The Next Step in Green Bond Financing

In recent years, green bonds have gained popularity as the investment industry is looking for environmentally friendly instruments. Yet, green bonds fragment bond issues, which reduces liquidity and thereby increases financing costs. Moreover, most green bonds are used to refinance existing activities. As a result, the growth in environmentally-friendly initiatives is limited. Finally, the product and market design of green bonds is such that prices are unlikely to reflect environmental performance accurately. This makes it hard for investors to differentiate among green bonds and allows firms to get away with window-dressing (greenwashing). We propose to split green bonds into regular bonds and green certificates. We show that this design 1. makes market prices more informative about environmental performance, 2. leads to more liquid securities and therefore lower financing costs, and 3. provides incentives to start new environmentally friendly projects rather than refinance existing ones.