to loosen emissions caps could then be counterbal-anced by new lobbying from investors who seek to tighten those caps. By that reading, the creation of green bonds could both weaken and strengthen ETS. How-ever, with a carbon tax, these outcomes are clearer. The aforementioned adverse feedback effects of green bonds for ETS prices do not occur for carbon taxes for which the rates are fixed by Parliament. With carbon taxes there is only the pos-itive effect that a carbon price (whether ETS or tax-based) has on the demand for green bonds. So the risk that green bonds and carbon pricing will undermine each other is smaller with carbon taxes than with ETS.
14This finding is original, but there have been related findings in the literature on how ETS interacts with other policies. Fischer & Preonas (2010) show a similar interaction effect between demand-side subsidies for the deployment of renewable energies and ETS prices. In Europe, many governments provide feed-in tariff and other demand-side subsidies to renewable electricity. At the same time, the electricity market is covered under an Emissions Trading Scheme, and the cap on the total amount of emissions is not tightened along with the expansion of renewable energies. As a result, a displace-ment of thermal energy by renewables reduces the scarcity of emissions permits under the cap. The ETS price falls accordingly, which reduces the ETS’s abatement incentive to the remaining (base-load) thermal energy suppliers. A similar adverse interaction effect exists when green consumerism shifts demand away from goods that are covered by an ETS to goods that are not covered, thereby lowering the ETS price (Perino, 2015). Our addition to this literature is that such an interaction also occurs between bonds and ETS, and its implications for the choice of carbon pricing in countries that seek to access growing green bond markets for financing their ecological transitions.
15To our best knowledge, this argument has not yet been made in the literature on the effect of green bonds on ETS. However, there is a related, wide-spread argument that the distribution of emisson permits creates a new lobby for the continuation of emissions trading because the entities which receive the permits have new economic interest in the maintenance of the ETS from which their permits derive value.
Chapter 2. The efficiency case for environmental taxation
Figure 2.1: Evolution of green bonds prices under different carbon pricing regimes
2.4.3.3 Empirics
The interaction effects described above are new additions to the literature, and so there are no empirical tests of these theoretical findings yet. However, a first analysis of the raw data from financial markets does confirm these results. As shown in Figure 2.1, green bonds are performing better in countries that employ carbon taxation than in countries with ETS.16