Among the many topics considered by investors in evaluating opportunities, and by issuers in structuring and identifying their securities, none seems to have more emerging momentum in the current investment environment than Environmental, Social and Governance considerations (known collectively as “ESG”).  Public finance professionals at Hinckley Allen are carefully monitoring developments in this area and this Update describes the current outlook regarding key topics in ESG guidance and industry practice.

The most recent significant development comes in the form of an August 9, 2022 release from the Municipal Securities Rulemaking Board (the “MSRB”), which summarizes the responses received to its Request for Information on ESG practices in the municipal market issued in December 2021 (the “RFI Responses Summary”) and reflects a diverse set of perspectives from different municipal bond industry players.

Background

Investors, issuers and regulators in the public finance marketplace are becoming increasingly ESG-conscious, demonstrated by an increased interest in ESG-related credit risks and impacts and a growing demand for ESG-focused projects or ESG-conscious issuers. However, a lack of uniform industry-wide disclosure guidelines, coupled with the inherent complexity of many ESG topics, makes it difficult for investors to gauge the ESG credit risks or impacts of issuers and to evaluate those characteristics within the broader ESG landscape. Similarly, no generally accepted definition exists with respect to what precisely constitutes an ESG-focused bond-financed project (sometimes referred to or marketed as “Green Bonds,” “Social Bonds” or “Sustainability Bonds”). Additionally, the distinction between labeling ESG-designated bonds versus evaluating the ESG characteristics of an issuer’s business overall, and how those different concepts relate to each other, can be confusing. All of the above has contributed to murkiness surrounding ESG investment considerations, both for investors and for issuers, which regulators of disclosure in the municipal bond market have not yet proposed to clarify.

One thing does seem clear – ESG-focused investing, whether in the form of specific ESG-focused projects or increased attention paid to an issuer’s overall ESG footprint, will likely continue to grow in significance and market share in the coming years. According to the Climate Bonds Initiative, municipal bonds labeled as “Green” have grown from roughly $2 billion in 2014 to over $20 billion in 2021.  In just one local example, the Commonwealth of Massachusetts (the “Commonwealth”) recently issued approximately $2.7 billion of taxable, business-tax backed special obligation revenue bonds with a “social” designation, making it the largest ESG-labeled bond deal to date in the municipal market. The proceeds will be used to pay down federal debt incurred by the Commonwealth to meet the unprecedented demand for unemployment insurance during the COVID-19 pandemic.

In addition, it is clear that investors are increasingly interested in understanding ESG-related credit risks in the municipal bond market, particularly as the impacts of climate change grow in severity. Examples of ESG-risks materializing with real credit impacts have begun to surface. Consider the Town of Paradise, California, which was all but destroyed in 2018 by a wildfire, and which had to rely on the State to help it meet its payment obligations for certain of its bonds backed by tax increment revenues.  When California stopped its financial assistance, an unscheduled draw on reserves by the Town caused the bond price to tumble (full story available here).

Scope of ESG Disclosures

As ESG considerations grow in significance, one key challenge that has emerged is a lack of uniform rules regarding ESG-related disclosure requirements for issuers. Rather than a canned paragraph or two, investors are increasingly looking for specific, measurable ESG information they can use to evaluate an issuer’s ESG-related practices or the ESG-related credit risks of investment opportunities. Issuers, on the other hand, often cite the cost and complexity associated with quantifying and characterizing such information as significant impediments to disclosure. Without a uniform set of standards, including definitions for the somewhat nebulous concepts that pervade this area (e.g. “sustainability,” “environmentally-friendly,” “social justice”), some investors worry that issuers can easily over-represent their ESG impact (a trend known as “greenwashing”).

In the absence of any definitive regulatory guidelines, certain industry organizations have attempted to provide non-binding, “best-practice” guidance for debt issuers when considering their own ESG disclosures. For example, the Government Finance Officers Association (“GFOA”) in 2021 unveiled a set of best practices that recommends issuers disclose “material ESG risks or factors having a nexus to credit or the ability to repay bonds,” and breaks down these recommendations into the E, S and G categories. According to these guidelines, the basic framework for the disclosure should include identifying: (i) primary risks or factors; and (ii) corresponding policy actions taken.  However, there is room for interpretation and discretion, as the guidance notes that “the importance and content of ESG disclosure will vary depending on the geographic location and unique demographics of each government.”  The full text of the guidelines are available here.

The above guidance does not have any binding effect on issuers.  However, it can still serve as a useful framework for issuers wishing to adopt a pro-active approach to their ESG disclosures. It can also provide a reference point for issuers regarding the types of information that may become required disclosures in the future. If that information is not readily available, issuers may wish to take steps now to begin to access or compile it.

Despite the increased interest in ESG-specific disclosures, some critics of additional disclosure standards, whether binding or not, argue that the current Rule 10b-5 disclosure obligations are sufficient to ensure adequate ESG-related disclosure, since the broad obligation under that Rule already requires disclosure of any material information, ESG-related or otherwise.

Labeling Bonds as ESG-Focused

Another critical challenge related to the lack of uniform standards in this area is evident in the context of labeling or marketing specific investment products as ESG-focused. In theory, a bond would only be labeled as “Green,” “Social,” “Sustainable” or with similar such designations if the proceeds were put towards certain ESG-focused uses. However, there is no uniformly accepted, industry-standard definition of what exactly constitutes an “ESG-focused use” or any related parameters for such designations.  What specific projects qualify?  What percentage of proceeds needs to be directed towards such objectives? What is required in terms of reporting on actual ESG impacts? Investors face a lack of clarity in evaluating ESG-labeled products, which presents an increased potential for misrepresentation or even fraud against investors. As in the issuer disclosure context, greenwashing can happen at the product level as well.

Third party servicers with ESG-specific competencies have emerged to help investors evaluate such opportunities, and in some cases, to provide certification or other verification that the standards of such servicer have been met.  However, there is still variation among the various methodologies and definitions, leading to continued uncertainty. Certain industry organizations have proposed model classification systems for labeling and marketing products with an ESG-focused designation. Here are some examples:

• The International Capital Market Association (the “ICMA”) has published guidelines for issuing various types of ESG-designated bonds, including “Green Bonds Principles,” “Social Bond Principles” and “Sustainability Bond Principles.” The ICMA also publishes a corresponding pre-issuance checklist for each type of ESG designation. The guidance is broken down into four main components (with criteria that must be met under each category): (1) use of proceeds; (2) process for project evaluation and selection; (3) management of proceeds; and (4) reporting. Copies of these publications are available here.
• The Climate Bonds Initiative in 2018 published the current version of its Climate Bonds Standard and Certification (version 3.0), which applies specific criteria consistent with lowering greenhouse gas emissions as established in the Paris Agreement. Issuers must complete an application process before receiving Certification. More details on the standard and the process can be found here.
• The GFOA published a set of best practices titled “Marketing Municipal Bonds as Green, Sustainable, Social, or Other Alternatively Designated Bonds” (available here), which lays out various important considerations in marketing ESG-designated bonds. Among these best practice recommendations are: (i) including descriptions of what procedures and standards were used to evaluate the projects and make an ESG determination; and (2) providing a self-certification or other third-party verification to such effect. Rather than providing explicit classification criteria, these guidelines encourage issuers to carefully weigh the benefits of issuing ESG-focused bonds against the costs, which could include upfront information gathering, program definition, and feasibility studies, including any third-party assessments, as well as ongoing costs to monitor, evaluate, and report on program progress and results.

Each of these models relies on its own set of criteria and definitions. Similar to the best practices cited above with respect to issuer ESG disclosures, none of these systems are compulsory for issuers, who can continue to label their securities with ESG-specific designations based on their own subjective criteria, without regulatory constraints (beyond standard prohibitions against material misrepresentations or omissions).  While reviewing for compliance, with the various standards set forth above can be a helpful piece of an investor’s evaluation process, it remains to be seen whether regulators will adopt any binding rules with respect to ESG-specific labeling and marketing. At present, if an issuer chooses to issue bonds with an ESG designation, it would be prudent to adopt and disclose one of the industry-recognized sets of standards or certifications to serve as the basis upon which any such designation is made.

Regulatory Developments

In December 2021, the MSRB issued a Request for Information (“RFI”) on ESG practices in the municipal market, as part of a “broader engagement on ESG trends in the municipal securities market to give all interested stakeholders an opportunity to provide their feedback.” The RFI can be viewed here. The comment period closed in March 2022, with the Board having received over 50 responses. On August 9, 2022, the MSRB released its RFI Responses Summary (available here). The comments received reflect a diversity of opinions and a robust level of stakeholder engagement from across the municipal market.

Although respondents expressed differing views and perspectives, some generally consistent themes from the RFI Responses Summary include:

• Acknowledgement of the evolving nature of ESG practices in the municipal securities market
  • ESG practices are continually evolving, but market-based solutions are also emerging and, as such, regulatory action (at this time) is premature
• Recognition of the challenges associated with ESG integration in the municipal securities market
  • There is a lack of ESG standards and uniform practice
  • ESG poses unique regulatory compliance challenges
• Identification of potential opportunities to improve market transparency through the MSRB’s Electronic Municipal Market Access (EMMA) website
  • Allow for voluntary ESG-related disclosures to be readily entered and accessed
  • Provide information about third-party verifiers/designators, including a description of the standards they apply when designating investments

Despite vocal pressure from some market participants in favor of increased regulation, the RFI Responses Summary does not provide any indication that the MSRB will be issuing ESG-related regulations in the near future.

The RFI Responses Summary also notes that, unlike the slower-evolving municipal bond market, the integration of ESG factors into investment analysis and decision-making has become more widespread in the public equities and corporate taxable fixed income markets.  Regulatory action to standardize and clarify ESG-related disclosure obligations is also further along in those markets, as evidenced by the Securities and Exchange Commission’s release earlier this year of two sets of proposed rules that would require certain ESG-related disclosures and labeling (together, the “SEC Proposed ESG Rules”). For now, these rules are only proposed and would apply only to publicly-traded companies (for the proposed rules issued in March 2022) and certain investment advisors and investment companies (for the proposed rules issued in May 2022), so the impact on the public finance market, even assuming adoption, would be limited. For more information about the SEC Proposed ESG Rules, please refer to Hinckley Allen’s detailed Client Alerts on this topic, which are available here and here.

Hinckley Allen’s core group of experienced public finance professionals will continue to monitor developments in this and other key areas of public finance law and we are available to review and advise on specific questions or circumstances related to the topics raised in this Update. For additional information, please contact one of the authors, or any member of our Public Finance Practice Group.