S&P Global Ratings' ESG report cards qualitatively describe how and why environmental, social, and governance factors may have a more positive, negative, or neutral influence on an individual entity's credit fundamentals that we incorporate into our forward-looking credit rating analysis. In this report, we analyze the ESG credit factors that could be most influential and material in our credit rating analysis for U.S. public finance (USPF) government and not-for-profit enterprise issuers in the Midwest and Central region of the country, which includes Iowa, Illinois, Indiana, Kentucky, Michigan, Minnesota, Missouri, North Dakota, Ohio, Pennsylvania, South Dakota, Wisconsin, and West Virginia. These comparative views of ESG factors are qualitative and established by analysts during analytic discussions and described in issuer-level credit rating reports, with the goal of providing insight and transparency.

We grouped the states covered in this report based on geographic proximity and commonly shared credit rating risks, including those associated with ESG. The risks and opportunities highlighted in this report are not exhaustive but rather broadly illustrative and represent where issuers across different sectors are positioned relative to those risks and opportunities. Beginning April 2020, S&P Global Ratings incorporated a summary paragraph in all issuer-level credit reports to provide transparency, on a comparative basis, of how material and influential ESG risks and opportunities are in our credit rating analysis. Select ESG summary paragraphs from issuers within this region are reproduced in the Appendix.

ESG In Credit Ratings

ESG risks and opportunities can affect an entity's capacity to meet its financial commitments, including debt service. S&P Global Ratings incorporates ESG considerations into its ratings methodologies and analytics, which enables analysts to integrate the qualitative and quantitative effects throughout our credit rating analysis (see "Through The ESG Lens 3.0: The Intersection Of ESG Credit Factors And U.S. Public Finance Credit Factors," published March 2, 2022, on RatingsDirect, and "Environmental, Social, And Governance Principles in Credit Ratings," Oct. 10, 2021).

Environmental - Neutral

The Midwest and Central region accounts for about 24% of the U.S. population (over 78 million) and spans 850,000 square miles. Environmental risks vary across this large area yet are typically neutral to our credit rating analysis for most USPF governments and not-for-profit enterprises. In some cases, we observe heightened or emerging risks at local levels stemming from flooding and severe storms, water contamination, and reliance on heavy greenhouse gas emitting industries; but the influence from these risks for most entities is limited because of infrequent occurrence or available financial mitigants, such as strong budget flexibility and liquidity, availability of insurance, and support from the Federal Emergency Management Agency (FEMA). In addition, the presence of the Great Lakes, the largest body of fresh water in the world, is an unparalleled opportunity for much of this region, providing ample access to drinking water in close proximity to population centers. Over time, affordable access to water could improve the region's draw for both business and residential relocation.

Physical risk.  This region's geography and climate insulate it from many physical risks and climate hazards that entities in other regions face. Inland flooding has been widespread in the region as the Mississippi and Missouri rivers flow through many of the states. However, it commonly occurs in sparsely populated areas or designated flood zones along rivers without much economic development, which can limit the materiality of the risk in our credit rating analysis. According to FEMA, severe weather events occurred more frequently in the region over the last five decades (see chart 1), and urban areas with aging utility infrastructure could face increased risks for damage potentially requiring additional capital or operational costs to restore. For example, metro Detroit has experienced increased flooding events in in recent years, including record rainfall in 2021 that overwhelmed portions of the Great Lakes Water Authority's system, a problem worsened by a power failure that caused drain backups that flooded thousands of homes. Similarly, Davenport experiences periodic flooding given its location along the Mississippi River, with a major flood in 2019. The city has since been working with the state on a $165 million flood mitigation plan to remediate the risk.

In addition, changing weather and precipitation patterns can trigger hydrological variation in the Great Lakes water basin, ultimately leading to rising and lowering water levels in relatively short time periods. This risk can render waterfront parks or beaches unusable and curb tourism over time, and potentially damage personal property and suppress assessed values. Furthermore, frequent or severe periods of excessive heat or rainfall can reduce crop output, a key economic component for the region's agricultural communities.

Federal funding and insurance are often available to help offset weather damage costs, but entities--particularly the smaller ones--with nominally slim reserves or liquidity to fund upfront expenditures face potentially higher credit rating risks. In addition, local governments and utility systems with repeated infrastructure failures following more intense weather events could also lose population or interest from developers in the long term depending upon how entities implement risk management, resiliency, and adaptation measures to harden infrastructure and assets against these events.

Chart 1

Waste and pollution.  Relative to the rest of the nation, most of this region is exposed to lead and copper water pipes, reflecting comparatively older infrastructure and a smaller percentage of rebuild (see chart 2). We expect that aggressive regulation such as the Environmental Protection Agency's Lead and Copper Rule will be effective in eliminating lead service lines but the timeline for compliance is unclear and costs could be significant for issuers with substantial exposure. We also view water contamination as a health and safety (social) risk that tends to disproportionately occur in vulnerable communities where affordability pressures may already be high, such as the cases in Flint and Benton Harbor, Mich. Some states may be better positioned to receive and deploy federal resources to replace water lines, which could help accelerate mitigation efforts.

Chart 2

Climate transition risk.  Regulation toward renewable energy production could have negative effects for governments and not-for-profit enterprises whose revenues and economic bases rely on the fossil fuel industry, which in this region includes much of North Dakota (oil drilling) and West Virginia (coal), small pockets of Illinois, Kentucky, Ohio, and Indiana (coal), and several areas of Pennsylvania with either coal or natural gas mining (Pennsylvania is the nation's second largest natural gas producer). About 46% of the nation's electric generation from coal is supplied by power providers in these states (according to the Energy Information Administration), leaving power utilities and end users particularly vulnerable to high costs of decommissioning coal mines and transitioning and connecting to new energy sources. Jobs in these sectors do not account for substantial overall employment in the region, but North Dakota and West Virginia have the first and third highest concentration in energy sector jobs in the nation, at 3.7% and 2.7%, respectively, with the national average at 0.4%. However, cyclical revenue trends tied to this industry can affect budgetary balance and periodically influence economic output. Transition to wind powered generation could create an opportunity for entities in this region, with some already paving the way. Iowa is among the three largest wind power generating states in the country, and North Dakota, Minnesota, and Illinois are also in the top 10 (according to the Energy Information Association).

In addition, heavy reliance on manufacturing and the automobile industry exposes much of this region to transition risks of changing regulation and consumer sentiment, considering the carbon emissions released throughout the manufacturing lifecycle. Chart 3 shows the high concentration of auto plants in this region. Positively, we believe this region is well positioned to attract new electric vehicle (EV) investment, as it has skilled work forces, infrastructure, and proximity to existing suppliers and manufacturers. In fact, sites in Michigan, Kentucky, and Indiana have secured multi-billion-dollar investments from the EV industry. S&P Global Ratings forecasts the EV market share in the U.S. will increase to above 15% by 2025, up from 4% in 2021, and we believe those communities that are able to secure investment will likely maintain or experience economic growth, supporting jobs, demand for transportation, health care, and education enterprises over the long term.

Chart 3

Social - Elevated

We view the exposure to social risks as moderately negative within our credit rating analysis for rated entities in this region. In our view, the risks stem from long-term demographic trends reflected in population stagnation or decline, which are driven by out-migration trends for employment opportunities in other parts of the country. We believe the recent trend of housing price and home value appreciation, particularly in certain urban areas in this region could exacerbate social risks and affordability.

Social capital.  During the last decade, most of the Midwest and Central states exhibited weaker population growth than the nation (see table 1). Notably, Illinois and West Virginia represented two of only three states that saw population declines, and the decline in Illinois is expected to accelerate to minus-2.5% during 2020-2025, the second largest across the nation.

Table 1

In line with its weak population trends, the region has a higher old-age dependent population compared to that of the nation (65.6% vs. 63.1%), with Michigan projected to have the nation's largest increase in the next two decades (see "Increasing Generational Dependency Poses Long-Term Social Risks To U.S. States' Fiscal And Economic Stability," Feb. 24, 2020). In chart 4, we illustrate "old-age dependency ratio" or the number of persons age 65 and over divided by the labor force (age 15 to 64) as defined by the Organization for Economic Cooperation and Development.

Chart 4

When analyzing the working-age population trends, we note that all but one state in the region saw weaker growth than national average from 2010-2020, based on S&P Global Market Intelligence data, and Michigan, Illinois, Ohio, and West Virginia are among the 10 states projected to experience the largest working-age population declines in the next two decades.

A shrinking working-age population could hinder long-term economic diversity and development as well as challenge demand for not-for-profit entities. This, coupled with a population that is aging more quickly compared to the nation, could result in state and local government budgetary pressures relating to education (public and private K-12 and higher education), health care, and social services as well as pension and other postemployment benefit contributions. It may also present affordability revenue challenges, such as property taxes and utility fees as costs for services and infrastructure are spread across a smaller or shrinking base. In the utility sector, this could make it difficult to fund infrastructure maintenance, expansion, and transition to renewable energy sources. As mentioned, lack of funding for deferred maintenance could result in repeated infrastructure failures and dampen future growth prospects. While an aging population could bolster demand for not-for-profit health care providers, it could increase the providers' expenditure for advanced and more expensive medical technologies and impact their ability to manage lower governmental reimbursement through Medicare, depending on the payer mix.

In the education sectors, public school district enrollment follows similar trends as those of the general population. According to National Center for Education Statistics data, from 2010 to 2020 there were relatively large enrollment declines in Illinois, Michigan, and West Virginia, while Iowa, Minnesota, North Dakota, and South Dakota enjoyed growth, supported by stronger population increases compared to the regional average. Overall public school district enrollment in the region declined by 4.8%, compared to only 0.2% for the U.S. These declines could also be partially driven by the prevalence of school choice programs (especially in Indiana and Michigan) and charter school law, which introduces more demand competition. Since the funding formula for school districts in most of these states are driven by enrollment, declining enrollment and heightened competition could pressure those schools that may be required to enhance curriculum and renovate facilities to attract prospective students.

For higher education, all but one of these states had enrollment declines over the last decade, each exceeding the nation (see table 2). Total higher education enrollment declined by 9.9% in the region as compared to 1.8% in the U.S., suggesting out-migration in the younger-age group toward education and future employment opportunities in the other parts of the country. Declining enrollment in higher education could have implications for state appropriations and direct impacts on student tuition and auxiliary revenue. With growing affordability concerns, especially for private colleges and universities, we think higher education institutions could face constraints to raise tuition revenue when competing with weaker demand. Indiana was an outlier, with a 26% enrollment increase, mainly driven by expansion of online and physical campuses by Purdue University and the opening of other higher education institutions. We believe the online education experience in Indiana highlights a potential mitigant to the region's social capital risk to expand demand nationally or even globally, subject to effective financial governance and successful management of program quality and student outcomes.

Table 2

Human capital.  Correlating with its lagging demographic trends, the region's employment base is growing at a slower pace compared to that of the U.S. and over the last decade, and the gap appears to be widening as shown in chart 5.

Chart 5

We estimate an approximate net loss of 1.7 million manufacturing jobs in the region from 2000 through 2019, followed by a sharp drop of 304,000 in 2020 largely due to the pandemic. Manufacturing jobs have since grown modestly in 2021 and are projected to improve further in 2022. However, with changing greenhouse gas emissions policies and increasing automation of work, we believe the region is unlikely to see a significant resurgence in manufacturing employment except for activity that may be driven by electric vehicles. Table 3 shows the share of manufacturing as a percentage of each state's GDP and employment. The loss of manufacturing jobs could have a significant effect on human capital and potentially require government financial or operational support to attract new industries or retrain employees, given how reliant the region is on this industry.

Table 3

The workforce in the region is relatively heavily unionized; labor union activities and negotiations can result in financial risks and operational disruptions for local governments and not-for-profit enterprises. A key aspect of our credit rating analysis is management's ability to manage operational challenges such as labor strikes and maintain budgetary balance.

Governance - Neutral

Ineffective identification, monitoring, and mitigation of risks, which can disrupt service delivery and budget balance, can have a significant influence on our view of an issuer's ability and willingness to pay its obligations, including debt service, on time and in full. Furthermore, we believe those entities burdened by high pension contributions could be negatively affected by risk management, culture, and oversight governance risks. While we believe there are some governance weaknesses in the region, overall we view it as neutral given the comparatively stable management and governance assessments in our credit rating analysis for governments and not-for-profit entities.

Risk management, culture, oversight.  Poorly funded pension and retiree health care obligations are somewhat common across this region. In addition, the aforementioned social risks (i.e., aging populations, shrinking labor force, and strong collective bargaining groups) in many of these states could also make it more difficult to fund these plans or implement changes. School districts in Illinois, Michigan, Kentucky, and Pennsylvania participate in state cost sharing pension plans that typically are poorly funded and therefore inherit decision making risks from these states that potentially create budgetary pressure if states reduce subsidies or shift contribution burdens. Many local governments in Illinois and Michigan also face severe pension pressure that stems partially from poor funding discipline of single employer plans. In Illinois, we view pension risk management as having a moderately negative influence on our state rating, due to limitations on altering pensions and a statutory requirement to meet funding goals of 90% by 2040, rather than 100%. We would view prudent funding policies, including assumptions and amortization practices that realistically capture liabilities and reduce the likelihood of volatility, as governance decisions that can mitigate pension funding risks (see "ESG Brief: ESG Pension And OPEB Analysis In U.S. Public Finance," Oct. 7, 2021).

Transparency and reporting.   The prescribed state frameworks that local governments and non-profit enterprises operate within are more likely to negatively influence credit ratings when they reduce predictability or flexibility or fail to support strong transparency. Almost all local governments and schools in these states are required to produce annual or biannual financial reports, but the quality and depth can vary. The only states in this region requiring all or nearly all its municipalities and counties to produce audits on a GAAP basis of accounting are Michigan, Minnesota, Ohio, and West Virginia. Issuers often produce GAAP audits even if not required but cash accounting remains common for schools in Illinois and Ohio, municipalities in Iowa and Pennsylvania, counties in Kentucky, and is the predominant statement basis for schools in Missouri and all local governments in Indiana. We believe cash accounting could reduce transparency and may negatively influence our credit rating analysis, as we have specific adjustments in our criteria for municipalities, counties, and utilities to account for this risk.

The Indiana State Board of Accounts is statutorily required to review and publish financial reports for Indiana municipalities, but these are often produced more than a year after the statement period and prescribe to a basis of accounting that is different than the accounting principles generally accepted in the United States. These comparatively weaker financial statement reporting requirements are described in our institutional framework for Indiana municipalities and counties that are not required to file a GAAP audit and, in some cases, have negatively influenced our credit rating analysis when not provided in a timely manner.

Appendix