On this episode of Free Range, host Mike Livermore is joined by UVA Law professors Quinn Curtis and Mitu Gulati, as well as UNC-Chapel Hill Law professor Mark Weidemaier, all experts in the regulation of financial markets, to discuss new paper, Green Bonds and Empty Promises.

A wide range of institutions borrow within the bond market, including municipalities, corporations, and sovereign nations. The essence of a bond is a set of promises, which include repayment terms and limits on opportunistic behavior by debtors. One new feature of the bond market is the rise of ESG (Environmental, Social, and Governance) investing. ESG is widespread within the mutual fund industry, but has found a place in the bond market as well. But there is a difference between investing in the environment through stocks and through bonds. Stocks allow the investor to earn more as companies gain wealth by adapting to climate change, but bonds are paid back at a fixed rate of return, so the risk and return equation is different.

Green bonds are a type of bond that is associated with environmental projects, but the actual language in bonds dealing with sustainability or environmental performance is often vague. This was one of the major research findings in Green Bons and Empty Promises – purportedly environmentally friendly bonds don’t actually limit how the borrower can spend the borrowed money (0:50-27:58).

To understand the market for green bonds, Gulati, Curtis, and Weidemaier began by defining the category “green.” For this, they relied on third party databases that are used throughout the industry when investors are building ESG portfolios. Issuers likely determined their own categorization, essentially deciding whether their own bonds would be listed as “green.” The green label matters because these bonds might have a lower interest rate, referred to as a green premium, although research indicates that any green premium that does exist is very small. But, green bonds do appear to enjoy a some benefit in terms of liquidity because many investor want to show their clients environmental responsibility.

After collecting a sample of green bonds, the team then investigated the actual promises found in them. Interestingly, their research found that green bonds generally do not possess legally enforceable commitments to use proceeds for environmental projects. Interview research found that many know the “green” label is PR and don’t expect the status quo to improve. (27:59-57:56).

The conversation wraps up with the methods in which the situation can be addressed, and all four provide their opinions. Weidemaier explains that legal enforceability would remove the market’s liquidity, transforming it to an affinity bond market that is no longer fungible. Another option is to simply kill the market, since green branding can still happen but then no one is misled on such a scale. Curtis believes that there is some room for improvement, as certifiers can begin considering legal enforceability and the market would inevitably become smaller, but more credible. This theory depends on the sincerity of the investors’ demand. Gulati considers the green bond market to have the potential to evolve into something better, since it is currently booming and the way it operates is unique. Livermore describes significant environmental improvements as being made mostly through policy, so the value in private markets is mainly that they raise awareness for climate change and may aid in a cultural shift to support pro-environmental policy (57:57-1:09:20).