The Optimal Design of Green Debt

Abstract

We develop a theory of optimal security design for financing green investments in the presence of greenwashing. Green outcomes are uncertain and can be obtained through the implementation of tangible projects and/or intangible effort-based strategies. When manipulation is not possible, the optimal contract takes the form of an outcome-based security design, similar to a sustainability-linked bond (SLB), with a payoff that is contingent on green outcomes. When manipulation is costless, the optimal contract takes the form of a project-based security design, similar to a green bond (GB), with a payoff that depends on the implementation of green projects. When green outcomes can be manipulated at some cost, the optimal contract is a hybrid which incorporates both an outcome-contingency (like an SLBs) and a project-contingency (like a GB). The model rationalizes several empirical facts.