Can environmental bonds manage policy-induced risks?

This paper describes how environmental bonds together with futures markets offer policy instruments for situations where private activity poses risks of large-scale environmental damages. The bond is a contract with an added contingent price to undertake an activity. It is paid only if the activities of the agent paying the bond lead to some specified undesirable outcome in a defined time interval. There is no need to establish fault. If the time interval is long enough and the bond large enough, the requirement can influence who has the resources to undertake the activities covered by this requirement. Futures markets provide contracts that allow these individuals' choices of hedges (through the purchase and sale decisions for these futures) to act as implicit "loans" to those undertaking the risky activity. In addition to reducing these opportunity costs, futures markets provide mechanisms to share risk and serve to create incentives for private enforcement of the public contract underlying the bond.