What type of investment provides stable returns, reduces greenhouse gases, protects ecosystems, and encourages the shift to renewable energy? Impact bonds – more specifically, climate impact bonds.
What is an Impact Bond?
Impact bonds are outcomes-based contracts where private funding is used to cover upfront costs by a provider to set up and deliver a particular service. The service is created to achieve measurable outcomes as specified by the commissioner. If these outcomes are met, the investor is repaid by the commissioner.
Rather than focusing on the activities, impact bonds differ from traditional contracts by focusing on outcomes and the involvement of third-party investors.
There are primarily two types of impact bonds: Social impact bonds (SIBs) and development impact bonds (DIBs). For SIBs, the outcome payer is the government. In the case of DIBs, the outcome payer is an external donor, a multilateral agency, or a philanthropic organization.
Who is Involved?
There are three key partners who are brought together by impact bonds: The outcome payer (commissioner), the service provider, and the investor. Each party has its own incentives for joining forces with the other two, but their goals become aligned once they enter an agreement.
Outcome payers (commissioners) identify social issues, specify outcome goals to address these issues, and pay when those goals are met. The commissioner performs a majority of the work in drawing up each contract.
Service providers develop programs to achieve the outcomes specified by the commissioners, receive upfront capital needed to implement these programs, and receive payments when targets are met.
Investors provide the upfront funding to finance the project and are repaid based on the results delivered by the service providers.
While each partner’s exact incentives may differ at the onset, impact bonds ensure expertise from a variety of fields is synthesized to tackle the world’s most challenging problems.
The Opportunity for Climate
Climate impact bonds are a subset of social impact bonds, where the government acts as the commissioner and pays a service provider when certain climate-oriented goals are met. This money is then passed back to the investors who funded the service provider’s project.
Climate change and environmental concerns cannot be avoided – they will not subside on their own. Given the urgency and the stakes, more and more people are wanting to join the fight but don’t know how.
Driving real change feels out-of-reach for many. Beyond making lifestyle choices that reduce one’s carbon footprint, climate impact bonds offer an alternate way for an individual to make an outsized, lasting difference. By getting money into the hands of those who know how to use it most effectively, investors can feel confident they’re helping tackle global issues while still generating a return.
These results-based contracts have captured the imagination of many and serve as a useful guide on how to merge social efforts with private capital markets to work on the biggest issues facing the planet. However, significant challenges still exist.
As with all social benefit projects, quantifying the costs, benefits, and results of certain programs remains incredibly complex. The structure of impact bonds necessitates a simple, reliable system for determining which projects should be undertaken and how the results of those projects should be measured. Many of the proposed solutions remain purely theoretical.
Furthermore, attracting funds from investors that are more than philanthropic in nature will require service providers to develop regimented programs with high likelihoods of success. Given the scale of many of the issues being faced, large amounts of capital will be required to create any lasting improvements. Investors will likely demand very favorable returns for the inherent risks of these projects.
Still, climate impact bonds, and impact bonds in general, offer an attractive means for an investor to balance philanthropic efforts while protecting capital and generating returns through a fixed income product. For someone interested in this type of investment, a growing number of options will become available in the years ahead, as impact bonds and the like will only increase in popularity.
The contributions and developments in impact investing is truly remarkable and speaks to the desire of a great many people to work together and serve the common good.