ESG: Separating politics from policy

Transcription:

Chip Barnett (00:03):
Hi and welcome to another edition of the Bond Buyer Podcast. I’m Chip Barnett and my guest today is Neal Pandozzi. He’s a partner at Bowditch & Dewey. He’s based in Boston and licensed in Massachusetts and Rhode Island. He’s served as bond counsel, disclosure counsel, borrowers counsel, underwriters counsel, lenders counsel and trustees counsel for a wide variety of different bond transactions. And today we’re going to be focusing in on ESG or Environmental Social and Governance issues as it’s known and the divisiveness that it’s causing in both Florida and around the country. Welcome to the Bond Buyer, Neal. 

Neal Pandozzi (00:43):
Thank you, Chip. Happy to be here. 

Chip Barnett (00:45):
There’s been a lot of politicization of the term ESG and woke in the U.S. today. Can you define what ESG and woke actually mean? 

Neal Pandozzi (00:56):
Sure. So as you just mentioned, the term ESG stands for environmental, social and governance factors.

To break that down, the environmental factor considers an issuer’s plans for mitigating and managing things like severe weather and climate related events, evaluating vulnerabilities to such events in terms of their materiality and financial impact, promoting energy efficiency and renewable energy initiatives and projects, reducing pollution and carbon emissions, maintaining and approving, improving public transportation, as well as drinking water and wastewater systems. So that’s environmental.

The social factor evaluates an issuer’s approach to providing things like public educational services, quality healthcare and mental health services, affordable housing to underserved populations, combating income disparities and unemployment, and promoting public safety and security.

And then finally, the governance factor. The G factor focuses on overall decision making processes, governmental decision making processes including internal controls, financial and budgeting practices, policymaking, transparency, cybersecurity pension, and OPEB liabilities, and long range planning. 

(02:41)
So that’s ESG in a nutshell. In terms of the factors as they relate to municipal bond issuers, the concept of woke in a nutshell, woke means being aware of and actively attentive to important societal facts and issues, especially issues of climate change and racial and social injustice. The word has been co-opted of late by certain conservative politicians. To me, a politically liberal or progressive viewpoint as in matters of racial and social justice, especially in a way that is considered by them unreasonable or extreme. The concept of woke has found its way into public finance, specifically through the concept of woke capitalism. And that’s the idea that there are investors and portfolio portfolios built around ESG-related issues like climate change or diversity. What we’ve been seeing relatively recently is that when purchasing — and really any security, but in our world, municipal bonds, individual and institutional investors, a certain, not all, but certain individual and institutional investors are increasingly considering ESG factors in evaluating an issuer’s or a conduit borrower’s overall financial condition operations and future prospects. 

(04:34)
They’re known as impact investors that they want to put their investor dollars into supporting projects that help support these types of initiatives. And these impact investors and ESG-driven funds are driving a market for these types of investments. And that’s why you’re beginning to see a focus on things like green bonds, social bonds, sustainability bonds, and just ESG related disclosures. In particular, you’re seeing issuers and conduit borrowers highlighting their ESG efforts in order to capitalize on the socially responsible or ESG investing movement. And that’s why you’re seeing more ESG disclosure appearing in official statements in varying degrees benefit depending on the relation of the ESG factors to the particular issuer and its investor mix. And again, as I view it, there are basically two ways of viewing ESG as it relates to public finance. 

(05:44)
One is with respect to specific bond issuances labeled as Green, Climate, Social, Sustainability. And in that situation you have an issuer that is dedicating the proceeds of a particular bond issue to these types of specific ESG-related projects. In contrast, there is general, what I’ll call ESG disclosure that is being added to official statements, and that is not necessarily related to the specific bond issue that is the subject of the official statement. That is just general disclosure about what the issuer is doing with respect to issues like climate change and the social principles that we had discussed. That doesn’t necessarily transform a bond issue into a green climate, social or sustainability bond. That is just more general disclosure by the issuer of what it is generally doing with respect to these factors. So, stated differently, ESG disclosure focuses on the issuer’s overall outlook, whereas a green climate, social or sustainability labeled bond issue focuses on the use of those specific bond proceeds to finance a particular ESG related project or set of projects. 

Chip Barnett (07:12):
Okay, Neil, thanks for that. Let’s break it down side by side. On the one side, a lot of Red or Republican dominated states have been enacting anti-ESG and anti-boycott laws. Could you discuss that a bit? 

Neal Pandozzi (07:29):
Yes. So what we have seen, and we started to see it in 2021, and it’s only been increasing in recent years, is that a number of states, I’ll just call them Red or conservative leaning states, for example, Texas, Kentucky, Louisiana, Oklahoma, West Virginia, Florida, which we’ll talk about it in a little more detail a bit later, like Idaho, Minnesota, Utah and Wyoming, just to name a few, they have either introduced or passed what is being referred to as anti-boycott laws and that target certain companies, for example, commercial banks and investment banks, that are perceived by these states as engaging in an economic boycott or discriminating against particular companies that are either engaged in certain industries such as fossil fuels, firearms, timber, mining, or agriculture, or companies that do not adhere to environmental emission standards beyond particular legal requirements. Companies that don’t meet certain defined diversity, companies that don’t facilitate access to abortions sex or gender change or transgender surgical procedures. 

(09:04)
So that’s what these anti-boycott laws are designed to identify. And in this context, the idea or the concept of boycotting or discriminating generally means a company that refuses to deal with, terminates business activities with, or otherwise takes any action that is intended to penalize, inflict economic harm on or limit commercial relations with these types of companies without some ordinary or reasonable business purpose or a traditional business reason that is specific to the customer and not based solely on these types of industries or policy positions. And you might ask what is considered an ordinary business purpose or a reasonable business purpose? And that’s generally considered to be under these laws any purpose that does not further specifically social, political or ideological interests. And a reasonable business purpose would be something directly related to promoting the financial success or stability, mitigating risk, complying with legal or regulatory requirements or limiting liability. 

(10:24)
So if the company has, again, an ordinary business purpose or a reasonable business purpose for having this policy position where they won’t deal with these specific companies, whether it’s fossil fuels, firearms, et cetera, that is generally okay. If there isn’t an ordinary business purpose or a reasonable business purpose, if it is purely just their policy is driven by the social, political, or ideological interests of this company, that’s going to be a problem under these anti boycott laws. Basically, they’re designed to identify companies, again, like commercial banks and investment banks, that are perceived as furthering a social, political or ideological interest. And in identifying these types of companies, states with these types of laws will consider a number of factors whether the particular, and I’ll obviously use commercial banks and investment banks because that’s sort of the main focus of our world, but they’ll look at things like, is the company participating in any branding, advertising or communications that promote this social, political or ideological interest, or are they participating in or affiliating with any coalition initiative or agreement that promotes these social, political, or ideological interests? 

(11:54)
I will say that in general, these anti-boycott measures are targeting contracts with state and local governments for goods and services valued at a hundred thousand dollars or more. So anything below that usually falls outside of the scope of these boycott laws. But again, for let’s say an underwriter that wants to participate on a state or local bond issue where these anti-boycott laws are in place, typically they’re going to have to provide some sort of written verification that they do not and will not in the future boycott these companies if they’re not on able to provide that verification. For the most part, they’re going to be perceived as fallen within these anti-boycott laws and they’re not going to be able to do business with state and local governments where laws are enacted if the value of their contract, their transaction is above a hundred thousand or more. 

(13:00)
I will say that most of these anti boycott legislation, but these laws do include exceptions, and the exceptions are interesting. And again, different states have different exceptions, but I’d say the majority of them, the exceptions, will look to see is banning a commercial banker or an investment bank because of this anti-boycott law? Is that inconsistent with the governmental entities, constitutional or statutory duties related to the issuance of debt obligations, poor toward deposit, custody management, borrowing or investment of funds? Will it prevent the governmental entity from obtaining the goods and services in an economically practicable manner or would it be contrary to the business needs of the public entity and prevent the public entity from fulfilling its legal duties or obligations? So there are exceptions to these anti boycott laws, it’s just a question of interpreting that language. How do you interpret that language so that as an underwriter, as a commercial bank, are you able to fit into one of those exceptions? 

(14:17)
Well, number one, do you have any sort of boycotting policy that would make it unlikely that you could give the written certification? That’s number one. If you do have that policy, that’s going to be perceived as a boycott. The next question is, do you fit into one of these exceptions and will the issuer agree that you do fit within one of these exceptions so that you can do business in the state? So again, it’s going to be interesting to see how this plays out in terms of whether commercial banks and investment banks can give the certification. On the one hand, if they can’t, will one of these exceptions apply? 

Chip Barnett (15:04):
Okay. Let’s flip over to the other side. Some blue states are Democratic dominated liberal states have been pushing a more pro-ESG agenda, often using their pension plans to do so. Could you talk a little bit about that? 

Neal Pandozzi (15:21):
Yeah, this yeah is very interesting. So as you mentioned, some Blue states and Democrat leaning states have enacted or introduced legislation allowing their retirement plans to consider ESG factors in their investment decisions. As a general matter, these laws allow the fiduciaries for these retirement plans to take into account what has been viewed as big picture risks such as increasing volatile climate incidents affecting the fossil fuel industry or lawsuits affecting gun manufacturers, which may make investing in them a more high risk venture. This is in contrast to certain Red state bills that would require public pension systems to divest from and terminate some investment relationships. What ESG policies are in place and that relates to the anti-boycott laws that we discussed earlier in this scenario and the Red state scenario, the fiduciary is mandated to make investment decisions solely on what it was perceived as the financial interests of the pension system, rather than furthering any sort of social, political or ideological interests.

The interesting state to watch on the Blue state side though is California, because California has taken this a step further and has introduced a bill that would prohibit financial institutions that do business with the firearms industry from working on the state’s public finance transactions including municipal bonds, capital projects, and the state’s debt portfolio. I should say this bill, the language is very general, so we don’t, and we don’t know exactly where this is going to go, but that’s going to be a very interesting one to watch 

Chip Barnett (17:24):
And we’ll be right back after this important method. And we’re back talking with Neil Pandozzi.

Let’s drill down a bit to the state level in Florida. What’s happening there now? 

Neal Pandozzi (17:39):
Just as the California bill is interesting on sort of the Blue State pro-ESG side, if you will, Florida is a 180 in that. In contrast to the basic anti-boycott Red state bills that we discussed earlier, the Florida House of Representatives has introduced and passed House Bill 3, which broadly eliminates consideration of ESG when issuing bonds. So this goes much further than a simple anti-boycott law. House bill 3, which I should say has passed the House and is now with the Senate. So we’re keeping a close eye on what comes out of the Senate in this regard, if anything. But this bill will ban using rating agencies whose ESG methodology will have a direct what is perceived as a direct negative impact on the issuer’s bond ratings. It prohibits any issuer from issuing ESG bonds. It prohibits, again, prohibits the entering into the contracts with the rating agencies if their ESG scores will have a direct negative impact on this particular issuer’s bond ratings. 

(18:59)
It prohibits the use of public funds or monies from a bond issuance to pay for the services of a third party verifier to certify the bonds have been designated as ESG bonds. So if you were going to pay that verifier out of cost of issuance from the bond proceeds, this would prohibit that. And it also prohibits the use of any second party opinion or a verifier report as to the compliance post ESG bonds with ESG standards and metrics. And it also prohibits complying with any post issuance reporting obligations that would relate to ESG bonds. Now you might ask yourself, how does Florida define ESG? Well, its defines it very broadly. In the bill, ESG is defined simply as environmental, social and governance. So very broadly defined and ESG bonds as well is broadly defined as any bonds that have been designated or labeled as bonds that will be used to finance a project with an ESG purpose, including but not limited to green bonds, climate bonds, green star designated bonds and other environmental bonds marketed as promoting an environmental objective. Social bonds marketed as promoting a social objective and sustainability bonds and sustainable development goal bonds marketed as promoting both environmental and social objectives.

(20:27)
And this term, this concept of or definition of ESG bonds, would also include bonds self-designated by the issuer as ESG labeled bonds as well as those designated by any third party verifier as ESG labeled bonds. So not only does this prohibit bonds that are designated by a third party verifier as any sort of ESG labeled bonds, it prohibits a Florida issuer on its own from issuing an ESG labeled bond. And you know what concerns me? Well, this definition concerns me for a number of reasons, but there are things in this definition like any bonds, not only bonds that have been labeled with an ESG purpose, so agreeing a bond that on the cover of the official statement says green bonds, sustainability bonds, climate bonds, but it also would also ban bonds that have been designated as bonds with an ESG purpose. And that feels very broad to me. So it’s not just the labeling, it’s bonds designated as having an ESG purpose. 

(21:58)
And again, having worked in public finance now for basically my entire career, I’ve been issuing bonds for governmental issuers since I was a first year associate, and I think you’d be hard pressed to find a bond that is issued by a governmental issuer that isn’t somehow tied to a social benefit, a governmental benefit, a climate benefit. So I am concerned about the breadth of this definition and what it means in terms of banning bonds that again could be perceived as promoting an environmental objective, a social objective, and again, the notion of prohibiting public funds from for use in complying with post issuance reporting obligations. Depending on what the bond is and depending on what your post issuance disclosure obligations are, that could be an issue. So again, the breadth and depth of the Florida bill goes far beyond your typical anti-boycott bill. And that’s sort of why I’m focused on what the Florida Senate does with it. 

Chip Barnett (23:21):
Do you think that this bill, if it passes as is, will have a wider impact across the country? 

Neal Pandozzi (23:30):
I think it remains to be seen, well first of all, it remains to be seen frankly whether it will pass the Florida Senate and in what form. If the number of anti boycott laws and bills among the various Red states or any indication, you could see where the passage of House Bill 3, either in its current form or some paired down version could spur other conservative or conservative leading or Red states to follow suit as we’ve seen with the anti-boycott bills. But I don’t know, I hope that if it does pass the Senate, but it passes with some revisions to this language to sort of narrow down the focus. It’s one thing if as a policy position you want to ban the issuance of ESG labeled bonds, but I would hope that whatever comes out of the Senate will be paired back so it doesn’t create what I view as a lot of ambiguity in terms of what you can and cannot issue in Florida. And if other states find this type of bill interesting, I hope they will approach it with the same degree of caution. 

Chip Barnett (24:45):
Do you think this could lead to a Red state-Blue state banking divide where some banks can only operate in some Red states or only operate in some Blue state? 

Neal Pandozzi (24:55):
I think the jury is still out at this point. The anti boycott laws have resulted in certain underwriters being compelled to walk away from particular Red state bond transactions as they review the various certification requirements and the exceptions to these laws that I talked about earlier. So far there are certain underwriters that happen to be able to comply with a particular Red state’s anti boycott laws while others are finding the certification process challenging. I think at the end of the day, whether these anti-boycott laws stand the test of time will depend on two factors. One is the willingness of these Red states to accept the potential for increased borrowing costs that may result from a smaller underwriter and investor pool, and two, the ability of various issuers in these states and the underwriters themselves to work together to utilize the exceptions that are baked into these laws in order to obtain the best deal economically while on the surface maintaining the particular states’ ESG policies because by utilizing the exceptions, you are still compliant with the anti-boycott law. 

Chip Barnett (26:13):
What could this ultimately need for consumers, for residents when there’s less competition among underwriters, financial advisors and bond counsel? 

Neal Pandozzi (26:23):
Well, it’s interesting. There have been a couple of studies that have been done in the wake of these anti-boycott laws that have shown the potential for increasing borrower costs with respect to issuing bonds where these anti-boycott bills are in place. And that would result from less competition among underwriters because you have fewer underwriters available to market your bonds as well as a smaller investor pool because you’re basically forstalling the types of impact investors and ESG related funds from participating in the purchase of these bonds. They’re going to look elsewhere, they’re going to look for bonds that comport with their ESG beliefs. And I’m also concerned about what do these various restrictions mean or what do they fortell? Potentially you’ve got less information for investors to evaluate the credit risk of an issuer. 

(27:24)
If we’re going to see paired back ESG-related disclosure that could lead to higher interest rates or the inclusion of more onerous covenants for issuers to mitigate any perceived risk due to less fully developed information about how an issuer is addressing ESG related issues. And it’s also the question of where does it end. Underwriters, they sell bonds during the retail order period and the institutional order period. What happens if the buyers of these bonds noted here to these anti-boycott requirements? I wonder about the reach of these laws beyond just the initial underwriters for the transaction. There’s also a potential exposure to liability under the anti-fraud provisions of the Securities Laws. If you include any untrue statement of material fact or omit a material fact in an official statement, are these laws going to restrict an issuer from providing disclosure that’s necessary to provide a full picture of its approach to these initiatives, particularly with respect to climate, since I think that one is particularly important for certain states, and I mean certain, and I use the Florida, the Florida bill in particular, but also with respect to these anti-boycott bills, certain of the defined terms and standards and concepts using the legislation are, in my view broadly drafted. cryptic and suffiently sweeping to create questions of how do you comply? 

(29:13)
One issuer, an underwriter’s view of the exceptions may not match someone else’s view of the exceptions. The same thing with Florida, one person’s view of what is an ESG bond may conflict with somebody else’s view of what an ESG bond is just because of how broadly that ESG bond definition is drafted. I see that from a bond counsel view, particularly with respect to Florida, creating the potential validation challenges for bond counsel and underwriters in terms of being able to say the bonds are valid, binding and enforceable. If that House Bill 3, as it currently is drafted, were to come into place. But I think at the end of the day, I am concerned that with respect to all these ESG initiatives, I want to make sure the taxpayers in these states fully understand the potential ramifications or side effects of these laws, whether it’s just a pure anti boycott law or whether it’s something more broad like we’re seeing in Florida. 

(30:27)
To illustrate this concern, I always like to use the analogy of a mortgage. You’re buying a house and you’re applying to two banks for a mortgage. Bank number one has a policy that limits or restricts it’s involved in fossil fuels or firearms industries. So that bank number one potentially could violate an anti boycott bill. Bank number one is willing to offer you a mortgage with an interest rate of 2%. Bank number two has no such policy. In other words, bank number two, we’ll do business with any industry. Bank number two is willing to offer you a mortgage with an interest rate of 5%. If you look at it purely in terms of cost savings, you would choose bank number one because bank number one is going to offer you the lower interest rate on your mortgage. Alternatively, your anti ESG or anti-woke beliefs and your own personal financial position may be strong enough to allow you to choose bank number two, because bank number two is even though bank number two is offering you a higher rate on your mortgage, you want to do business with bank number two, because their policies are in line with yours, no discriminating or boycotting against any particular industry. 

(31:50)
Either way you at least understand the underlying financial implications of the decision so that you’re able to make an informed choice. I worry that that point is getting lost among sort of the attention grabbing ESG headlines. And that is my concern because at the end of the day, it’s the taxpayers who are potentially going to pay increased borrowing costs as a result of these laws. They may end up, you know, may have a more difficult time in a state like Florida if House Bill 3 passes that would result in higher borrowing costs. And again, it’s the taxpayer dollars that are going to go to pay those increased amounts. And again, I think any taxpayer has the right to choose. You have to choose, again, if the policies are in line and that’s what you want to do, that’s fine. I just want to make sure that from a financial perspective, the taxpayers understand what the economic implications are of these ESG policies and I should say it’s the anti-ESG and maybe the pro-ESG policies on the Blue State question with California saying that it wants to say that you can’t do business with someone that promotes the firearms industry. 

(33:25)
Again, you may agree about policy, but what is the economic impact to California taxpayers of cutting off that particular industry. Same thing with the pension restrictions. What are the economic or financial implications of saying that we’re only going to invest in pro-ESG companies. Everyone has the right to make that decision. I just want to make sure that it’s a fully informed decision. 

Chip Barnett (33:59):
Neal Pandozzi of Bowditch & Dewey, thank you very much for being here with us today. 

Neal Pandozzi (34:04):
Well thank you for having me, Chip. 

Chip Barnett (34:05):
And thanks to the listeners of this Bond Buyer podcast. Thanks to Kevin Parise who did the audio production for this episode. And don’t forget to rate us, review us and subscribe at www.bondbuyer.com/subscribe. For the Bond Buyer I’m Chip Barnett. And thank you for listening.