By their nature, entities that issue in the municipal bond market have substantial positive environmental and social impacts that make them ideal for investors seeking ESG investment opportunities. Municipal asset managers who are aware of this fit are increasingly touting their ESG capabilities; although these claims are often confusing as they conflate ESG credit risks with ESG impacts. This lack of focus, as well as the general lack of ESG disclosure in the municipal market, lead us to believe that this initial push is driven by marketing initiatives, rather than analytically honest ESG scoring. Within this environment, we question those offering municipal ESG funds who claim that they are materially different in terms of ESG impact from other, non-ESG-labelled municipal bond funds.
Measuring the Municipal ESG Market
As fixed income investors focus on climate risks and social inequality, ESG-related bond issuance has seen record growth in recent years. Comprised of government and not-for-profit issuers with a mission driven approach to operations, the municipal bond sector would seem a natural fit for ESG investing. Nevertheless, the number of municipal bond funds designated as impact funds is currently just a fraction of the overall ESG market. While there are now 16 municipal bond funds encompassing $2.2 billion in assets designated as impact funds, this is just a fraction of the 86 funds encompassing $90.4 billion in assets designated as impact funds in the non-municipal fund universe (Figure 1).
Muni ESG Funds Comprise a Fraction of Overall ESG Universe
Morningstar as of January 31, 2022.
However, this is beginning to change as shown by the volume of municipal bonds issued with an ESG designation, which has grown by more than 750% over the last 10 years (Figure 2).
ESG Muni Bond Issuance has Grown Over Time
Bloomberg, Barclays as of December 31, 2021.
Separating ESG Risk from ESG Impact
Although ESG risks are not new, they continue to attract heightened attention given the effects of climate change and social inequities. These credit concerns are captured by the internal credit rating we assign to every bond as part of the relative value assessment undertaken before every investment and include:
- physical risks, such as climate change-related fires, floods, and droughts, which affect an issuer’s operations;
- capital budget/leverage risks related to the need to finance adaptation projects, such as sea wall construction or airport relocations;
- transition risks to economies currently dependent on fossil fuels or utilities powered by fossil fuels;
- and demographic risks that affect future revenue generating potential and service needs
Measuring ESG Impact
By contrast, ESG impacts measure an issuer’s effect on the environment and society, regardless of whether it is credit material, and we assign a separate ESG Impact Rating to every investment. These ratings assess an issuer’s policy- and mission-driven decisions and the degree to which those decisions minimize an issuer’s negative environmental and social impacts and contribute to positive impacts.
Our proprietary ESG impact ratings are a key tool in our ESG-oriented strategies, which seek to generate positive environmental and societal outcomes. For corporate credits, ESG impact ratings are determined based on an analysis of Key Performance Indicators tailored to each industry, using data provided by a number of third-party sources.
To provide sufficient granularity, we assign ESG impact scores on a scale of zero to 100, although these are broadly divided into five categories (Figure 3):
Five Categories of ESG Impact Scores
PGIM Fixed Income. The above information is shown for illustrative purposes only. ESG ratings are subject to change without notice. Please see the Notice for additional disclosures.
As we do for all fixed income investments, PGIM Fixed Income municipal analysts assign ESG Impact Ratings, which measure environmental and social impacts and the degree to which these are impeded or supported by governance considerations. Assessments are derived using information that is available through the Electronic Municipal Market Access (EMMA) system to ensure a consistent basis for measurement. Not surprisingly, given the strong alignment of municipal issuers’ missions with ESG goals, ESG Impact Ratings for municipal bonds are clustered in the upper end of this scale.
Notably, the weighted average ESG Impact Rating on our representative national municipal bond portfolio is 67.7; investments in this fund are not subject to any minimum ESG Impact Rating threshold. This score is higher than the average ESG Impact Rating of 60.4 for our global corporate ESG bond portfolio, which does limit investments to meet client ESG objectives.1 This comparison illustrates the viability of municipal bonds as an attractive option for investors seeking an investment strategy that generates positive environmental and societal outcomes.
ESG Data and Municipal Credits
We seek to apply the same approach used for corporate credits when assigning ESG impact scores to municipal credits. However, we are limited by the ESG data that is available and frustrated by issuers’ and investors’ tendency to conflate ESG Risk with ESG Impact. Limited disclosure by municipal issuers restrains our ability to apply our methodology beyond a certain number of factors.
Additionally, when looking at a handful of municipal issuers that have issued both “green” certified and “non-green” certified bonds, there is effectively no premium for investing in municipal “green” bonds, which would be an indicator of higher demand. By comparison, investment grade ESG corporate bonds priced 2.4 bps tighter on average in the primary market compared to non-ESG bonds over the last four years, and we expect to see this differential to increase over time.2
To be sure, municipal market participants increasingly acknowledge the need for more robust ESG-related disclosure, and its availability is growing. However, it tends to be primarily related to ESG risk disclosure provided by rating agencies, issuers, and third-party vendors dedicated to ESG investing. As only a subset of ESG impacts tend to be immediately credit material, these data fail to give a full picture of an issuer’s ESG impact profile. The few that are focused on municipal ESG Impact concentrate on specific sectors rather than the broad municipal market.
Without the benefit of more robust ESG disclosure, our muni credit analysts work with what is available to measure ESG impacts and assign ESG Impact Ratings to municipal issuers. For example, for water and wastewater utilities, we rely on measures of capital investment as an indicator of environmental impact, as most utilities’ capital improvement plans are primarily devoted to meeting environmental regulatory requirements.
For governmental credits (states/counties/cities/school districts), we recognize the most significant ESG impacts are policy driven. To assign state-level ESG impact scores, we rely on third-party sources that score and rank the states on environmental policies (e.g., GHG tailpipe emissions standards, transit funding, utility standards), performance against various social benchmarks (access to education, food insecurity, life expectancy, affordable housing availability), and governance measures focused on accountability and transparency. These scores are combined into a single raw score that we map to our 100-point ESG impact rating scale.
What’s Next for Muni ESG?
While ESG investing is not as developed in the municipal market as it is in the corporate market, interest in this area is growing. However, we continue to expect this segment of the market to be driven by marketing considerations over the short term and evolve in fits and starts. ESG investors demand consistent, data-focused impact disclosure, which is costly for issuers to provide in the absence of a bond pricing incentive. Nonetheless, at PGIM Fixed Income, we have developed an approach to measuring ESG Impact within the municipal bond market that aligns with more developed corporate ESG assessments, which may provide a roadmap toward better dissemination of ESG information, more standardized disclosure, and a more robust assessment of an issuer’s overall environmental and societal impact.
1 As of March 31, 2022. PGIM Fixed Income’s ESG process may yield different results than other investment managers, and PGIM Fixed Income’s ESG rankings and factors may change over time. For illustrative purposes only.
2 Reuters, Global issuance of sustainable bonds hits record in 2021. December 23, 2021.