Joseph Krist

Publisher

ESG AND RATINGS

This week we read about an effort to develop a rating system for municipal bond credits based on non-financial criteria. The plan is to introduce several economic and demographic factors into the ratings process which heretofore are not currently weighted. Some of the factors include an analysis of housing affordability. The goal is to try to use the investment process to drive social policies on the behalf of municipal bond investors.

We note a couple of problems with this process. Owning bonds and objectively rating them for someone else seems to be inconsistent.  One of the entities expressed belief that by rating bonds and taking investment positions in bonds, they would somehow have access to officials and information that is not provided now. There seems to be an underlying assumption that bondholders have control over local decision making. Were that true, the municipal market would function much differently.

If the market had that sort of pull, it would be in the position of effectively dictating policy to be carried out by a locally elected entity. Is it the market’s job to achieve general social goals? Would local residents not object to having policies dictated from outside entities against whom local residents have no direct recourse? Do you believe for a minute that the municipal bond investment community wanted to see credits like NYC in the 70’s, Philadelphia and D.C. in the eighties, and Puerto Rico currently be run as poorly and irresponsibly as they were?

Puerto Rico provides the best example. Municipal bond investors would like to see an economy less centered on government employment and income redistribution. They would like to see a solid educational system, a functioning power system, and real development of the local economy. Yet, throughout the process the “bloody shirt” of accusations of colonialism and prejudice weighs down the conversation. Even in the midst of its restructuring, there remains a high level of concern that the Commonwealth will return to its “bad old ways” as soon as outside oversight is ended.

We expect to see more instances of the debate over what constitutes a healthy municipal bond credit as ESG investing moves center stage. One of the current hurdles to development of sound ESG investing criteria is that there is no real definition in the municipal market for what constitutes ESG investments. The industry needs to develop agreed upon standards as well as agreed upon metrics to be established to enable what are at the end of the day, quantitative investment decision making issues.

And it also must be noted that “corporate” approaches to municipal bond analysis are nearly always doomed to fail. Until the Tower Amendment is no longer preventing the imposition of full SEC reporting requirements for municipal issuers, the municipal market will remain unique. Expecting that an investor will receive better disclosure through its ownership of small bond positions reflects a bit of naivete.

In the end, the municipal market needs to move more quickly to develop an accepted set of standards to fairly analyze the ESG sector. We need to define our terms and provide an objective way to measure or quantify those issues which define whether or not a bond issue is green or social. Right now, there are more entities providing rivalling definitions of what is green or social or good governance than I have fingers to count. That has to change. Once that framework has been fully established, then the market will be able to evaluate and price risk.

Until then, the ESG concept remains primarily a marketing tool or a “greenwashing” tool.

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OIL AND GAS IN NORTH DAKOTA

In 1889, Congress passed the Enabling Act “to provide for the division of Dakota [Territory] into two states, and to enable the people of North Dakota, South Dakota, Montana, and Washington to form constitutions and state governments, and to be admitted into the union on an equal footing with the original states, and to make donations of public lands to such states.” The Enabling Act provided further land grants to the State of North Dakota for the support of colleges, universities, the state capitol, and other public institutions.

Revenues are generated through the management of trust assets, which include approximately 706,600 surface acres and nearly 2.6 million mineral acres in the state.  Article IX, Section 2 of the North Dakota Constitution directs that the “net proceeds of all fines for violation of state laws and all other sums which may be added by law, must be faithfully used and applied each year for the benefit of the common schools of the state and no part of the fund must ever be diverted, even temporarily, from this purpose or used for any purpose other than the maintenance of common schools as provided by law.”

The Department of Trust Lands conducted an audit in 2016 that claimed that one drilling company was underpaying royalties to the agency that leases rights for grazing and oil, coal and gravel production from state lands.  So, the department sued the company for breach of contract. Previous litigation on similar issues had historically been found in favor of the state up through the state Supreme Court level. The case was sent back to the lower court for retrial.

Now, a state district court judge found in favor of the energy company. The judge said the state’s claim of a breach of contract with the company was in question because the state failed to provide “any contract or lease … that allows this court to meaningfully review the contract obligations and whether a breach has occurred.” If upheld, there are significant ramifications for the state.

The Board had notified more than two dozen energy companies last year that they must pay money they had deducted from royalties owed to the state for developing its minerals. An earlier audit found that some oil companies took improper deductions for transportation, processing and other costs out of royalties owed to the state

NEBRASKA UTILITY PRESSURES

The Nebraska Power Review Board is a five-member body appointed by the Governor created in 1963 to regulate Nebraska’s publicly owned electrical utility industry. As a 100% public power state (the nation’s only), the Power Board is unique. The Board’s operating funds are received entirely from assessments levied on power suppliers operating in the State of Nebraska. The executive director is appointed by the Board. As constructed, the Board puts the Governor in a position of real influence if they choose to be.

One of the Board’s primary responsibilities is the creation and certification of retail and wholesale service area agreements between electric utilities operating in Nebraska. Any amendments to existing agreements must be approved by the Board. The Board maintains the official records pertaining to these agreements, which establish the geographic territory in which each utility operating in Nebraska has the exclusive right to serve customers. There are approximately 390 such agreements maintained by the Board.

Now, likely at the Governor’s behest, the Board is considering whether it should have the final say over contracts reached between power districts and energy suppliers, such as wind farms, and be able to weigh in on whether existing power plants should be decommissioned. The Governor is squarely on the partisan view that coal plants should remain open and his administration is not considered supportive of wind renewables.

This could potentially put the larger generation utilities in a difficult position. The Nebraska Public Power District owns and operates a large coal fired plant that is among the state’s largest carbon emitters. NPPD has been under pressure from customers and renewables advocates as it plans its future. Other utilities seeking to diversify away from fossil fueled sources could see those efforts limited or even thwarted. 

Any recent expansions of capacity in the state have been through power purchase agreements.  Those agreements are currently exempt under state law from review by the Power Review Board. The concern for the utilities is that local control – through elected officials in the case of the large Omaha, Lincoln, and NPPD systems – is the issue. It would be another form of a favorite topic of ours – preemption. It is not a surprise that an ideological governor would seek to so overtly intervene.

FLOOD INSURANCE

The National Flood Insurance Program (NFIP) is managed by the Federal Emergency Management Agency and is delivered to the public by a network of approximately 60 insurance companies. Rates are set in accordance with ratings established by FEMA. Since the 1970s, rates have been predominantly based on relatively static measurements, emphasizing a property’s elevation within a zone. This year, that rating system is undergoing major change.

Risk Rating 2.0 is designed to incorporate more flood risk variables. These include flood frequency, multiple flood types—river overflow, storm surge, coastal erosion and heavy rainfall—and distance to a water source along with property characteristics such as elevation and the cost to rebuild. The changes will be phased in over two years.  New policies beginning Oct. 1, 2021, will be subject to the new rating methodology. Also beginning Oct. 1, existing policyholders eligible for renewal will be able to take advantage of immediate decreases in their premiums.

In one example, Monroe County which covers the Florida Keys — FEMA says more than 90% of homeowners will see their annual flood insurance premiums go up, sometimes by thousands of dollars a year. It would be higher, but annual increases for each homeowner are statutorily at 18%. Congress is apt to make changes more favorable to homeowners if the politics of the issue dictate such an action.

Recently, the First Street Foundation released a report documenting the risk on a local level from flooding. First Street, like many others, is attempting to show modeling which “quantifies” the potential risk from flooding related to climate change over the next 30 years. Like any other model, the variables examined and the precise mathematical strategies are a product of unique circumstances.

First, they define their infrastructure categories. Critical infrastructure includes facilities such as airports, fire stations, hospitals, police stations, ports, power stations, superfund/hazardous waste sites, water outfalls, and wastewater treatment facilities. Social infrastructure includes government buildings, historic buildings, houses of worship, museums, and schools. 

The report’s analysis found that over the next 30 years, risk to residential properties is expected to increase by 10%, risk to social infrastructure will increase by 9%, risk to commercial properties is expected to increase 7% and risk to critical infrastructure facilities is projected to increase by 6%. Additionally, 2.0 million miles of road (23%) are at risk today, expected to increase by 3% over the next 30 years. Distinct patterns of county-level community risk highlight significantly increasing risk along the Atlantic and Gulf Coasts and large increases in risk in the Northwest. Risk is concentrated along the coastal areas of the Southeastern U.S. and the Appalachian Mountain region.

Among counties, Washington County, NC has the most significant county level increase in flood risk; with a 100% increase in critical infrastructure flooding, a 50.8% increase in the flooding of residential properties, a 51.7% increase in the risk of flooding of commercial properties, and a 32.3% increase in the flooding of roads over up to the year 2051. The highest concentration of community risk exists in Louisiana, Florida, Kentucky, and West Virginia, as 17 of the top 20 most at risk counties in the U.S. (85%) are in these 4 states.

At the city level, a large percentage of risk is concentrated in Louisiana (3 cities) and Florida (6 cities). The major population centers of New Orleans, LA Miami, FL (St. Petersburg, FL); and Tampa, FL all rank among the “most at risk” cities.

KAWASAKI SUBWAY CARS

For the last 20 years, U.S. rapid transit systems have been modernizing their rolling stock. With American-owned rail car production essentially a thing of the past, foreign owned producers have become the primary suppliers. New York’s MTA has made six purchases from the Japanese manufacturer, Kawasaki. Other purchasers include the Port Authority Trans Hudson line (PATH) and the Washington D.C. Metro system.

Over the weekend, problems with Washington Metro’s fleet led to derailments. The Metro decided to temporarily pull all of its Kawasaki rolling stock out of service for detailed inspections. For WMATA, this represents some 60% of its fleet. This has led to significant service cutbacks. Safety is a crucial issue for WMATA after a series of incidents over recent years.

WMATA has been aware of wheel set assembly issue since 2017. She said preliminary data showed that since 2017, there have been 31 WMATA wheel assembly failures –including 18 in this year — and 21 failures were uncovered during inspections that began Friday and are ongoing. This has raised concerns at the National Transportation Safety Board. The Board has announced that it may issue an “urgent recommendation” telling transit agencies to inspect Kawasaki train cars.

For the PATH system, such a recommendation could impact its entire fleet of subway cars. The MTA has been the largest buyer. SEPTA, serving Philadelphia is another customer although its Kawasaki rolling stock is some 40 years old.  The transit agencies will want the situation resolved, not just because of the obvious issues, but also because the production of the equipment is in factories in the U.S. Kawasaki and the Canadian builder Bombardier, both produced their U.S. rolling stock in factories in New York State. A Chinese electric bus manufacturer produces for the U.S. market at a California factory.

TRAVEL INDICATORS – AVIATION

United Airlines said on Tuesday that it had $7.8 billion in operating revenue during the third quarter, which was better than Wall Street had expected. The company expressed optimism about the coming months. The airline pointed to the fact that government officials around the world are slowly easing travel restrictions and companies are starting to send employees on more business trips.

The 24 U.S. scheduled passenger airlines employed 407,965 full-time equivalents (FTEs) in August 2021, a 1.3% increase from July 2021 (402,561). August’s total number of FTEs was up 5,404 from July but still down 40,295 FTEs, or 10.8%, from the March 2020 (457,260) onset of the pandemic. The August FTE total was also down 9.2% from the most recent corresponding pre-pandemic month, August 2019 (449,461). August 2021 had the lowest FTE total for the month of August since 2015 (397,007).

The employment increase between July and August resulted largely from the four network airlines, which added 4,704 FTEs. This increase was led by Delta Air Lines, which added 2,342 FTEs for a month-over-month increase of 3.3%. Southwest Airlines decreased the most with a loss of 229 FTEs or 0.4%.

NATURAL GAS AND MUNI UTILITY CREDITS

This winter is shaping up as a costly one for utility customers especially if they rely on natural gas. Natural gas prices have been steadily increasing but we have yet to see evidence of the potential impact of rising prices on individual utilities and their customers.  That is beginning to change.

The Colorado Springs City Council established a new rate schedule for its customers for this winter. It takes into effect the rising cost of gas to the utility to generate power and will translate into significant rate increases for customers. The new rates will increase natural gas prices on average by $15.92 per month up to $75.33, or about 26.8%, and electric costs by $12.60 up to $105.82, or about 13.5%. The increases are scheduled to take effect in November and stay in place through February.

For those utilities which use natural gas either directly for heating and cooking or to fuel their generation plants, we expect that increases in rates will be the norm. The city projected in August spending $4 to $4.50 per 1,000 cubic feet of gas over the winter. The actual price of gas is already closing in on $5 per 1,000 cubic feet of gas this month. The Colorado Springs combined utility system spent $140 million in February of this year during the well documented cold snap.

Colorado Springs raised natural gas prices by about $22 per month for residential users and electrical prices by $7 per month through April 2022 to pay off the cold-snap costs.  Natural gas prices are also largely responsible for putting Utilities $280 million over its $1.1 billion budget for this year. 

THE BEIGE BOOK

The Fed’s latest summary of economic activity came out this week. Economic activity continued to increase across all Districts, with the pace of growth characterized as slight to modest in most Districts. Manufacturing activity generally increased at a moderate pace. Residential housing markets continued to experience steady demand for new and existing homes, with activity constrained by low inventories.

Conversely, commercial real estate conditions continued to deteriorate in many Districts, with the exception being warehouse and industrial space where construction and leasing activity remained steady. Consumer spending growth remained positive, but some Districts reported a leveling off of retail sales and a slight uptick in tourism activity.

Demand for autos remained steady, but low inventories have constrained sales to varying degrees. Reports on agriculture conditions were mixed, as some Districts are experiencing drought conditions. Districts characterized the outlooks of contacts as generally optimistic or positive, but with a considerable degree of uncertainty. Restaurateurs in many Districts expressed concern that cooler weather would slow sales, as they have relied on outdoor dining.

We note that much of this period covers a time when a push to require vaccination as a condition of school attendance (teachers), working in an office, or attending public events in enclosed places was still in its early stages. While there have been some prominent examples of resistance, vaccine mandates have proven effective. Once vaccination was attached to employment requirements, vaccination rates in certain jobs (like schools, sports teams) rocketed up.

We note that despite a lot of noise from opponents, legal challenges to vaccination mandates are falling short in the courts. The fact is that vaccination requirements are nothing new. Most school districts require vaccination for mumps, measles, and other diseases so it’s been hard to see how opponents have a case. As vaccination takes hold, there should be real economic benefits.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.