Social Policy Bonds

Social policy bonds are a financial instrument that seeks to link aspects of the financial market with public policy objectives.

Basically these are bonds, sold by government and freely tradeable on the market, that are redeemable for a fixed price only when some specific policy-related metric is met. The concept has not been put into practice anyhere.

The idea was developed by Ronnie Horesh, a New Zealand economist.

Mini HOWTO on bonds: There are many types of bonds -- coupon bonds, bearer bonds, convertible bonds, etc. For our purposes we'll look at a simple kind of generic bond. Bonds have a face value and a market value. The face value is the amount the issuer states they will pay upon redemption, which is traditionally set at a fixed date. In other words, if I issue a bond I say, "I will pay you $100.00 on April 20th, 2010." It's basically an IOU. The market price is the price people are willing to pay for my promise. If I look like I am good for the money, I may be able to get $80.00 for that promise. If I look like a risky investment, I might only get $20 for the promise. Other factors come into play, such as the length to maturity, i.e. the length of time until the bonds can be redeemed or the buyer's perception of how any given economic trend will affect my ability to pay.

Bonds rarely issued for more than 10 years. (Although the Coca-Cola corporation has issued 100-year bonds.) David Bowie issued bonds against the future royalties of his classic hit songs - and got $55 million dollars out of it.

SPBs are like David Bowie' bonds: a promise of payment against some future event, in this case the achievement of some policy goal set by the government.

How are the bonds valuable? For passive investors, investors who bought the bonds and intend to do nothing other than collect their money at the redemption event, the bonds are only valuable insofar as the goal set forth by the government is met. For another class of investors the bonds can be valuable because they actively undertake action to meet the social policy goal. Another example: Let's say the local government issues 100,000 bonds redeemable for $100 each if the literacy rate in my city increases by 5 percentage points (as measured by some standard technique). So, if literacy rates increase by the desired amount the bonds will be worth $10,000,000. For simplicity's sake let's say I buy all the bonds, and I buy them for $25 each. I have spent $2,500,000 on the bonds. If the literacy rate goes up by the required 5% I will make $7,500,000. I now have an incentive to raise the literacy rate, and to do it as cheaply and effectively as I can. Maybe I can pay the school district to hire several reading tutors, tutors that the district would not ordinarily be able to afford. If I can do that for less than $7,500,000 (the difference between what I paid for the bonds and what they will be worth upon achieving the goal) then I stand to make some money.

In this sense SPBs are different from simple outsourcing. In an outsourcing scenario, the school district would contract with some third party for a set price. Conditions may be included in the contract, but the third party is still getting paid for their work. With SPBs investors don't get paid unless the target is met.

One impediment to the deployment of SPBs is that the desired outcome must first be quantified. For example, government would have to set a price for a five-percent reduction in crime or a ten-percent rise in literacy rates. This kind of quantification is not currently performed. Instead most governments simply allocate money to an agency which is then responsible for some vaguely defined set of duties. One of the key aspects of the SPBs, highlighted by Mr. Horesh, is that "someone other than government employees decide" what actions to take as well as how much to spend. Another benefit is that SPBs spread the efforts at solving a particular policy issue among different groups. In my literacy example above, if I had purchased only half of the bonds and another investor had purchased the other half, the city would have had two independent groups working to help solve the problem. SPBs also cap the government's expenditures with regard to a particular item, and thereby move the risk of losing money from the government to the investors. Often a government agency given money directed at some policy objective is the same agency tasked with measuring the status of the progress toward the policy goal. Another advantage of SPBs is that they could alleviate these potential conflicts of interest.

Mr. Horesh lists five example areas where the bonds could be effective in acheiving improvements by injecting both clarity and financial rewards into the policy area:

  • crime prevention
  • health
  • education
  • employment
  • air, water, or noise pollution

Injecting Incentives Into the Solution of Social and Environmental Problems: Social Policy Bonds
Ronnie Horesh
iUniversity Press
ISBN: 0-595-15374-7