The tax-exempt market has been relatively slow to jump on the environmental, social and governance (ESG) bandwagon as market participants continue to search for a standard analytical approach.
So far, the institutional buy-side has been leading the charge into sustainable investing, leaving bond underwriters and issuers scratching their heads as to how to best respond.
The lack of industry consensus has also opened the door to accusations the ESG rating process is inherently biased against conservative values. Herein, we argue that successful integration of ESG factors into the municipal market critically depends on the clear distinction between "risk" and "impact" factors, and on a clear understanding of the fragmented, bespoke nature of our market.
We believe issuers and public finance professionals should focus primarily on risk factors, especially environmental risk and governance risk, arguably the least controversial (read: non-politicized) components of ESG, and leave "impact" considerations to the buy-side.
Further, the risk assessment framework should be tailored to each sector of the market and to the various types of issuers that have access to tax-exempt financing.
Distinguish between 'risk' and 'impact' factors
The problem with an umbrella term like ESG is that it means different things to different people and thus lends itself to misinterpretation and outright distortion. For one reason or another, politicians from conservative states have seized upon the ESG concept as proof that the rating process is inherently biased toward "liberal" values.
West Virginia, for instance, doesn't want its credit rating to suffer from the inescapable decline of coal as a fuel source. Yet, throughout the history of the municipal market, states whose economies have been dependent on the volatile fossil fuel industry, have at one time or another paid the price in terms of cost of capital.
You may recall that the oil bust in Texas back in the 1980s devastated the Lone Star State's single-family housing sector, with bonds trading at just cents on the dollar.
To sidestep any political minefield related to ESG as a general concept, municipal market participants must always make a clear distinction between the risk aspect and the impact aspect of ESG.
Risk factors should be based on objective data and not on anyone's cultural values.
Impact factors, on the other hand, are entirely values-based and therefore defy objective scoring.
That's why we believe our industry should coalesce around objective measures of ESG risk and leave the impact considerations to the investors and their proxies. Buy-side participants should welcome this as they structure impact strategies to match their clients' needs.
Based on my four decades of experience as a municipal credit specialist, I can readily attest that environmental risk and governance risk factors have always been part of traditional municipal credit analysis, along with socio-economic factors. They have just taken on greater prominence in recent years due to the rising fiscal impact of climate-related events and the advent of new technology-related threats, such as cybersecurity.
Disclosure of ESG-related risk factors is certainly a topic that is still evolving in the municipal market, even as market participants await clear guidance from the Securities and Exchange Commission, through the Municipal Securities Rulemaking Board.
The regulatory board has already made it clear it considers any risk factor considered material by investors, whether ESG-related or not, to be within the purview of existing risk disclosure guidelines established by the SEC. Materiality is determined by the investor, not by the issuer.
When it comes to impact, in contrast to private corporate entities, traditional municipal issuers are already tasked with public service. Therefore, in our opinion, impact considerations in most cases really boil down to assessing how well municipal bond issuers are fulfilling their public service mission.
Take into account the diversity of municipal market issuers
Bespoke is a word that is often used (and abused) by market participants to describe the diverse and fragmented nature of the tax-exempt market, consisting of as many as 40,000 or so distinct obligors. Municipal investors routinely deal with not one, but 50 state markets and several territorial markets, each with its own unique characteristics and legal twists.
Within each of these sub-sovereign markets, one can find a wide variety of credit structures, ranging from fairly straightforward, traditional full faith and credit pledges to convoluted securitization schemes.
Last but not least, the type of issuers that can access tax-exempt financing goes well beyond the typical state and local governmental entities and their component units, and sometimes involve private corporate entities.
The recognition that our market is not monolithic is a key step toward successful integration of ESG factors, in our view. For instance, ESG considerations should apply fully to traditional state and local governments (and their agencies and enterprises), as well as to not-for-profit healthcare and private higher education institutions.
Municipal utilities that are accounted for as enterprise funds, along with dedicated or securitized revenue structures should assume the ESG characteristics of their primary governments. A Joint Action Agency's ESG score should be a "roll-up" of the underlying members' ESG scores.
The list above is only meant to be a conversation starter, of course, as many types of tax-exempt bond issuers don't lend themselves to easy categorization. Whether ESG risk factors apply to many of them continues to be a subject of active debate and we would certainly welcome your feedback on this subject.
What about labeled bonds?
Given the current regulatory crackdown against "greenwashing" in other markets, our industry would be best served by adopting a more disciplined approach to labeled bonds, which include "green", "social" and "sustainable" bonds. Certification by a third-party verifier is helpful, but it must be accompanied by an ongoing, genuine commitment on the issuer's part to achieve a clearly documented set of goals.
We find that ongoing commitment to be lacking in many "green bond" deals, perhaps out of fear of potential liability. If the bond label is only valid as of the date of issuance and no assurance is given that it will stick for the life of the bonds, is it any wonder the market has not assigned any significant "greenium" to most labeled deals?
Therein lies the rub, as Shakespeare would say. Investors won't pay up for the green label (i.e. through lower yields) if they see no serious commitment on the part of the issuer, and the issuer won't commit ongoing resources to the effort if they don't get any pricing benefit from it!
Ideally, any labeled bond issue should be viewed in the context of the issuer's overall ESG profile. Labeled bonds issued by an issuer that already has a demonstrated commitment to sustainability goals should logically trade better than those issued by an entity that has adopted a more casual approach.
In an ideal world — and yes, we're still a long way from it — an issuer's first priority would be to clearly identify the environmental and social issues facing it, based on objective data points and not on a vague, one-size-fits-all narrative. It would then communicate to investors how it plans to address those specific issues, on an ongoing and consistent basis.
Lastly, it would issue labeled bonds whose use-of-proceeds targets would match the environmental and social concerns it has previously identified. The bond label should also have some teeth to it, in the sense that it comes with a serious commitment to maintain the green status over the life of the bonds.
It's hard to believe that an issuer which checks all the above boxes would not be rewarded by market participants with a lower cost of capital and improved liquidity for its bonds.
Goodbye 'ESG,' hello 'E,' 'S' and 'G'
In a way, the municipal market's lagging response to ESG concerns may, for once, turn out to be a good thing: we are now in a position to learn from the experience of other asset classes and avoid the early pitfalls that have inevitably arisen.
Is ESG relevant to U.S. public finance? Absolutely.
There's no doubt that municipal issuers are on the frontline of the fight against climate change, for they are already responsible for implementing many of the potential solutions designed to reduce our carbon footprint and to mitigate the impact of natural hazards.
In fact, it may be beneficial for our industry to steer clear of vague buzzwords such as ESG, which lend themselves to distortion and misunderstanding, and really focus on the specific risks that our bond issuers are currently facing, e.g. climate change, shortage of affordable housing, cybersecurity etc.
In time, many issuers will come to realize the "new" ESG focus is really nothing new. It's really something they've been doing all along and they just need to communicate this to the market in a consistent and thoughtful manner, backed by objective data.
