Voluntary disclosure and adverse selection: Bayesian game theoretical inference for green bond labelling regimes

Abstract

The impact finance market has sought to ‘internalise externalities and adjust risk perceptions’ (G20 Green Finance Study Group, 2016), demonstrating the private sector’s capability in resolving the climate free-rider problem through the ‘greening’ of economic activities, partially bypassing corrective government intervention. As the market continues to develop, however, the voluntary disclosure regime that the market operates under threatens to enforce an adverse selection problem and contribute to a fundamental erosion of confidence in the market segment, constraining the potential of impact finance instruments to effect positive social and environmental change. This paper relates the work of Crawford and Sobel (1982), Milgrom (1981), Verrecchia (1983), Jung and Kwon (1988), Myers and Majluf (1984) to the green bond market and draws inferences to inform recommendations for policy-led solutions aimed at ensuring the alignment of green bonds’ proceeds to the interests of society (desirable outcomes within the scope of the Paris agreement, for example) and upholding the market’s credibility. This paper additionally explores the transplantation of sustainability linker mechanisms into green bond architecture to ensure simultaneous issuer-level alignment.