Bond default and impairment is famously low in the municipal bond market. But the case of Paradise, California, offers an example of the rising financial risks posed by climate and management decisions.
After the town was nearly destroyed in 2018 by California’s deadliest wildfire to date, the state stepped in to help the successor to the Paradise redevelopment agency continue to make twice-annual payments on 2009 bonds that were backed by tax increment revenues.
But the state’s help ended earlier this year, and on June 1 the successor agency reported an unscheduled draw on reserves to cover a payment on its 2009 bonds. Successor agencies manage the obligations redevelopment agencies incurred before the
S&P noted that the town’s management had declined to tap other revenues, like settlement funds utility PG&E paid for causing the fire, to make the payment, a decision that the ratings agency said it considers a risk captured “under our environmental, social and governance factors, which is a key credit driver of the rating action.”
The bond prices, which before the fire hovered around 105 cents on the dollar, had tumbled to a low of 54 the month after the fire, before climbing back up to around the high 90s. After the town reported its unscheduled draw on reserves, the price dropped to 94 cents on the dollar. The upcoming December payment will largely drain the reserve fund, and it’s unclear whether the bonds, some of which go out to 2043, will remain whole.
The fresh risk of the bond default, even years after the fire, is a reminder of why disclosure related to environmental, social and governance factors is
Even the terms of the debate have sparked confusion, with participants urging regulators and standard-setting bodies to
On the labeled bond side, there remains a lack of clear pricing benefit in the tax-exempt primary market regardless of the level of disclosure. But primary market ESG-labeled deals with greater disclosure do attract more investors compared to vanilla bonds, and a slight ‘greenium’ is becoming apparent in the secondary market.
Listen to Barry Fick, Executive Director of the Minnesota Higher Education Facilities Authority, who
On the risk disclosure side, the debate falls into familiar territory: issuers push back against additional mandates and investors and analysts want more than a template paragraph in the official statement.
Despite the disagreements, most in the market agree that regulatory action is on the horizon. The Securities and Exchange Commission and the Municipal Securities Rulemaking Board have dialed up their focus, and the development of some type of standards seems likely.
Enforcing standards
SEC Chair Gary Gensler in March unveiled long-anticipated proposed rules for reliable and relevant ESG-related disclosure for certain companies. The commission lacks any explicit authority to mandate the content of disclosure by muni issuers, but many market participants
The SEC can indirectly impose standards on muni issuers through regulation of underwriters and also through the enforcement of the anti-fraud provisions of the federal securities laws, a tool that could be used to shape a new disclosure regime.
“There’s a pattern of behavior,” said Lisa Washburn, chief credit officer and managing director at Municipal Market Analytics, referring to the SEC’s past enforcement actions on hot-topic issues like pension disclosure or timeliness.
“They have in the past taken some actions to assist the market in understanding what the expectations are,” she said. “If there were an event that impaired — not necessarily a default — the value related to a bond, and that bond issuer either knew of or discussed climate change and didn’t disclose it in their official statement, I could envision a scenario where a similar type of action could take place.”
In June, speaking at the Government Finance Officers Association’s annual conference, the SEC’s OMS Director Dave Sanchez
“When we’re talking about climate risk and general disclosure, this is an area where there’s a lot of noise and discomfort,” Sanchez said. “The point right now is using the same principles you should use for other disclosure; you’re just looking at these like do they have a credit impact, a financial impact on revenues used to pay back the bonds. The rules have not changed, you’re just applying it to a different topic."
What the issuer knows about its ESG risks is a key question as an issuer preps a deal, said Kevin Civale, a shareholder at Stradling Yocca Carlson & Rauth who acts as disclosure and underwriters’ counsel.
Issuers, particularly in Civale’s California-based practice, are well aware of climate risks, he said. But they often lack specific information relating to the impacts, severity or timing of climate change or how they could affect their credit or financial position.
If they lack that information, “federal securities laws don’t require them to speculate,” Civale said. But if they have more specific information — if they have commissioned studies, for example — then “the issuer needs to carefully consider whether more specific climate change disclosure is warranted,” he said.
Familiar tensions
The MSRB in December 2021 issued a
The responses revealed some themes across the market, and many respondents seem to support development of voluntary best practices. The Government Finance Officers Association in 2021 unveiled
The MSRB’s role in developing standards remains unclear, as it lacks authority over issuers and it’s uncertain what the board plans to do — if anything — with the RFI. The MSRB said it
Whatever the MSRB’s actual role is, the 52 responses it received for its RFI illustrates how the ESG debate is part of long-standing tension in the market between investors who would like to see more disclosure and issuers who argue it’s costly and possibly irrelevant.
The State of Utah, leading a coalition of 23 states,
On the other side, Nuveen, one of the market’s largest investors, said in its response that it supports expanded disclosure. “We believe all investors stand to benefit from expanded access to reliable, comparable ESG data from municipal issuers,” the firm said.
Labeled bonds
During his GFOA speech, Sanchez said disclosure issues may be more complicated for bonds that carry an ESG label either by the issuer or a third-party vendor. One of the fastest-growing sectors in the muni market, green, social and sustainability-labeled bonds totaled just under 10% of muni issuance in 2021, for a total of $46.5 billion, according to the Climate Bonds Initiative. That’s up from 5.5% in 2020.
The SEC’s proposed changes to its Names Rule will force muni issuers to conduct further analysis on how their investments are achieving the ESG outcomes they say they are, which may eventually bring some standardization to issuers of ESG-labeled municipal debt.
While any proposal that the Commission puts forward won’t have a direct effect on the municipal bond industry, market participants still believe the proposed amendments will serve as a precedent for proposals the SEC’s Office of Municipal Securities is considering for the future.
The Names Rule was codified into law in 2001, and generally requires that any investment fund whose name suggests a certain type of investment invest at least 80% in that type of asset. The SEC is proposing to expand its 80% requirement to include ESG-related fund names, making it so fund managers are required to provide proof that 80% of the portfolio adheres to its stated methodology.
But the proposal will also touch all those that fund managers deal with, which often include muni bond issuers.
This places more of an impetus on issuers, as they’ll have to provide specific analysis as to how a specific muni bond would fit into a fund.
“Folks that want to be included in those funds, whether that's an equity issue or a bond issue, will need to start identifying, measuring and disclosing the criteria that would qualify them for inclusion in the fund,” said April Hamlin, a partner at Ballard Spahr and co-leader of the firm’s ESG and Agribusiness team. “To me, it's all designed to prevent greenwashing by changing the behavior of those that are promoting investment in ESG or greener or sustainable investments,” Hamlin said. “Whether it's bond funds or equity funds, it's the same consequence.”
The SEC established an ESG Task Force within its enforcement division, with the enforcement of these types of cases its primary objective. The greenwashing cases that group has already brought shines some light on the approach the Commission is hoping to establish. Days before the proposed changes to the Names Rule were introduced, the Commission charged BNY Mellon for misstatements and omissions made about its ESG considerations in investment decisions.
For designated ESG muni bonds, the key disclosure is a discussion of the use of proceeds, said Candace Partridge, CBI’s social and sustainability bond data manager.
Social bonds that finance affordable housing development is an example of how disclosure regularly falls short, Partridge said.
“I usually have at most a paragraph to go off of, it’s usually just one or two sentences, and when you’re doing something like affordable housing, there’s a lot more nuance we need to unpack,” she said, like impact on property values, gentrification or if it will actually help disadvantaged communities.
Green bonds make up nearly 70% of ESG-labeled muni bonds, according to CBI. Meanwhile, the market this year saw its first and only issuance of a so-called sustainability-linked bond, when the Arizona Industrial Development Authority issued $200 million of unrated, taxable, sustainability-linked revenue bonds in February. The financing was on behalf of NewLife Forest Restoration LLC, a wood product manufacturing company, for a forest restoration project. The bonds’ yields are tied to the company’s ability to meet sustainability goals. The 2028 bonds carried 9% coupons and the 2047 bonds had 11% coupons, and the interest rates will rise by 150 basis points or more if the company fails to meet certain sustainability targets, according to the
Despite the growing appetite for ESG-linked bonds, a pricing advantage remains unclear, particularly in the tax-exempt primary market. A clear pricing advantage would help to develop the sector in part because it would cover the increased costs of issuing green bonds, like obtaining certification, Partridge said.
“This is taxpayer money, we all understand that,” she said. “A pricing differential would help because you have to cover the transaction costs somehow.”
Issuers should start simply and view disclosure as an opportunity to tell their story, said Mike Brown, the environmental finance manager for the San Francisco Public Utilities Commission, during a June 16 webinar on green, social and sustainable municipal bond opportunities hosted by the CBI.
“If we’re saying projects are green and making those statements to the investor community, they really need to be green projects,” Brown said. The SFPUC annually discloses project spending as well as project impacts, he said. “There’s a lot of opportunity for U.S. munis, because there are projects that are being financed by the bonds, but often there are other kinds of benefits being accrued to the community,” like new jobs or arts and education outcomes. “It’s an opportunity to showcase all the positive things you’re doing for the community.”
The heterogenous nature of the muni market, with 50,000 issuers of all sizes and resource levels, complicates the landscape, but increasingly, issuers want to step up their disclosure because they realize it’s important, Civale said.
“Issuers very frequently say this is something that our stakeholders care about, and at the end of the day, most folks will do it because they frankly think it’s the right thing to do,” he said.
