How ESG affects credit ratings

Bonds

Transcription:
00;00;03;16 – 00;00;24;27
Chip Barnett
Hi and welcome to another Bond Buyer podcast. I’m Chip Barnett. My guest today is Nora Wittstruck. She’s senior director and ESG sector leader at S&P Global Ratings. And we’re going to be talking about climate change and sea level rise and how it’s going to affect South Florida and many other parts of the country. Welcome to The Bond Buyer.

00;00;25;12 – 00;00;27;03
Nora Wittstruck
Thank you, Chip. Thanks for having me.

00;00;27;28 – 00;00;38;20
Chip Barnett
Can you tell our listeners you know about how S&P looks and environmental, social and governance issues when evaluating ratings on a municipality or entity?

00;00;38;29 – 00;01;21;07
Nora Wittstruck
Sure. So S&P Global Ratings incorporates ESG risks and opportunities into our sector specific criteria, and that includes elements of climate risks associated with severe weather that we incorporate into our economic analysis or into our service area. Characteristics of enterprises. We also incorporate social risks and governance risks throughout each of our criteria, primarily within four not for profit enterprises in the market position, because we understand and realize that demographics and affordability and income levels, all of those things affect demand for an enterprise.

00;01;21;19 – 00;01;50;21
Nora Wittstruck
They can affect how much economic activity you draw for a specific area. And in addition to that, our management and governance analysis for all of our criteria, including for governments, is basically very similar to some of the things that we look at for our governance risks. And that can be transparency in reporting and what you’ve said you would you will adhere to with in your policies and practices.

00;01;50;27 – 00;02;23;06
Nora Wittstruck
It also incorporates how frequently and regularly you communicate with stakeholders in your community and with other stakeholders like rating agencies. And then it also incorporates, you know, what types of planning activities you’ve undertaken to help mitigate some of the risks that you might see particularly in your community, from acute environmental risks like hurricanes or storms or wildfires, or more chronic risks like drought that we’ve seen across the western U.S. in addition to our sector specific criteria.

00;02;23;15 – 00;02;52;04
Nora Wittstruck
We released an ESG Principles Criteria last year that looks at how ESG risks can evolve and change depending upon the sector in which the entity sits or dependent upon the region where an entity is located, etc.. So in combination with both of those criteria, we are able to look at ESG risks and opportunities and how they affect an entities credit profile.

00;02;52;21 – 00;02;57;22
Chip Barnett
How much weight you assign to environmental factors such as climate change?

00;02;57;24 – 00;03;25;13
Nora Wittstruck
So we don’t, in our criteria, assign certain weights to certain risks other than those that we detail in our criteria framework already. So, for example, in our local government criteria, the economic aspect accounts for 30% of the rating outcome. So for us, it’s a combination of two things the materiality of the risk, the visibility of the risk within our analysis.

00;03;25;13 – 00;03;53;19
Nora Wittstruck
And then also potentially what aspect or criteria component that risk can affect. So, for example, when there’s an acute risk like a hurricane, particularly in some of the coastal areas in Florida or the coastal areas in Louisiana, you know, we believe that depending upon the severity of that event, it could disrupt the economic operations within your service area or within your economic base.

00;03;54;25 – 00;04;21;10
Nora Wittstruck
So really, if we make an adjustment for that risk within our economic profile for local governments, it could theoretically affect potentially 30% of the rating outcome. But independently, we do not separately weigh environmental risks other than, as I mentioned, how they’re incorporated into different elements of the criteria and how those elements of the criteria affect the rating outcome.

00;04;21;19 – 00;04;25;07
Chip Barnett
Do you take into account any mitigation that an issuer may be taking?

00;04;25;07 – 00;04;50;26
Nora Wittstruck
We absolutely look at mitigation measures. We look at, for example, we actually looked at all of the counties in South Florida that we rate and we looked at their planning practices relative to resiliency and the types of infrastructure investments that they’re making to mitigate the risks that they’re subject to, i.e., the acute risk and and also the chronic risks relative to sea level rise.

00;04;51;14 – 00;05;16;05
Nora Wittstruck
We found in that particular analysis that South Florida counties and counties in Florida in general are pretty sophisticated in terms of their planning mechanisms. We also looked at how the state of Florida is supporting their local governments in terms of these risks. You know, the Department of Environmental Protection is overseeing a lot of the planned development within these local governments.

00;05;16;11 – 00;05;45;14
Nora Wittstruck
We also know that from a relationship with FEMA, these resiliency plans have to be updated at least every five years. Actually, the counties are updating them almost annually and in some cases much more frequently than every five years as they’re required to do under federal statute. So we definitely take mitigation measures into a into account when we’re looking at the risk relative to the comprehensive criteria framework that we’re applying.

00;05;46;00 – 00;05;50;10
Chip Barnett
Switching gears a little, could you talk a little bit about social and governance factors?

00;05;51;02 – 00;06;33;19
Nora Wittstruck
Sure. So I think the market focuses particularly on environmental risks. Because they are the ones that could definitely change a credit profile overnight depending upon the severity of a particular event. I think social and governance factors can sometimes have a bit slower burn relative to an entity’s credit profile. So social risks for us in the government space are typically ones that we account for or call social capital and social capital is really the community aspects that a government entity operates within.

00;06;33;28 – 00;07;09;23
Nora Wittstruck
So that could be the demographic profile of your community. And whether that is growing faster or slower than the state, the region or the U.S., it could mean how utility looks at their rate user fees relative to the economic and demographic factors within their entity, because it could help them raise rates or or maybe hinder their ability to raise rates if rates are already very high and the incomes in the region or service area are a little bit below the U.S..

00;07;10;04 – 00;07;40;27
Nora Wittstruck
We also look at other relationships that the community has with the government in regards to unrest or social situations that could be occurring in the region that could lead to maybe some strife between the community and the government that could potentially at some point hinder the ability to pass a bond referendum or even raise taxes, property taxes and things like that.

00;07;41;07 – 00;08;13;12
Nora Wittstruck
So social capital in the U.S. public finance space is a particularly relevant social risk and unfortunately one that sometimes entities don’t have a lot of control over. But we want to understand how leadership teams and management teams are executing on their ability to diversify their economy or, you know, ensure that there is access to government services for vulnerable populations and how they’re going about executing on those goals.

00;08;13;28 – 00;08;16;18
Chip Barnett
Okay. And we’ll be right back after these messages.

00;08;19;21 – 00;08;30;26
Chip Barnett
And we’re back talking about ESG with S&P’s Nora Wittstruck. Let’s dove into the environmental factors. How is climate change been affecting your view of certain credit?

00;08;31;21 – 00;09;05;19
Nora Wittstruck
So climate change and the events that global warming have taken into account, in our view, are definitely accelerating. We view the fact that global warming is creating more frequent and severe physical risks. Those are ones that are driven by hurricane or severe weather or drought natural capital or the lack of water in certain areas and how that could hinder demographic growth if there’s not enough water to supply a growing population.

00;09;05;29 – 00;09;38;08
Nora Wittstruck
I would say that right now our view is that entities in SPF are generally well prepared to manage these risks. They’re you know, we take into account reserves that an entity might have to handle the initial costs associated with an event like clean up police over time potentially needing to activate FEMA protocols. And this, you know, the costs that are associated with that.

00;09;38;27 – 00;10;09;09
Nora Wittstruck
And typically when we don’t view them being prepared is when the risk becomes material and results in a credit rating action. So last year, when we well, I should say each month, S&P Global Ratings releases what we call an ESG and credit ratings newsletter. And in that newsletter, we identify by practice or not only U.S. public finance, but sovereigns and corporates and banks and insurance and structured finance.

00;10;09;18 – 00;10;34;13
Nora Wittstruck
We put all of our credit rating actions that are driven by an ESG risk or opportunity into a newsletter and discuss those with the market. And so in 20, 21, U.S. public finance took a 180 rating actions driven by an ESG factor. And so that would have been a credit rating change and outlook change or credit watch action.

00;10;34;29 – 00;11;05;14
Nora Wittstruck
Of those 180, 11 were positive in nature so that could have been an outlook going from negative to stable or maybe a rating upgrade but the majority of them were negative rating actions and out of the 180, 74 were driven by a climate risk. So that would have been a physical risk or even climate transition risk which is the evolution of decarbonizing the economy.

00;11;05;14 – 00;11;25;24
Nora Wittstruck
And how that can affect the way that particularly public power entities operate. So it is something that we’re watching. We think that physical risks will continue to be a very integral part of, of our analysis and of the types of rating actions that we take going forward.

00;11;26;04 – 00;11;30;19
Chip Barnett
And in certain sectors that are more vulnerable than others to environmental factors?

00;11;31;25 – 00;11;55;24
Nora Wittstruck
Well, you know, U.S. public finance entities are very different than corporate entities, I’m sure, as you and your audience knows. I mean, corporate entities, you know, they can divest risk, they can divest assets that might be located in an area that is more subject to sea level rise or acute events. And in U.S. public finance entities, don’t have that luxury.

00;11;55;24 – 00;12;26;26
Nora Wittstruck
The state of Florida can’t just divest its coastline, if you will. So we do view that entities located in coastal areas as being particularly more at risk. But one thing that we’ve been seeing and as an event of global warming, we’ve seen particularly bad flooding events as well as you know, in New York City after Hurricane Ida, it wasn’t the acute event that that you know, caused issues within New York City.

00;12;27;01 – 00;12;56;12
Nora Wittstruck
It was really that long flooding, that long rain event that created a lot of flooding and flooding issues for the city. So flooding, we think, is a chronic event. It particularly is usually more expensive to deal with than acute risks. And so flooding can really affect anywhere. And that’s that’s a risk that we’ve been you know, we’ve been watching a bit more we’ve talking to issuers about how they deal with with flooding.

00;12;56;23 – 00;13;37;08
Nora Wittstruck
And then, of course, there’s certain sectors that are probably more explicit, exposed to energy transition. Public power is one of them. How are they transitioning their fuel supply from carbon based fuel to a renewable source? And and how they’re dealing with the infrastructure or the storage that’s required for renewable energy versus gas and and carbon based fuel. So I think I would say that all entities are exposed to some form more than likely of environmental risks, but they are probably more concentrated in certain sectors.

00;13;37;08 – 00;13;47;16
Nora Wittstruck
And those that, you know, draw are boundary based or asset based which is nearly every SPF entity in, you know, in the sector that we rate.

00;13;48;09 – 00;14;01;29
Chip Barnett
Can you talk a little bit about sea level rise? I know in South Florida and actually entities all along the Gulf Coast and the East and West Coast, this is this has been a critical issue. Can you talk a little bit about that?

00;14;02;13 – 00;14;39;27
Nora Wittstruck
It definitely is a critical issue. I know we we’ve seen high level analysis of beach erosion. And on the Louisiana coast. And, of course, you know, we rate a lot of issuers in Florida and in South Florida in particular. And it is a concern. And I think one of the things we’ve started talking to issuers about and one thing we’ve articulated to market participants is that a capital improvement plan and the ability to integrate those resiliency efforts into your investments that you need to make are a particularly strong mitigation aspect.

00;14;39;27 – 00;15;14;07
Nora Wittstruck
To your to stabilize your credit rating in terms of sea level rise. I think what we’ve seen our European counterparts do and what we’re starting to see in very limited instances in the US is that adaptation aspect. So how are issuers looking at different climate scenarios and bidding capital projects to account for different climate scenarios under a two feet of sea level rise area aspect to six feet, maybe ten feet of sea level rise.

00;15;14;07 – 00;15;50;05
Nora Wittstruck
And not only do they bid a two foot sea level wall to protect their economic base, but maybe they bid, hey, can we look at two feet and how that project can be adapted for six feet or ten feet of sea level rise over time? That’s an inordinately more expensive way to bid capital projects. So it is something that requires potentially more resources but I think that’s where we see issuers beginning to make a difference in how they’re making their economic base more resilient against sea level rise.

00;15;50;19 – 00;16;23;23
Nora Wittstruck
I think the other things that we’ve seen is definitely changes in development code or zoning codes potentially prohibit development within very exposed areas within a community. And then in the very, somewhat more political way, we’ve started to see what’s called managed retreat, which is where entities actually make a decision to move existing development out of a particularly exposed area and into a more inland or different area of the community that is less exposed.

00;16;24;08 – 00;16;26;02
Chip Barnett
Do you have any last thoughts for our listeners?

00;16;26;02 – 00;16;55;11
Nora Wittstruck
So I guess my last start is, is that ESG within the municipal market can be very confusing. I think there is the aspect of labeled transactions, green bonds social bonds, and a lot of people conflating that with ESG alone. There’s obviously investment strategies where certain investors are making decisions on what bonds to buy because they want to put them in particular ESG funds.

00;16;55;22 – 00;17;27;11
Nora Wittstruck
But really what S&P does, at least in the practice and the analytical efforts of I lead for S&P, is how these risks affect the issuers credit quality and how an issuer can manage this emerging risk just like they manage any other emerging risk like a pandemic. And so, you know, I think that is really how we can articulate the difference between, you know, what S&P does versus maybe what an investor is looking for.

00;17;27;18 – 00;17;47;04
Nora Wittstruck
And we really want to make sure that that that is something that the market understands, because right now there’s a lot of different conversations that sort of go under the umbrella of ESG and it can definitely be confusing. And with it evolving so quickly, I think that makes it even more a little bit like you’re drinking from a firehose.

00;17;47;04 – 00;18;02;29
Nora Wittstruck
So I hope that the efforts that S&P has undertaken, as well as many other market participants have undertaken, will help sort of start to delineate the the differences in those conversations and how they relate to the market that we rate.

00;18;03;18 – 00;18;07;01
Chip Barnett
Nora Wittstruck of S&P, thank you very much for being here today.

00;18;07;03 – 00;18;08;06
Nora Wittstruck
Thank you for having me.

00;18;08;17 – 00;18;27;25
Chip Barnett
And thank you to the listeners of this latest Bond Buyer podcast. Thanks to Kellie Malone, who did the audio production for this episode. And don’t forget the read review us and subscribe at www.bondbuyer.com/Subscribe. From the Bond Buyer, I’m Chip Barnett, and thanks again for listening.

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