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ECON 4999X Green Finance and Sustainability Chapter 8 DEYU RAO D Y R A O @ U S T. H K D E Y U R A O . G I T H U B . I O D E P T. O F E C O N O M I C S , H K U S T P L E A S E D O N O T C I R C U L A T E T H E S E S L I D E S W I T H O U T M Y P E R M I S S I O N . U P L O A D I N G M A T E R I A L S F R O M T H I S C O U R S E T O W E B S I T E S T H A T S E L L S U C H C O N T E N T I S C O N S I D E R E D M I S C O N D U C T A N D M A Y A L S O P U T Y O U A T R I S K F O R V I O L A T I N G C O P Y R I G H T P O L I C I E S .
SBMT4000: SBM Undergraduate Honors Research Project (6 credits) https://bmundergrad.hkust.edu.h k/academics/academic- planning/predoctoral- training/previewKey:22310
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Pilot Programme to Enhance Talent Training for the Insurance Sector
Previously… Why should the market/investors care? Corporate green bond Signaling Greenwashing (taking advantage of signaling) Low financing cost
Theoretical framework behind firm’s ESG decisions When lenders can actually enforce the follow-through, competitive pressure from non-ESG lenders facilitates ESG integration (there exists conditions, theoretically, that) Social responsibility is complimentary to profit-seeking capital Oehmke, Martin, and Marcus Opp. 2022. “A Theory of Socially Responsible Investment.” Unpublished Manuscript
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Model setup Consider an Entrepreneur Risk neutral, limited liability Two technologies {Clean, Dirty} Dirty tech generates higher financial value, but clean tech generates higher social value (= financial value - external costs) Firm scale K Two tech generates same cash flow With probability p, So constant return before and no return after And zero otherwise (failed!) Firm scale Return (if succeed)
Model setup Consider an Entrepreneur Has some initial endowment (which may be sufficient to achieve optimal firm scale) Cares about social external costs to some degree (which depends on scenarios later on) Firm scale Return (if succeed)
Model setup Investors Financial investor Does not internalize external costs and only care about financial payoffs Socially responsible investor Internalize external cost to some degree The socially responsible investor may be Type I: care about the level of social cost that firm produces Type II: care about the social cost of investing in firm, relative to not investing (and firm can get financed by brown investors) “Is it my responsibility to lure firms from brown investors?”
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Model setup Financing arrangement Entrepreneur issues securities that pays some amount upon project success (and zero otherwise) No resource if fail, so doesn’t matter if this is debt or equity Entrepreneur decides on investment scale and tech
Brown-only market If only financial investors are present (all investors are brown) Firm choose scale and tech to maximize payoff Dirty tech (assuming firms do not care about social value at all, or do not care enough) K cap Firm may choose dirty tech if financing from brown investors, even if she were to choose the clean tech under self-financing! Firm might care more about social value than brown investors (who do not care at all) “Corrupted” by the financial market
Brown-only market If only financial investors are present (all investors are brown) What can the social planner do? If firms are self-financing, and internalizes 5% of social cost, issue a tax = 95% of social cost Clean tech (which is socially optimal) adopted Externality corrected We can, of course, ban the dirty technology But this is only effective when firms are self-financing (has enough endowment to reach K cap independently)
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Brown-only market If only financial investors are present (all investors are brown) What can the social planner do? If firm relies on external financing from brown investors (who care 0% of social cost), tax alone is not enough to correct for all externality! Imagine if entrepreneur has little (or no) money to start with, and most (or all) of the project is externally financed by brown investors: Entrepreneur corrupted - still choose dirty under tax = 95% social cost But should the planner charge tax = 100% social cost to firms?
Brown-only market If only financial investors are present (all investors are brown) What can the social planner do? Charging tax = 100% social cost to firms is “overly” corrective, when firms internalize 5% of social cost This is because we assume entrepreneurs cares to a non-zero degree to start with What should social planners do then? Here we have two market failures, which calls for two corrective policies: Externality <– Pigouvian tax; Financial constraint of firms <- subsidy for larger firm scale
Brown-only market If only financial investors are present (all investors are brown) What can the social planner do? Financial constraint of firms (underinvestment) <- subsidy for larger firm scale Subsidized loan or equity injection
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Brown+green market What if we include socially responsible investors? SR investors Loan contract specifies technology Internalize social cost if it takes up loan SR investors + entrepreneur may or may not fully internalize Even if they (aggregately) care as much as the social external cost (e.g., 5%+95%), what about firm’s profit?
Benchmark Cases What if we include socially responsible investors? If firms can raise fund from brown and green investors Recall the green investor may be Type I: care about the level of social cost that firm produces Type II: care about the social cost of investing in firm, relative to not investing (and firm can get financed by brown investors)
Benchmark Cases What if we include socially responsible investors? If firms can raise fund from brown and green investors If green investors are Type I (care about the level of social cost that firm produces) Green investors cannot extract any financial rent (since market is competitive) Green investors payoff is just the social values (since financial values = 0) Therefore, green investors are strictly optimal NOT to invest in firms that generates ANY social cost. So green investors would NOT invest No impact on firm behaviour, compared to an all-brown-investor market
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Benchmark Cases What if we include socially responsible investors? If firms can raise fund from brown and green investors If green investors are Type II (care about the alternative that firms gets financed by brown investors) “If I don’t invest, they might stay dirty. If I invest, they can reduce social cost.” Then the tech choice would maximize the bilateral surplus (entrepreneur + investor)
Benchmark Cases The optimal financing agreement (with brown and Type II green investors): Green + regular bond: two face values, two prices; green bond contains a tech choice covenant Dual-class share: a fraction of shares with some return and control rights of tech, the rest non-voting Under this optimal agreement If firm would choose dirty tech when only financing from brown investors, green investors can facilitate tech switch if they jointly care sufficiently about SR (e.g., 5%+95%)
Benchmark Cases Complementarity between brown and green (Type II) investors Only when brown is present too, can the switch (and socially optimal result) happen Surprisingly, if only green (Type II) investors are present, they might not decide to participate (take up deal), because the counterfactual is less threatening (no brown investors waiting to finance firm) For the complementarity to work, there must be Underinvestment in clean tech Green investor internalizes social cost relative to counterfactual – the threat of dirty production (enabled by financial investors) act as a quasi asset , generating additional motive to participate Because of this quasi asset, scale of clean tech increases, which is socially valuable
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Benchmark Cases Other results Green investor/fund would suffer a financial loss (cost of making social impact) If green investors + entrepreneur fully account for social cost, imposing Pigouvian tax on top will be welfare decreasing , as production will be discouraged Pigouvian tax + investment/scale subsidy is always first-best, regardless of whether there is green investor in the market or not We discussed the brown-only market With green, the discouraged scale will recover from subsidy
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Additional questions What if this entrepreneur is financed by funds? Can the green fund attract individual investors? Recall financial loss. As if the entrepreneur is trying to obtain finance from multiple green funds/investors Free-rider Problem: One investor may free-ride on other green investors, if non-excludable externality Asymmetric Exposure: Green investors with larger exposure (desire to reduce social cost) may invest more Coordination: requires a sufficiently large endowment (on the green investors) Warm glow: potentially mitigates free-riding
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What if the mandate cannot be enforced Information asymmetry – “allows” greenwashing in model Firms can pledge (on the contract, etc.) but no enforcement/punishment if deviates ex post Whether a firm (borrower) would pursue a green project depends on The borrowing rates Who (brown or green) investors bid first Chang, Dongkyu, Keeyoung Rhee, and Aaron Yoon. "ESG Integration under Asymmetric Information." Available at SSRN 4325281 (2023).
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Information asymmetry Setup: incorporating different probability of success Green project – low prob. of success , some social return Brown project – high prob. of success , zero social return Lender cannot attach a binding covenant, restricting borrower’s decision Firms would always choose the one with lowest repayment terms Other assumptions are the same (brown > green in financial value; green>brown in social value)
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Information asymmetry Results: Firm has the incentive to choose green project if the repayment terms are sufficiently high Intuitions: Firm can effectively lower the total expected repayment cost by shifting risk to the green project, which has a smaller probability of success and thus fulfilling repayment This benefit of lowering the repayment cost increases with the repayment term, incentivizing the firm to choose the green project More importantly, firm endogenously values social return more than financial return from its investment at a high repayment term a large portion of the financial return is to be paid out to the lender
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Information asymmetry However, now the presence of brown lenders deters, rather than incentivizes, green investments Brown lenders are willing to offer a lower repayment term as long as the firm, in response, is believed to choose the brown project that has a smaller financial risk Under the competition with brown lenders, green lenders cannot effectively raise the repayment cost The firm will surely reject any offer with a repayment term higher than that offered by brown lenders, resulting in brown investments
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Information asymmetry Can green investors help? Yes, if green lenders bid to lend first and brown lenders only gets to pick after firm reject all green lenders Then green lenders can help reveal the “type” of borrowers Introducing brown and green borrowers/firms Green lenders can “cleanse” the market, if they (are believed to) finance brown firms first (and take them off market) Brown lenders will expect the left-overs to be green firms (more likely to invest in risky green project) and demand higher repayment terms, which incentivize the borrower (regardless of type) to go green
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Information asymmetry Green lenders can “cleanse” the market, if they finance brown firms first (and take them off market) Brown lenders will expect the left-overs to be green firms (more likely to invest in risky green project) and demand higher repayment terms, which incentivize the borrower (regardless of type) to go green Green lenders think: the leftover borrowers (regardless of type) would face harsh terms in 2 nd round, then the green lender’s optimal strategy is to offer harsh terms to all firms Some firms may take it in the first round, and get incentivized to go green Some may go to 2 nd round, facing equally harsh terms, and incentivized to go green This only works when brown lenders/investors believe the left-overs must be all green Installing this belief is the key
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