Baker, Bergstresser, Serafeim, and Wurgler (2018): U.S. Green Bonds

Why this paper is on the syllabus

If Flammer asks whether green bonds affect what firms actually do, Baker, Bergstresser, Serafeim, and Wurgler ask how green bonds are priced and held in financial markets. That makes this the core asset-pricing paper in the green-instruments lecture and the natural complement to Flammer in our discussion of sustainable debt instruments.

The central issue is whether investors are willing to accept a marginally lower financial return in order to hold environmentally preferable assets. If they are, then green bonds can lower the financing cost of green projects, and private capital markets can support environmental investment through a channel that does not depend on regulation or subsidy.

The question

Do green bonds trade at a price premium relative to otherwise comparable ordinary bonds, and are they held by a distinctive investor clientele?

In yield language, a price premium is equivalent to a lower yield. If some investors derive utility directly from holding green assets, beyond the risk-and-return profile of the bond’s cash flows, they may accept slightly lower yields on green bonds than on otherwise similar conventional bonds. That wedge in yields, if it exists, is the empirical object of interest.

The market and the basic theory

The paper focuses on the U.S. green bond market, with particular attention to municipal green bonds. That focus is deliberate and useful. The municipal market is large, deep, and contains substantial within-issuer variation in bond characteristics, which makes it possible to compare green bonds to ordinary bonds issued by the same type of entity with similar maturity, tax status, and credit quality.

The authors organize the empirical analysis around a simple but powerful theoretical framework. Some investors care only about risk and expected return, as in a standard asset-pricing model. Other investors care about risk and expected return and about the environmental character of the assets they hold. The paper refers to this additional source of value as nonpecuniary utility from holding green assets.

That framework yields two sharp empirical predictions.

First, if green-preferring investors are marginal in the pricing of at least some green bonds, then those bonds should trade at higher prices and therefore lower yields than otherwise comparable ordinary bonds.

Second, green bonds should be held disproportionately by the investors who value the green label, producing measurably higher ownership concentration than is observed for ordinary bonds with similar risk characteristics.

What the authors do

The paper proceeds in three main steps. It first describes the structure of the U.S. green bond market: who issues green bonds, what kinds of projects those bonds finance, and how the market has grown over time.

It then studies pricing in both the primary market, where bonds are first placed with investors, and the secondary market, where they trade subsequently. The authors compare green municipal bonds to ordinary municipal bonds while conditioning on the factors that standard models of municipal yields account for: maturity, tax status, credit rating, issue size, issuer characteristics, and broad market conditions at the time of pricing.

Finally, the paper studies the ownership of these bonds. Using holdings data for insurance companies, mutual funds, and pension funds, the authors test whether green bonds are more concentrated in the portfolios of the kinds of investors who would plausibly value the environmental label, including specialized environmental funds and institutions with stated sustainability mandates.

How the pricing strategy works

The main empirical challenge is that green bonds are not randomly assigned. Issuers who choose to label a bond green may differ systematically from those who do not, and green bonds may differ in purpose, maturity, or risk from the ordinary bonds they are compared to.

The paper addresses this in two ways. First, it conditions on a rich set of bond- and issuer-level controls, including issuer fixed effects where the data allow, so that identification relies on within-issuer variation across bonds with different green status. Second, it makes use of an especially informative subset of cases in which the same issuer places a green bond and an ordinary bond at the same time, in a single bundled issue. Those bundled issues are particularly clean, because they hold the issuer and the market timing fixed by construction and isolate variation in the green label.

The research question is not whether the authors have a perfect experiment. The question is whether, after absorbing the standard determinants of municipal yields, a residual green premium remains, and whether that residual lines up with the predictions of the clientele theory.

How the ownership strategy works

The ownership analysis complements the pricing analysis in a theoretically disciplined way. If the green label truly matters to a subset of investors, green bonds should not only be cheaper for issuers. They should also be held disproportionately by the investors who value them.

The authors measure ownership concentration across institutional investors and test whether it is systematically higher for green bonds than for ordinary bonds with comparable characteristics. The theory predicts especially strong concentration for bonds that are small or nearly riskless, because those are the bonds for which a green-preferring investor can tilt their portfolio toward the green asset without taking on substantial undesired risk or absorbing a large share of the market themselves.

Main findings on pricing

The paper documents a green premium in U.S. municipal bonds. In the main large-sample regressions, after-tax yields at issuance are approximately 5 to 9 basis points lower for green municipal bonds than for otherwise comparable ordinary municipal bonds.

A 5 to 9 basis point wedge is not large in absolute terms, but it is not negligible. On a bond with a duration of roughly ten years, the paper notes that a 5 basis point yield reduction corresponds to approximately a 0.5 percentage point higher bond price. In other words, investors are willing to pay a measurable premium for the green label, and that premium translates into real financing-cost savings for issuers over the life of the bond.

The bundled-issue evidence is also informative. When the same issuer places a green bond and an ordinary bond simultaneously, there is little green premium at the issue date, but a modest premium emerges later in the secondary market. That timing pattern helps the authors separate the roles of initial marketing and placement from subsequent trading in the secondary market, and it suggests that investor preferences for green assets become more sharply reflected in prices as the bonds clear initial distribution.

Main findings on ownership

The ownership results are consistent with the clientele theory. Green bonds are more closely held than ordinary bonds, and the concentration is especially strong for small or nearly riskless green bonds. That pattern fits the prediction that green-preferring investors can most easily tilt their portfolios toward green assets when those assets do not expose them to large residual risk or require them to absorb a disproportionate share of a deep market.

The ownership evidence reinforces the pricing result in an important way. A price premium on its own could in principle reflect many things, including liquidity differences, selection, or measurement issues. A price premium combined with concentrated ownership by a particular investor clientele is the joint pattern the theory predicts, and it is much harder to generate from alternative explanations that do not involve investor preferences for green assets.

The paper also examines the role of certification. A subset of labeled green bonds are certified by third parties and registered with the Climate Bonds Initiative, which imposes standards on project eligibility and use of proceeds. Certification appears to sharpen the market meaning of the label, because it gives investors a stronger basis to believe that the bond is genuinely financing green projects rather than simply being marketed as green.

Why the paper matters

The paper matters because it provides a clean example of how investor preferences can affect asset prices in a setting with a large, liquid market and credible controls. In the standard textbook view, prices reflect only risk and expected cash flows. This paper documents that, in this market, a nonfinancial attribute of the asset also appears to carry pricing weight, consistent with a meaningful clientele of green-preferring investors.

The result has a direct environmental implication. If investors accept modestly lower yields on green bonds, then green projects can be financed at modestly lower cost. The magnitude is not large enough to substitute for climate policy, but it is a real channel through which private capital markets can lower the cost of capital for environmental investment.

The paper is also important because it carefully separates two questions that are often conflated in discussions of green finance. One question is whether investors value green assets and are willing to pay for them. The other question is whether green finance improves real environmental outcomes at the firm or project level. Baker et al. speak primarily to the first question, which is why the paper pairs naturally with Flammer, who focuses on real-side outcomes.

What to focus on when you read

On a first read, keep three ideas clear.

First, understand the theoretical framework. A green premium requires the existence of a clientele of investors who derive nonpecuniary utility from the environmental attribute of the bond, and who are marginal in pricing at least some of the bonds in the sample.

Second, focus on the two empirical predictions and how they interact. Lower yields and more concentrated ownership are the joint signature of a clientele effect, and it is the combination of the two that identifies the mechanism rather than either one alone.

Third, pay attention to certification and market structure. The green label carries more pricing and ownership weight when investors have a credible basis for believing it, and certification through programs such as the Climate Bonds Initiative is the main mechanism through which that credibility is established in the U.S. market.

Terms to know

• Greenium: the lower yield, equivalently the higher price, commanded by a green bond relative to a comparable ordinary bond.
• Nonpecuniary utility: value that investors receive from holding an asset that is not captured in the asset’s financial return, such as utility derived from the environmental attributes of the issue.
• Ownership concentration: the extent to which an asset is held by a relatively narrow set of investors, often measured by the share held by the largest institutional holders.
• Primary market: the market in which a bond is initially placed with investors at issuance.
• Secondary market: the market in which an outstanding bond trades between investors after issuance.
• Certification: third-party verification that a green bond meets a stated standard for project eligibility and use of proceeds, often provided through programs such as the Climate Bonds Initiative.