California's ESG scores lag the state's policy efforts

California policymakers consider the state to be “where it goes, so goes the nation” on social justice and environmental matters.

But despite spending billions and adopting policies to improve the environment and deal with social issues like homelessness and poverty, California remains challenged in those departments, as reflected in its blah-at-best scores from S&P Global Ratings for its handling of environmental, social and governance issues.

S&P gave the state across-the-board scores of 3, or "moderately negative," on its one-to-five ESG scale for the three categories, which it deemed “a moderately negative consideration in the credit rating analysis for California,” according to its March 31 ESG report.

Bloomberg News

Given the state’s emphasis on progressive politics that talks up the importance of the environment and social equity, state officials aren't likely to challenge the increasing focus of rating agencies or investors on ESG factors in the way Idaho, Utah and West Virginia have.

“The rating agencies are gradually recognizing the importance of ESG scoring when they assign a rating to an issuer; California is no exception in receiving such a score,” said Tim Schaefer, California’s deputy treasurer for public finance.

“At this point, we don’t believe our ESG scores and that rating process are having any adverse or positive effect,” Schaefer said. “It seems to be having no effect on the pricing of our bonds.”

He compared it to the difficulty the industry has in determining if bonds carrying an ESG label achieve better pricing.

“We have sold a couple of green bonds for buildings in a lease revenue structure and sold bonds for our ‘No Place Like Home’ program,” Schaefer said. The latter bonds, which funded supportive housing for mentally ill people, were certified as social bonds without third-party verification. “We see chatter in the market about better pricing. It’s not that we are skeptical, it’s just tough to prove.”

The state holds Aa2, AA-minus and AA issuer ratings from Moody’s Investors Service, S&P and Fitch Ratings. All assign stable outlooks.

To some extent, California's environmental challenges make it a victim of circumstances that belie its efforts.

In the two decades starting in 2000, California reduced its total annual carbon emissions from energy by more than 6%, according to U.S. Energy Information Administration data. In 2019, its per-capita carbon emissions from energy were the second-lowest of any state, only trailing New York, according to the EIA.

But that can't protect the state from global climate changes, namely increased heat that is implicated in drought and the state's increasing wildfire problem.

The eight largest wildfires in California history, by acres burned, have all taken place since 2017, according to the state Department of Forestry and Fire Protection. The largest 15 all happened since 2003.

“There is only so much the state can do as an individual state,” because environmental conditions like pollution don’t respect state boundaries, said Howard Cure, director of municipal bond credit research for Evercore Wealth Management. “Unless the country adopts a more national policy, the state is vulnerable.”

The 2018 Camp Fire is an object lesson in the impact environmental risks can pose for municipal debt; after burning down nearly every building in the town of Paradise, outstanding redevelopment bonds are subject to debt service reserve draws and the risk of default.

In addition to extreme weather, California faces fire-related challenges from a dense population, partly responsible for an increase in the number of people living in the so-called wildland-urban interface area, Cure said. The number of people living at the edge of forested areas has increased the risk to property and lives from wildfires, he said.

More than 39 million people were living in California as of July 1, 2021, according to the U.S. Census Bureau.

“It also has a vulnerable water system subject to drought,” Cure said.

The state’s agriculture-rich Central Valley and southern California are dependent on imported water from the State Water Project, a system of dams, reservoirs, power plants, pumping plants and aqueducts that transports water south from the Owens Valley in northern California. The state is also dependent on water from the drought-devastated Colorado River that supplies water to seven states.

The drought has been so severe that there have been cuts to irrigation water supplies for farmers in the Central Valley, considered the nation’s salad bowl, because roughly 70% of the country's lettuce and other vegetables originate there.

The exposure to climate-related events like wildfires and drought, not to mention earthquakes, “can affect the state’s economy and disrupt population migration should these areas become undesirable,” S&P analysts wrote.

The shortage of affordable housing, high social service costs and income disparity, said S&P analysts, have created challenging demographic trends. One-third of the state’s population relies on Medicaid.

While S&P assigned California "moderately negative" scores across the board in its ESG assessment, its G-3 for governance stands out as one of only five states with that score. S&P gave 45 states a higher G-2, or "neutral" score for governance.

One problem: the state has persistently provided audited results well after the end of the fiscal year. The audited results for the fiscal year ended June 30, 2020, weren’t released until Feb. 2, 2022, which S&P considers “very late,” analysts wrote.

The state has incorporated increased spending in response to its other ESG risks within its long-term financial and capital planning, S&P analysts wrote.

“We believe the state is addressing these concerns through increased funding for various social programs, such as bond-financed programs for housing of the homeless mentally ill, changes to residential zoning laws, and increased social service spending,” they wrote.

The state and many big cities and counties have approved and sold billions of dollars of bonds to fund affordable and supportive housing. Despite efforts like Project Roomkey, which has provided shelter for 40,000 people, according to the Public Policy Institute of California, these efforts aren’t always visible at street level. The state had 161,000 homeless people in 2020, according to the last pre-pandemic tally by the U.S. Department of Housing and Urban Development.

S&P analysts said in an April 2021 report that it considered the state’s social risks “elevated” compared to other states due to a shortage of affordable housing and high social service costs given the income disparity in the state.

“California is addressing this through increased funding for various social programs to rectify income disparity over the long term,” analysts wrote in the report.

Gov. Gavin Newsom and lawmakers have increased spending over the past several years to combat a plethora of environmental and social woes.

The state’s fiscal 2023 budget, a framework version of which Newsom signed Monday, contains a $2 billion multiyear affordable housing package, $2 billion for college student housing and a $19 billion multi-year climate-energy package for drought and wildfire resilience programs, energy projects and zero-emission vehicles.

Newsom reiterated the point Thursday, responding to a Supreme Court ruling limiting the EPA's ability to regulate greenhouse gas emissions.

"California will remain the tentpole for this movement with record investments and aggressive policies to reduce pollution, to protect people from extreme weather, and to leave our children and grandchildren a world that’s better off than we found it,” he said.

The state and its largest cities have also approved and spent billions of dollars in bond money over the past 10 years to reduce homelessness through programs targeting affordable housing construction and temporary housing.

It will take more than money to solve California’s challenges, particularly its housing crisis, Cure said.

“My view on the homelessness issue is that the state really has to intervene on issues like zoning and variances,” Cure said. “The state putting money behind it is not going to be enough. They need to incentivize the private sector as far as real estate developers are concerned.”

The state will need to spend to fortify its roads, water and electric grids, Cure said.

“They are trying to make a coordinated effort where they have vulnerabilities, he said.

Though the state included $47 billion in multi-year spending for infrastructure in its fiscal 2023 budget, Cure wonders what it will do in leaner years. On governance, Cure said he would give them a mixed score, because the water situation is so concerning.

“What do they do, restrict development until they figure it out? I don’t think the state wants to do that.”