The Official Statement for the City of Hampton’s recently issued Environmental Impact Bond (EIB) describes a transaction that isn’t quite as ‘impactful’ as the press releases suggest. In fact, the sole basis on which the $11 million of Series 2020A Bonds are designated as an EIB is the City’s intention to review some specific social and environmental outcomes on three small stormwater projects. The intention is very explicitly not a promise:
A more accurate description of the 2020As would be “Environmental Intention Bonds”. Still, good intentions matter. For the City to go to the extra effort of considering social and economic outcomes, summarizing all that in a lengthy appendix to the OS and stating very publicly that they intend to check it again with third parties as the projects are completed is definitely going in the right direction. But is there some way to turn good intentions into at least a little actual impact to this type of minimalist EIB?
Reputational Impact
Moral obligation bonds are a well-established feature of the muni market landscape. They work through the issuer’s reputation and track record with respect to an ‘impact’ (i.e. payment) that is not an explicit obligation. Likewise, the ‘moral obligation’ stated in this EIB might have a real-world impact if the bond investors actually hold the City to account in some reputational way, either positively or negatively, based on the independent reviewer’s assessment of outcomes. Presumably, this would work through their interest in and demand for the City’s future bond issues. Or perhaps a willingness to be quoted in a positive press release if the outcome is good or actively expressing disappointment in a letter if it’s not?
Realistically, that’s not likely to happen. Payment is one thing and stormwater performance variation is quite another. The issue is too small and too similar to a standard highly rated City bond for a portfolio manager to put much time into non-fundamental details. And the stakes are too low in terms of outcomes for these to surface in some dramatic or controversial way – a really, really great stormwater project won’t hit national headlines and an okay-not-so-great project won’t either. The designation also won’t change – Series 2020A bonds get to keep the EIB label as a kind of participation trophy, regardless of results. For public bond investors, the label is the impact.
Relationship Impact
It would be different if this type of EIB were privately placed with a relationship-oriented, buy-and-hold lender. In a relationship lending context, following through with good intentions and aspirational plans matters, even if they’re explicitly non-contractual and not related to repayment. Good results will be proudly reported, bad results will be explained. Even if relatively minor, results are added to the overall relationship management mix, which the borrower has an interest in actively maintaining. In that process, getting the EIB label by describing intended outcomes is just the first step. Actual follow-through is the impact, even if that only entails monitoring and reporting outcomes for a directly interested and important audience.
This relationship lending mechanism was probably an aspect of prior EIBs, DC Water (privately placed with Calvert and Goldman philanthropic funds) and Atlanta (public issue but separately placed by an ESG-oriented specialty underwriter) on top of relatively minor outcome-related yield adjustments.
But that type of private or specialty placement is relatively costly compared to a vanilla issue in the mainstream muni market. However sincere their good intentions, Hampton finance officials doubtless looked at the relatively high cost of previous EIBs and decided that they didn’t want to pay that kind of premium over their usual bonds to get the EIB label. And the 2020A bonds show that they didn’t have to. This will set the bar for municipal EIBs if it can be replicated – which is likely, given the way that the Green Bond market developed. How can any city council agree to pay a premium for the EIB label if they can effectively get it for free?
But if a Project is Financed with Both Bonds and a Private Placement…
However, there is a scenario where an issuer could get the best of both worlds – vanilla bond pricing and relationship impact value. Imagine an infrastructure project that will be financed about 50% with muni bonds and the balance privately placed (for some reason — more on that below) with a single, strongly ESG-oriented relationship lender. If the project has an element of influenceable ESG performance (in operation or at construction completion), the financing for that element might be more or less segregable (precisely for specific capex, roughly in terms of overall cost percentages) and issued as a separate series. That series, identical to the rest of the project’s bond except for a Hampton-type intentions disclosure and outcome review, would get the EIB label. Bond managers would buy it, check the ESG box in the pitch book, happily put it in their fund’s green bucket and then probably not think about the EIB aspects ever again, as described above.
The ESG-oriented relationship lender to the project, however, could — and should, if true to their stated principles — keep an eye on what the EIB is promising even though they’re not buying the bonds. Same project and same issuer, so everything in the EIB goes into the relationship mix. In this hypothetical scenario, the EIB bond series buyers get the EIB label (and they’re done) but the EIB outcomes will arguably have an impact directly on the relationship between the borrower and the ESG lender.
Of course, a 50/50-ish mix of bonds and a private placement to finance a fairly standard tax or rate-supported piece of municipal infrastructure usually won’t be cost-effective for a highly rated issuer who can do the whole thing with bonds. But if the private placement lender is a government loan program offering competitive rates and special features…
EIB-WIFIA Combination
The EPA’s WIFIA Loan Program is in fact a realistic ESG lender in this combination scenario, which makes it distinctly un-hypothetical. WIFIA is in effect a buy-and-hold relationship lender that even highly rated public-sector agencies (the folks who build most water projects) find very cost-effective. The maximum share of project debt is 49% and the 51% balance is usually done with muni bonds. WIFIA does a total of about $5 billion in loans for more than fifty water infrastructure projects a year, so there’s a good chance that a combination scenario will align with the facts and circumstances of at least a few projects.
Most importantly, the Program’s ESG orientation is deeply imbedded on many levels of its policy objectives and will be especially emphasized under the new Administration. For Program applicants, ESG considerations are central to the criteria by which loans are prioritized for competitive selection. A WIFIA financing proposal that included Hampton-type EIB promises in the bond part would get positive attention, not only for the intended ESG outcomes themselves but for the willingness to describe them in a public bond document. That connects the relationship story to the public policy arena and raises the bar for everybody involved, including the Program.
EIB bondholders may not care about outcomes. But WIFIA will. In an EIB-WIFIA combination, the project’s stakeholders can take intended ESG outcomes promised by the EIB more seriously. Good outcomes, not just labels, should matter — which is exactly the point of impact finance.