Examine Examines How Clear Air Act Impacts Municipal Bond Market – Watts Up With That?
CARNEGIE MELLON UNIVERSITY
Announcement of the science business
Research has examined the effects of climate risk on financial markets, but few studies have looked at the effects of environmental policy on these markets. A new study examined whether federal policies to reduce local air pollution – particularly the Clean Air Act – had an impact on the municipal bond market from 2005 to 2019. The study concludes that an increase in regulatory rigor or uncertainty about future environmental policies increases the cost of local government debt to finance infrastructure and other projects. The results have policy implications, including the risk that environmental regulations could compromise the ability of local governments to raise capital for critical infrastructure.
The study by researchers at Carnegie Mellon University (CMU) appears as a working paper of the National Bureau of Economic Research.
“Our work provides the first empirical evidence that environmental policy affects the returns on municipal bonds and thus the cost of raising funds for the delivery of essential local public goods such as hospitals, schools and roads,” explains Akshaya Jha, assistant professor of economics and public order at Heinz College of the CMU, who co-authored the study. Researchers selected the Clean Air Act to study, in part because it is one of the most significant federal interventions in markets in the post-war era. In 2010, annual pollution control expenditures required to comply with the law were approximately $ 3 billion, with annual benefits of the law exceeding $ 200 billion.
A central component of the Clean Air Act are the National Ambient Air Quality Standards (NAAQS), with which the US Environmental Protection Agency (EPA) defines the maximum permissible concentrations of local air pollutants. The establishment of the NAAQS is a two-pronged process. First, the EPA announces a proposed rule. After a public comment phase, the final NAAQS will be announced.
Districts with pollution levels above the final NAAQS in a given year are considered unreached. While the EPA sets the standards, it is the responsibility of state and local governments to develop compliance plans. Compliance often dictates that polluting companies in local jurisdictions must reduce emissions, which can be costly.
The researchers collected secondary market data on municipal bonds from the Electronic Municipal Market Access database. Municipal bonds are issued by local governments and are typically used to fund projects such as schools, roads, and infrastructure. This data includes secondary market deals in the US municipal bond market, including more than 140 million deals from 2005 to 2019. The study looked at only municipal deals that could be linked to a county and focused on regulations targeting ground-level ozone resulting in more than 81 million stores equivalent to around 3,000 counties.
The study concluded that:
Municipal bond yields rose in response to the announcement of the proposed rule, but fell after the final standard was announced. This suggests that investors are demanding higher returns to offset the uncertainty created by the announcement of the proposed rule. This uncertainty will be resolved with the announcement of the final ruling, which will lower the returns required for investors to hold the bond.
Around the annual compliance announcements, returns fell for counties that had maintained compliance but increased for counties that were newly non-compliant. This suggests that investors believed that municipalities affected by non-compliance were at higher risk of default.
The yields for district bonds just above the relevant ozone standard were significantly higher than for district bonds just below the standard. This suggests that an increase in regulatory rigor or uncertainty about future environmental policies has increased the cost of municipal debt taken on.
A growing number of studies have documented that climate risk has been priced into the financial markets. “Our results for local air pollution regulations suggest that any cost-benefit analysis of the new climate policy should take into account the impact of extreme weather events on financial markets and the costs of complying with the new policy,” notes Stephen A. Karolyi, assistant Professor of Finance and Accounting at the CMU’s Tepper School of Business who co-authored the study.
Since municipal bonds are used to fund local public goods such as schools, infrastructure, and health care facilities, distortions in municipal bond yields could jeopardize local governments’ ability to raise capital, the authors suggest.
“Our findings should be part of a policy debate about the tradeoffs involved in delivering local public goods and federal environmental regulations,” suggests Nicholas Muller, associate professor of economics, engineering and public policy at CMU’s Tepper School of Business other co-author.