The rise of Environmental, Social, and Governance (ESG) investing in corporate securities has reached the municipal-bond markets. But recent experience shows that incorporating ESG factors into municipal investing can be a convoluted, quixotic effort.
While ESG encompasses a wide range of factors, it is the “E” that gets the most attention in the municipal bond market, with climate change being a major concern. When thinking about the role of climate change in municipal finance, we can imagine two issues: (1) Does climate change increase the risk of a municipal-bond default for specific issuers?; and (2) can investors choose bonds that finance projects that provide the largest reductions in greenhouse-gas emissions? Let’s consider these two questions in turn.
Climate Change and Default Risk
Unlike corporate equities, municipal bonds offer little financial upside related to global warming. While an equity investor may achieve enormous returns by purchasing shares in a company that invents new green technologies, the best-case scenario for a municipal-bond buyer is the return of principal at par along with interest payments that rarely exceed 5 percent annually.
But investors may be able to avoid the loss of interest and principal if they can predict whether a given municipal issuer is going to be affected by a climate-related disaster such as flooding, fires, or drought. Unfortunately, this isn’t so easy.
Many municipal-bond issuers have authority over large geographic areas only portions of which are subject to climate impacts. Consider, for example, the State of California. Its forests are burning, and may well continue to do so, but most of the vulnerable areas are far away from the coastal cities that generate most of the state’s tax revenue. So a large increase in California forest fires is unlikely to be a significant credit event for the state’s municipal bondholders.
Scientists expect coastal areas to be affected by sea-level rise, but the initial effects in California will likely be confined to areas very close to the Pacific Ocean. Property one mile or more away from the coastline should suffer limited impacts, at least during the life of any given municipal bond, which is generally 30 years or less.
Smaller jurisdictions could be at greater risk from climate change, but even in these cases, the default-risk implications may not be intuitive. In November 2018, a wildfire wiped out the small California city of Paradise, which had issued pension-obligation bonds in conjunction with two other California cities back in 2007. Two months later, Moody’s downgraded the bonds by three notches to Caa3, noting that “the heavy physical, social, and economic damage to the town, will inexorably devastate its financial position, realistically eliminating any short term ability to pay debt service on its share of the bonds, thus rendering a near-term default almost certain.”
But that default did not occur thanks to proceeds from an insurance settlement and the state legislature’s decision to backfill Paradise’s lost property tax receipts, prompting Moody’s to upgrade the bonds by one notch in August 2019. Earlier this year, Moody’s further upgraded the bonds to Ba2 after the town received $270 million from Pacific Gas & Electric, whose power lines were blamed for the conflagration.
The bonds now carry a higher rating than they did prior to the fire, reflecting an informed view that Paradise is now better positioned to perform on its pension obligation bonds than before it burned down.
Of course, these circumstances may not occur after all adverse climate events, but the federal government has shown an increasing propensity to provide aid in the aftermath of major disasters. The takeaway for analysts trying to assess the default-risk implications of environmental factors is that they may have to also perform analysis of intergovernmental aid offsets as well as insurance and litigation payouts to get the full story.
Finally, there is a question of how climate-model results can translate into better-informed opinions about the prospects for asset destruction. For example, the latest report from the Intergovernmental Panel on Climate Change states:
Increasing evaporative demand will expand agricultural and ecological drought and fire weather (particularly in summertime) in Central North America, Western North America and North Central America (from medium to high confidence). Severe wind storms, tropical cyclones, and dust storms in North America are shifting toward more extreme characteristics (medium confidence), and both observations and projections point to strong changes in the seasonal and geographic range of snow and ice conditions in the coming decades (very high confidence).
Converting these generalized predictions into risk assessments for specific geographic areas requires a lot of assumptions, especially for those predictions made with less-than-very-high confidence.
Given uncertainties around the specific impacts of climate change on individual municipal-bond issuers, as well the availability of third-party assistance, it is hard to see how climate-risk analysis can benefit bondholders. Over the past 80 years, general-obligation municipal-bond defaults have been quite rare. Further, the most recent major defaults — notably, those in Detroit and Puerto Rico — have coincided with high levels of debt (including pension debt) and population loss. So, for now, it appears that traditional economic and fiscal analysis is sufficient to protect municipal-bond investors from most defaults.
Encouraging Municipal Climate Investments
Some municipal-bond investors would like to use their assets to fund a robust state and local government response to climate change, while many municipal issuers would like to demonstrate their leadership on climate issues. But with so much demand for municipal securities and near record-low bond yields, it is hard for issuers to reduce interest costs by issuing green bonds.
Whether or not green bonds provide measurable financial benefits, interest in green bond certification is high. Since 2014, local governments in North America have issued over $50 billion in bonds carrying green certifications from the Climate Bonds Initiative, an NGO that publishes sector-specific standards for providing such certifications. CBI does not certify the bonds itself but authorizes third-party verifiers to apply its criteria and provide certifications.
But if an institutional investor buys a portfolio of certified climate bonds, would that institution make a meaningful contribution to combatting climate change? The answer depends on how well the standards are crafted and implemented.
One city with an especially aggressive green-bond program is San Francisco. The controller touts a report from C40 Cities noting that San Francisco has already reduced its greenhouse gas emissions by 36 percent since 1990 (although most of that reduction cannot be attributed to green bonds, which the city only began issuing in 2015).
Certifications notwithstanding, it is far from clear that investing in San Francisco bonds is a great way to combat climate change. One San Francisco certified green bond helped finance the Salesforce Transit Center, a new transportation terminal that recently opened in the city’s downtown. The Series 2019 green bonds helped fund a rooftop park for the center as well as its “train box.”
Although the rooftop park’s trees provide some climate benefits, this is not the case with the train box, which was built to accommodate commuter-rail service from San Jose, as well as California High-Speed Rail. But trains cannot reach the station until a subway tunnel is constructed between the Salesforce Transit Center and the current terminus at the Caltrain station.
Only 1.4 miles separate the two locations, but the subway project has yet to be funded. Transit officials will have to pull together $6 billion to build the line and make associated improvements. Even if the bipartisan infrastructure bill is signed into law, San Francisco will have to compete with other communities for the federal share of this funding package. And, even once funding is identified, it could take a decade or more to start service. Even the transit advocates at Streetsblog project a start date of “sometime after 2032.”
So bond funding of the train box will not result in any transit service for at least thirteen years from the date of issuance, if it ever does. Even then, it is not clear that many train passengers will use the new station, given the transition to work-from-home now occurring in the Bay Area and nationally. Further, train ridership overstates the climate benefit to the extent that riders switch to the train from walking or other transit alternatives. Right now, passengers alighting at the Caltrain terminus often board a light rail train that connects to downtown.
Building a train station in San Francisco without connecting track in hopes that it will attract a subway line and passengers ditching their cars to use it does not seem like the most efficient way of using bond proceeds to reduce greenhouse gas emissions. But investors relying on climate bond certifications would not know that.
In addition to the certifications, several rating agencies and analytics firms are assigning ESG ratings and scores to municipal-bond issuers and their debt securities. Much of this analysis is proprietary and thus not readily available for analysis. But a recent Standard and Poor’s analysis of a San Francisco green-bond offering for additional transit upgrades does not address ridership impacts, let alone estimate the number of car trips displaced or carbon emission reductions.
At this stage, municipal ESG analysis is relatively new. But it looks like it will have to go a long evolution before it can provide meaningful guidance to investors hoping to fight climate change in the most cost-effective manner.
For now, municipal investors seem best served by pursuing strategies that maximize their risk-adjusted returns, employing traditional credit analysis. While it is theoretically possible to achieve better financial and environmental results by incorporating ESG factors, real-world benefits are likely to be elusive given the incomplete amount of available information.
A version of this column previously appeared in National Review Capital Matters.