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Modigliani-Miller for Climate Change Financing

In recent years, attention has focused on alternative instruments to finance projects to combat climate change. Advocates of these so-called “Green Bonds” sometimes argue that the bonds result in the financing of more “green” projects and are thus a critical weapon in the battle against climate change. While this claim may be true, it doesn’t necessarily follow.

Projects that are economically viable would get funding from traditional sources just as easily as from non-traditional Green Bonds. After all, profit-seeking investors hoping will finance projects offering higher returns. So, in this perspective, the issue is whether Green Bonds allow projects that don’t offer as high private returns (but generate high social returns) to go forward.

It is possible, for example, that Green Bonds attract socially-minded investors that are prepared to accept lower rates of return. But if the buyers of Green Bonds are mandated to finance green projects, it isn’t at all clear that more projects would be undertaken–those projects could just as easily be financed by plain-vanilla bonds. In this case, the issuance of Green Bonds merely displaces plain vanilla with the same number of green projects undertaken.

The only way to increase the number of projects is to increase the rate of return on them or reduce the rate of return investors are prepared to accept. Trust funds that provide “sweeteners” to a financing package do the latter. But, if we are serious about addressing climate change and really want to expand the volume of projects undertaken, the relative returns of carbon-based projects have to fall relative to green alternatives. That is to say, the way a project is financed is less important than the underlying stream of returns on that project.

Fifty years or so ago, Modigliani and Miller (M-M) made an analogous argument with respect to corporate finance. Given the strong assumptions they invoked, whether a firm is financed more by debt or equity is irrelevant to the value of the firm. What matters for firm valuation is the underlying profit stream.

Looking at Green Bonds though the Modigliani-Miller lens is useful because of the importance of the challenge the international community faces. Now, it might be the case that Green Bonds are worthy of the claims made of them; in particular, they could they address information asymmetries that prevent investors with a mandate to invest in green projects finding them. This would be consistent with the original M-M result, which assumes full information and perfect certainty. But I suspect that investors with green mandates have a surfeit of investment opportunities. And, if Green Bonds are merely as a fashion statement and are viewed as a substitute for measures to alter the relative return on carbon-based and green projects, through carbon taxes, for example, questions could legitimately be raised whether they are worth the effort.

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