Limits to environmental bonds

Abstract

Bonds have recently been promoted as an alternative tool to control environmental damages, particularly in those instances when the innovative activities of a firm have uncertain future impacts. Under this mechanism, a firm would post a bond ex ante, forfeiting all or a portion of the bond if its activities harmed environmental resources. While the benefits of bonds have been developed, there has been little systematic effort to explore their limitations. In contrast, the labor literature has extensively studied the limits of bonds as a mechanism to prevent worker shirking. Using insights from this parallel problem, this paper explores the limits to environmental bonds, focusing on the problems of moral hazard, liquidity constraints, and legal restrictions. Each limit offers a challenge to the success of environmental bonds. We explore the use of bonds in surface mining and agricultural nonpoint pollution as motivating examples. We also consider how other incentive schemes suggested by the labor literature might prove useful in the context of environmental management. We consider the labor mechanisms of efficiency wages, increasing wage profiles, trust funds, and rank-order tournaments.