Research has studied the effects of climate risk on financial markets, but few studies have looked at the effect of environmental policy on these markets. A new study examined whether federal policy to mitigate local air pollution – in particular, the Clean Air Act – affected the municipal bond market from 2005 to 2019. The study concludes that increasing regulatory stringency or uncertainty about future environmental policy has increased the cost of municipal debt used to finance infrastructure and other projects. The findings have policy implications, including the risk that environmental regulations undermine the ability of local governments to raise capital for critical infrastructure.
The study, carried out by researchers at Carnegie Mellon University (CMU), appears as a working paper from the National Bureau of Economic Research.
“Our work provides the first empirical evidence that environmental policy affects municipal bond yields, and therefore the cost of raising funds to provide essential local public goods, such as hospitals, schools and roads,” says Akshaya. Jha, assistant professor of economics and public policy at CMU’s Heinz College, co-author of the study. Researchers chose the Clean Air Act to study, in part because it was one of the most significant federal interventions in post-war markets. In 2010, the annual pollution control spending required to comply with the law was around $ 3 billion, with annual benefits of the law of over $ 200 billion.
The National Ambient Air Quality Standards (NAAQS), by which the United States Environmental Protection Agency (EPA) sets the maximum allowable concentrations of local air pollutants, are a central part of the Clean Air Act. Establishing the NAAQS is a two-part process. First, the EPA announces a proposed rule. Then, after a period of public comment, the final NAAQS are announced.
Counties with pollution levels above the final NAAQS in any given year are considered non-compliant. While the EPA sets the standards, state and local governments are responsible for making plans to ensure compliance. Often times, compliance requires polluting companies in local jurisdictions to reduce emission levels, which can be costly.
Researchers collected data on the municipal bond secondary market from the Municipal Market Electronic Access database. Municipal bonds are issued by local governments and are typically used to finance projects such as schools, roads, and infrastructure. This data includes secondary market transactions in the U.S. municipal bond market, including more than 140 million transactions from 2005 to 2019. The study looked only at municipal transactions that could be county-related and focused on ground-level ozone regulations, resulting in over 81 million occupations corresponding to approximately 3,000 counties.
The study concluded that:
Municipal bond yields rose in response to the announcement of the proposed rule, but declined after the announcement of the final standard. This suggests that investors are demanding higher returns to offset the uncertainty induced by the announcement of the proposed rule; this uncertainty is resolved with the announcement of the final rule, lowering the returns needed by investors to hold the bond.
Around annual compliance announcements, yields fell for counties that remained compliant, but increased for newly non-compliant counties. This suggests that investors perceived that municipalities facing non-fulfillment had a higher risk of default.
Yields were significantly higher for bonds in counties just above the relevant ozone standard than for bonds in counties just below the standard. This suggests that increasing regulatory stringency or uncertainty about future environmental policy has increased the cost of municipal debt raised.
A growing body of research has shown that climate risk has been assessed in financial markets. “Our results regarding local air pollution regulations suggest that any cost-benefit analysis of the new climate policy must take into account the impacts on financial markets of extreme weather events and the costs associated with complying with the new policy,” notes Stephen. A. Karolyi, assistant professor of finance and accounting at the Tepper School of Business at CMU, co-author of the study.
Since municipal bonds are used to finance local public goods, such as schools, infrastructure, and health care facilities, distortions in municipal bond yields could compromise the ability of local governments to raise capital, suggest the authors. .
“Our findings should be part of a political debate about the trade-offs inherent in providing local public goods and environmental regulations at the federal level,” suggests Nicholas Muller, associate professor of economics, engineering and public policy at the CMU’s Tepper School of Business, another co-author.
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