ESG affects 7% of U.S. public finance ratings

BY SourceMedia | MUNICIPAL | 05/17/22 12:55 PM EDT By Connor Hussey

Environmental, social, and governance factors do not impact the vast majority of Fitch Ratings' U.S. public finance ratings.

That?s according to a recent analysis by Fitch that analyzed how ESG risks are intertwined with credit risks.

?We're just trying to provide some transparency to investors on where ESG risks are also relevant to the credit profile,? said Arlene Bohner, managing director and head of US public finance at Fitch Ratings. ?These are observations on existing ratings, they're not scores on ESG performance,? she added. ?They don't change the way we assign our credit ratings, or what level of credit rating we assign.?

Many market participants have expressed discomfort at the level of attention and legislative priority that ESG considerations have received in recent years.

Fitch rates each issuer on a 1 to 5 scale, with 1 and 2 having no impact on credit; 3 is low impact, 4 is medium impact and a 5 would have a high impact on credit. A score of 1 would mean ESG is irrelevant to the transaction, program ratings and sector whereas a 2 would be relevant to the sector.

A score of 3 is where ESG is minimally relevant to ratings, or actively mitigated where the results have no impact on the transaction or program rating. A 4 would be where it is relevant to the transaction, not a key ratings driver but still has an impact on the ratings and 5 is where ESG considerations are highly relevant and have a significant impact on the issuer.

The report looked at 12 individual issuers as case studies as to how Fitch determines a 4 or 5 rating on its ESG Relevance Scores. While not every ESG factor affects every issuer, governance factors affect public finance ratings the most.

Governance is the single most important ESG factor in U.S. public finance ratings, given the impact of governance structure, Fitch said. But even then, governance is assessed to have a medium or high relevance for just 3% of issuer ratings and social factors and environmental considerations influence just 2% of ratings.

The report divides its ESG Relevance Scores into sectors, highlighting that the percentage of issuers with a score of 4 or 5 is 3.9% for tax-supported, 9.8% for public power/water and sewer, 4.3% for healthcare, 4.6% in education, nonprofit and revenue master and 56.5% for community development and social lending.

?The range of environmental factors? effect on USPF rating decisions continues to expand reflecting in part the broad financial and capital effects of physical climate events,? the report said.

The report chose to highlight San Antonio (Texas) City Public Service, which maintains a score of 4 due to its exposure to environmental impacts. Fitch demostrated that this score isn?t just from a perceived weakness in San Antonio?s public power, but a response to weakened operating cost flexibility exhibited during winter storms in February 2021.

?The systematic failure of the regional organized market to supply sufficient energy resulted in widespread blackouts across the region,? the report said. ?This weakness, together with the uncertainty of CPS?s future leveraging to recover remaining costs associated with the winter storm, contribute to the Negative Rating Outlook on CPS?s long-term rating of ?AA-?.?

An example of an issuer with an even higher exposure to environmental considerations is the North Slope Borough of Alaska, which has a score of 5 due to Biodiversity and Natural Resources Management. It?s top 10 taxpayers are all energy companies, Fitch said.

Fitch noted North Slope's limited economic horizons outside of oil production, despite its otherwise positive financial position.

?Continued exploration of oil fields across the borough and large gas reserves on the North Slope suggest that energy extraction activity will continue at a significant level for the foreseeable future despite market volatility,? the report said. ?Although the borough's harsh climate is likely to support only a very limited economy in the era following energy production, the borough?s over $1 billion permanent fund as of June 30, 2021 combined with $155 million unrestricted general fund balance, supports financial resilience.?

An issuer impacted on the social side is the Metropolitan Transportation Authority in New York, which maintains a score of 4 because its labor relations and practices reflect a history of labor-related spending pressures, which include costs derived from fringe benefits for existing and retired employees.

?While the MTA has consistently provided near-term solutions to its budgetary challenges via a combination of fare increases, cost saving programs and nonrecurring measures, it has been unable to achieve meaningful labor reforms that could have provided more flexibility to address its fiscal stresses, including large out-year structural budget gaps.?

The City of Santa Cruz (California) also scored a 4 due to Human Rights, Community Relations and Access and Affordability due to its potential for the City?s leverage to reach higher ?than currently contemplated,? due to uncertainty concerning drought, capital plan execution and unit cost escalation.

Governance issues are most prevalent for issuers, Fitch said, as 5 of its 12 case studies are dedicated to this.

The Los Angeles Department of Water and Sewer earned a 4 for its governance structure, due to its ongoing investigation with the Department of Justice and David Wright, former general manager of LADWP?s guilty plea to one count of bribery at the end of last year.

Those with governance factors that scored a 5 include Yoakum Independent School District in Texas, due to its proximity to Eagle Ford Shale, one of the most actively drilled targets for unconventional oil and gas in the U.S., in addition to Reedy Creek Improvement District in Florida, due to the passage of a bill that would eliminate special districts, including the one that encompasses the Walt Disney World Resort.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.