In 2017, the EFC wrote about an exciting new financial instrument: the Environmental Impact Bond (EIB). At the time of the original blog post, EIBs were mostly theoretical, the only one in existence being issued by DC Water, but still very early in the process. Modeled after the Social Impact Bond, an EIB was novel and intriguing. Today, EIBs remain exciting, but more of them are beginning to surface. EIBs are tied to a group, Quantified Ventures, that structures the bond and has been pushing the ball forward.
The first EIB, issued by DC Water, aimed to address combined sewer overflows (CSOs) and a consent decree by utilizing green infrastructure, instead of the traditional gray infrastructure. The EIB allowed DC Water to share the risk of an unconventional project with impact investors, in this case Goldman Sachs and the Calvert Foundation. This works through a “pay for success” model, which creates a performance payout system that aligns the interest of the utility/municipality with that of the investors. The EIB creates a situation where otherwise risk-averse local governments can think outside the (gray infrastructure) box.
How does an EIB work?
There are a few key components of an EIB that separate it from a traditional, tax-free, municipal bond. Project size, outcomes-based payouts, impact investment, risk-sharing, and co-benefits are just a few components of this innovative financing mechanism; all of which are detailed below.
Project Size: It needs to be a big (>$5 Million) project.
To put it bluntly, an EIB needs to finance a large project or a series of smaller projects that are equally costly. The costs to structure an EIB cannot be lumped into the total cost of the bond (yet), so EIBs require a third party (think the Walton Foundation, McKnight Foundation, or Chesapeake Bay Foundation) to fund the structuring costs. Because EIBs are very case specific, structuring the bond is typically time-intensive and costly. Under current design and market conditions, small projects are just not feasible.
Outcomes-Based Payouts: If the project overperforms, everyone “wins.”
The “effective interest rate” of the bond is directly tied to the performance of the project. Say, for example, that outcome is flow through a combined sewer system. To start, a baseline flow would be established, normalizing for weather and other variables. Then, some statistical modeling is used to establish a curve of potential outcomes (in this case, flow through the combined sewer) based on the installment.
Based on this curve, the tiers of performance are set. In the case of DC Water, there are three performance tiers. If the project underperforms (Performance Tier 3) and reduces less than 18.6% of flow, the investors pay a $3.3 million “risk share payment” to DC water. If the project meets the base case performance (Performance Tier 2), no performance payouts are made. If it over performs (Performance Tier 1) and reduces greater than 41.6% of flow, DC Water pays the investors a $3.3 million “outcome payment.” This is with the understanding that if this project overperforms, the utility will likely save money in the long-term.
While the labeling of this payment differs to reflect the benefit to the local government/utility based on project performance, the payment amount and structuring remains the same. These three tiers establish three “effective interest rates.” In many cases, Performance Tier 2 (the most common outcome; think middle of the bell curve) has an effective interest rate that matches the market rate.
Impact Investment: There’s a pool of money out there for projects that create measurable change.
This one doesn’t involve much explanation. In many cases, there are large investment firms looking to invest in projects with environmental, social, or governance improvement goals. Investors want to invest in things that have an impact and provide a financial return. EIBs provide an avenue to meet these goals, and provide positive press for all parties along the way.
Risk-Sharing: Innovation does not have to be a scary, costly word.
In many cases, innovation is a gamble. Green infrastructure installments, though rich in intrinsic benefits to the community, are often challenging to evaluate. In some cases, they just do not work, or the measurement technique makes it impossible to tell if the project is achieving the designed goal. Quantified Ventures aims to eliminate that measurement challenge by establishing a desired outcome, as explained above, and sharing the risk through performance-based payouts. This risk-sharing is what encourages local governments to take the gamble and try innovation.
Co-Benefits: Why stop at addressing water quality and flooding when an EIB can do so much more?
Many EIBs accomplish other goals on the path to installing natural infrastructure. In some cases, they introduce green space to new areas. In other cases, they provide work force development.
Are there other examples?
Yes. Since the DC Water EIB, Quantified Ventures has structured EIBs with many other municipalities and utilities including Atlanta and Baltimore. Quantified Ventures is also currently working with Memphis, New Orleans, Buffalo, and Hampton, VA, among others, to figure out to make an EIB “work” for their communities and reach necessary environmental service goals.
The Atlanta EIB is particularly exciting as it aims to address water quality and water quantity challenges in historic neighborhoods around Proctor Creek, known as a prominent location during the Civil Rights movement. The neighborhood is downstream from downtown Atlanta, and due to rapid urbanization, Proctor Creek is essentially a funnel of all downtown runoff, causing chronic flooding, property damage, and water quality challenges. The Atlanta Department of Watershed Management has worked to address some of these challenges in the past, largely with gray infrastructure.
Despite these efforts, many challenges remained—not the least of which were the public health and environmental justice challenges of immense run-off-based flooding in economically distressed neighborhoods. Additionally, the neighborhoods lacked dedicated green space. An EIB could be the ticket to addressing the entire package of challenges. Additionally, it provided an opportunity for workforce development for green infrastructure installments.
For the finance-minded, perhaps the most exciting aspect of this EIB is the fact that it was the first publicly issued bond of its kind. Atlanta’s high bond rating and the desire to innovate drove the public issuance, and it sets the stage for future EIBs.
The other EIBs in action provide different, innovative ways to address flooding and water quality challenges. The New Orleans EIB, which remains in very early stages of development, will use a portion of the funding to capitalize a low-interest “green mortgage” program through the Finance Authority of New Orleans (FANO). These green mortgages will help fund stormwater installments and energy efficiency programs across the public and private sectors—bridging the public/private hurdle often experienced with stormwater management.
Looking Forward
Could this tool be the solution to financing “risky” green infrastructure? Unfortunately, it is still too soon to tell. The DC Water EIB will release its evaluation in 2021, providing the first glance into to how the total cost and efficacy of the project shook out. Either way, it is an exciting tool that provides opportunity for innovation.
In the case of low-lying areas, like New Orleans, gray infrastructure cannot be the only way forward. EIBs provide an avenue for trying something new without the risk of losing it all in the process.
For more information on existing EIBs, visit: https://www.quantifiedventures.com/case-studies
Austin Thompson joined the EFC at UNC in 2018 as a project director. In this role, she conducts applied research and provides technical assistance and training for environmental service providers. Thompson holds a BS in Biological Sciences from the University of South Carolina and a Master’s of Environmental Management from Duke University, with a concentration in Environmental Economics and Policy.
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