Last year, S&P Global revised its credit rating outlook on Minneapolis’ outstanding general obligation debt to negative from stable. One reason: higher social risks following George Floyd’s murder. The civil unrest and calls for police reform following Floyd’s death in May created an “elevated likelihood” of large legal settlements that could “pressure the city’s budget for a prolonged period,” S&P noted in a September 2020 ratings report.

The three major rating agencies—S&P, Fitch, and Moody’s—have for years analyzed both financial and nonfinancial factors when determining a municipality’s credit risk level. But as investors’ interest in environmental, social, and governance (ESG) factors grows, these agencies are taking a closer look at everything from governance structures and transparency, to natural disasters and climate transition risks, to public safety and human rights.

In a time of heightened concerns about both economic inequities exacerbated by the COVID-19 pandemic and broader racial justice, interest in equity factors is also growing among public-sector leaders. In January, the treasurer of Pennsylvania and the city controller of Philadelphia called on the three major agencies to explicitly evaluate a government’s reliance on fees and fines when assessing municipal bond ratings.

“As more and more investors take interest in the needs of a broader set of stakeholders and rating agencies view risks facing governments more broadly, the relationship between equity-related ESG factors and a city’s credit rating will grow.”

As part of the City Budgeting for Equity & Recovery program, What Works Cities brought city leaders and rating agency leaders together in August to discuss the relationship between municipal credit ratings, ESG factors, and inequities.

The extent to which a particular agency ties a particular city’s ability to pay to noneconomic risk factors definitely varies—there’s no straight line between one ESG factor and a rating downgrade or upgrade. But what seems certain is that in the coming years, as more and more investors take interest in the needs of a broader set of stakeholders and rating agencies view risks facing governments more broadly, the relationship between equity-related ESG factors and a city’s credit rating will grow.

Common ESG Factors

The particular mix of ESG risk factors analyzed by each rating agency and the extent to which those factors influence specific credit rating decisions is in flux. Here are examples of factors often in the mix right now but by no means is this a comprehensive list.

• Environmental: natural disasters and climate change, water and wastewater management, waste and pollution, energy management.
• Social: labor relations/labor unrest, income inequality, demographic/population trends, political unrest, affordability of services, health and safety.
• Governance: data quality and transparency of information and decision-making, governance structure, management strategy, political stability and rights, risk culture and mitigation (i.e., cybersecurity).

Although ESG factors don’t directly determine credit ratings, they frequently play a role in U.S. public finance rating changes. S&P research shows that between 2017 and 2018, 34% of rating changes in the sector were due to ESG credit factors; governance factors were the key drivers of two-thirds (67%) of these changes, followed by social (28%) and environmental (5%). (Many governance factors, such as data quality and data-driven decision-making, are integrated into What Works Cities (WWC) certification criteria.)

While social factors have been less influential on rating changes, they could grow in importance if racial, economic, and health equity gaps widen.

“Inequality—racial or otherwise—raises social risk and can adversely affect economic, fiscal, and institutional strength,” Moody’s noted last year. “[T]he inequality dynamic…exacerbates credit-related social risks in the U.S.”

Similarly, environmental factors could become more influential as the effects of climate change grow more pronounced, multiplying the frequency and cost of recovery and reconstruction efforts cities face.

Going forward, rating agencies will continue to track ESG factors and more traditional quantitative factors (i.e., revenues, expenditures, liabilities) while analyzing a city’s long-term ability to pay back issued debt. The influence of specific ESG criteria on ratings will change as cities grapple with such major risk-related trends as natural disasters and income inequality.

At the same time, how agencies quantify ESG factors—which data streams they analyze and how they relate them to a city’s ability to pay—is still in the early stages of development. That gives cities an opportunity to step up with their own data practices to show how they’re taking equity-related risks seriously.

“Cities that take a data-driven approach to management…are more likely to have a higher credit rating.”

You Can’t Manage What You Don’t Measure

Here’s a piece of good news for any city working to ramp up data-driven governance practices: They correlate to higher credit ratings. Cities that take a data-driven approach to management (as indicated by their WWC certification scores), are more likely to have a higher credit rating, according to a research paper published by Johns Hopkins University last year. This positive relationship between credit ratings and data-driven governance was found even when controlling for various fiscal and demographic factors that typically relate to municipal bond ratings.

This makes sense. WWC partnerships with more than 150 cities across the United States have shown that when cities improve the way they leverage data for decision-making, they deliver higher-quality services and are more resilient in the face of challenges. By tracking and analyzing data detailing specific equity metrics—for example, through the Equity Indicators tool developed by CUNY’s Institute for State and Local Governance—cities can employ evidence-based decision-making practices that keep budgets aligned to equity priorities.

With a robust data infrastructure in place, cities can track and address ESG factors rating agencies have on their radars. This signals a commitment to managing ESG-related risks as investor interest in them grows. But ultimately, creating a strong ESG profile is about more than the investor community and bond ratings. It’s about building more resilient and inclusive communities through equitably designed and delivered government services.

Jennifer Park is a vice president and managing director at Results for America and founding director of What Works Cities Certification.

Anjali Chainani, former director of policy for the city of Philadelphia, is a senior advisor at What Works Cities and leads the City Budgeting for Equity & Recovery program.