On the corporate use of green bonds

• Author: Mark Bagnoli,Susan G. Watts
• Published date: 01 January 2020
• Date: 01 January 2020
• DOI: http://doi.org/10.1111/jems.12331

J Econ Manage Strat. 2020;29:187–209. wileyonlinelibrary.com/journal/jems © 2019 Wiley Periodicals, Inc.

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187

Received: 5 January 2019

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Revised: 27 June 2019

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Accepted: 25 September 2019

DOI: 10.1111/jems.12331

ORIGINAL ARTICLE

On the corporate use of green bonds

Mark Bagnoli

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Susan G. Watts

Department of Management, Krannert

Graduate School of Management, Purdue

University, West Lafayette, Indiana

Correspondence

Mark Bagnoli, Department of

Management, Krannert Graduate School

of Management, Purdue University, West

Lafayette, IN 47906.

Email: mbagnoli@purdue.edu

Abstract

When do wholesalers issue green bonds to finance their socially responsible

activities instead of charging a premium for the products they produce? We

show that in less competitive retail markets when retailers can “skim”more of

the premium that end consumers pay for socially responsible products, green

bonds provide additional funds to help cover the cost of a wholesaler’s socially

responsible activities. Similar incentives arise if the wholesaler’s input is a small

component of the end consumers’product, or if it is difficult for end consumers

to identify the wholesaler’s socially responsible activities.

KEYWORDS

corporate social responsibility, green bonds, intermediate good producer, retail competition

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INTRODUCTION

Many studies explore the financial benefits from selling socially responsible products (SRPs) or linking the sale of a

firm’s product(s) to its socially responsible activities (see, e.g., Bagnoli & Watts, 2003; Baron, 2001; Besley & Ghatak,

2007 and the surveys by Lyon & Maxwell, 2008; Orlitzky, Siegel, & Waldman, 2011).

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The basic idea is that a firm may

find it profitable to sell SRPs when consumers are willing to support the firm's socially responsible activities by paying

more for its product. With the recent development of a reasonably liquid market for (what are generically referred to as)

green bonds—and with it, the development of Green Bond Principles, the Climate Bond Initiative and the creation of

green bond indices and exchange‐traded funds, firms have begun to access capital markets by issuing these new debt

instruments.

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Green bonds are standard bonds with a key difference: the proceeds from the issue are contractually

pledged to fund the firm’s socially responsible activities.

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They are usually issued at a premium which allows the issuer

to collect some of society’s willignesses to contribute to socially responsible activities.

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Using equity‐type securities,

which would also need to be purchased at a premium, is more problematic because the buyers would find it difficult or

impossible to ensure that the funds are used for the issuer’s socially responsible activities unless they have voting

control of the firm.

We develop a model that offers initial insights into the optimality of issuing green bonds. The model focuses on

wholesalers, firms that do not sell directly to end consumers, to improve our understanding how such firms garner

financial support for their socially responsible activities. We focus on these “upstream”or intermediate good producers

(wholesalers) because it is more difficult for them to capture the financial benefits of selling SRPs. That is, the part of

the premium consumers pay for the SRP that flows to the wholesaler may not be sufficient to warrant the wholesaler

engaging in socially responsible activities. In such cases, contributions made by paying a premium for the firm's green

bonds may allow it to collect sufficient payments to profitably engage in these activities.

In our model, a wholesaler first decides whether to offer a socially responsible input or not (an SR input or an nSR

input) and, if it offers the SR input, whether to finance the SR input’s fixed production costs with green bonds. The

wholesaler then chooses the price it charges retailers for the input. The retailers use the wholesaler’s input and other

inputs to produce the product sold to end consumers. If the wholesaler chooses to sell the SR input to retailers, they use

it to make the product they sell socially responsible.

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We solve for the wholesaler’s equilibrium profits in each case

(when it sells the SR input and issues green bonds, when it sells the SR input but does not issue green bonds, and when

it sells the nSR input) and develop conditions under which the wholesaler chooses to sell the SR input and when it

chooses to finance its production using green bonds.

Our analysis highlights the key forces that (a) impact the wholesaler’s ability to profitably fund its socially

responsible activities and (b) motivate the wholesaler to finance using green bonds. One key force that affects the

wholesaler’s ability to extract profits from sale of the SR input is the magnitude of the double‐marginalization problem.

A less competitive retail market allows retailers to “skim”more of the extra profits generated by consumers’

contributions to fund the wholesaler’s socially responsible activities. The more competitive the retail market is, the

greater the profits the wholesaler extracts.

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Interestingly, for moderate levels of competitiveness in the retail market, the

wholesaler’s ability to capture contributions from the retail market is greater but still insufficient to warrant producing

the SR input. However, because the wholesaler captures a relatively small share of the contributions from the product

market, it now finds it optimal to divert some of the contributions from the purchase of the SRP to the purchase of

green bonds. Thus, with more competition, the wholesaler shifts from selling the nSR input to selling the SR input and

issuing green bonds. With even more competition, the wholesaler’s ability to capture contributions from the retail

market rises until diversion becomes the less profitable option. At that point, the wholesaler switches from issuing to

not issuing green bonds.

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This feature of equilibrium is common in the most important cases we study. For example, as the SR input becomes

more important in the production of the SRP, the wholesaler switches from selling the nSR input to selling the SR input

and issuing green bonds, and as the SR input becomes even more important to the production of the SRP, the

wholesaler switches to not issuing green bonds. Intuitively, when the wholesaler’s input is a small component of the

retail products’marginal costs, the wholesaler finds it difficult to extract a sufficient portion of the end consumers’

contributions to warrant selling the SR input. As the input’s importance grows, the wholesaler is able to extract more of

their contributions but finds it optimal to divert some of the contributions to the purchase of green bonds. As the input

becomes even more important, the wholesaler finds it is able to extract more contributions from the retail market and,

at some point, diverting contributions to the purchase of green bonds is less profitable than having the consumers buy

(i.e., contribute) in the retail market. The same pattern and intuition holds as the wholesaler’s socially responsible

activities become more visible to the end consumers.

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We also show that when end consumers are willing to contribute more to the socially responsible activity, the

equilibrium changes from the wholesaler selling the nSR input to selling the SR input and issuing green bonds. For

even larger values, the wholesaler switches to selling the SR input without issuing green bonds. Intuitively, if end

consumers are only willing to make small contributions, it does not pay the wholesaler to engage in socially responsible

activities. For intermediate willingness to contribute, the wholesaler finds it optimal to capture some of their

contributions directly through the sale of green bonds and some indirectly through the sale of the product the end

consumers purchase. Finally, if their willingness to contribute is even larger, the losses from diverting contributions

from the purchase of the end product to buying green bonds rise until it is no longer worthwhile and the wholesaler

stops issuing green bonds.

Thus, in the extremes, the wholesaler sells either the nSR input or the SR input without issuing green bonds. It is in

the intermediate cases where the benefits from issuing green bonds at a premium offer the wholesaler the opportunity

to supplement the funding of its socially responsible activities (see Figure 1). There are two exceptions to this general

pattern. First, if the premium and other benefits that accrue to issuing green bonds increases, it is strictly more likely

that the wholesaler issues green bonds. Second, if the fixed costs of producing the socially responsible input increase,

the wholesaler is strictly less likely to sell the socially responsible input.

Our results offer insights into some of the financing choices we observe in practice. For example, our model suggests

that the growing importance of clean and/or sustainable energy sources to consumers should lead to issuing green

bonds and may help to explain why sustainable energy projects were among the first to be financed using green bonds.

Similarly, the extreme visibility and importance (to end consumers) of organic farming suggest why wholesalers capture

contributions in the retail market only rather than using the green bond market to help finance their socially

responsible activities.

Our analysis of the importance of the SR input in the production of the product purchased by end consumers may

also help explain the differential market responses to the use of conflict diamonds and conflict minerals. Specifically,

because conflict minerals are a very small part of the cost of producing electronics, our results suggest that it is unlikely

that the wholesaler can capture a sufficient share of the end consumers’contributions to allow it to voluntarily provide

conflict‐free minerals profitably. In contrast, because conflict diamonds are a large part of the production technology for

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