The green sin: how exchange rate volatility and financial openness affect green premia

We propose a model with mean-variance foreign investors who exhibit a convex disutility associated with brown bond holdings. The model predicts that green bond premia should be smaller in economies with a more closed financial account and highly volatile exchange rates. This happens because foreign intermediaries invest relatively less in those economies, which in turn lowers the marginal disutility of investing in polluting activities. We find strong empirical evidence in favor of this hypothesis using a global bond market dataset. Exchange rate volatility and financial account openness are thus able to explain the higher financing costs of green projects in emerging markets than in advanced economies, especially when green bonds are denominated in local currency: a disadvantage that we can call the 'green sin' of emerging economies.