How Environmental Regulations Are Quietly Raising Borrowing Costs for US Municipalities

Environmental regulations in the United States are designed first and foremost to protect public health. Rules targeting air pollution, especially under the Clean Air Act, have played a major role in reducing harmful emissions and improving quality of life. But new research suggests there is another side to the story—one that plays out in financial markets rather than hospitals or air quality monitors. According to a recent academic study, environmental regulations can also lead to higher borrowing costs for counties, affecting how local governments fund schools, hospitals, and critical infrastructure.

The research, published in the journal Management Science, examines how changes and uncertainty in US air pollution regulations influence the municipal bond market. Municipal bonds are a key financing tool for local governments, and they are traditionally seen as relatively safe investments. However, the study shows that these bonds are more sensitive to environmental policy than many people might expect.

The Connection Between Air Pollution Rules and Municipal Bonds

At the center of the research is the US Environmental Protection Agency (EPA) and its enforcement of air quality standards, particularly those related to ground-level ozone. Under the Clean Air Act, counties are regularly assessed to determine whether they meet federal pollution thresholds. Counties that fail to meet these standards are labeled as being in nonattainment, which can trigger stricter regulatory requirements and higher compliance costs.

The study finds that when counties fall out of compliance, investors begin to view them as riskier borrowers. This perception shows up almost immediately in the form of higher interest rates on their municipal bonds. In simple terms, counties that are struggling with pollution issues end up paying more to borrow money.

This matters because municipal bonds are commonly used to finance schools, hospitals, roads, water systems, and other public infrastructure. Even small increases in interest rates can translate into millions of dollars in additional costs over the life of a bond.

Who Conducted the Study and What They Analyzed

The research was led by Akshaya Jha, an assistant professor of economics and public policy at Carnegie Mellon University’s Heinz College of Information Systems and Public Policy. The study was coauthored by Nicholas Z. Muller of Carnegie Mellon’s Tepper School of Business and Stephen A. Karolyi of George Mason University’s Costello College of Business.

To understand how markets react to environmental policy, the researchers analyzed more than 140 million municipal bond trades spanning the years 2005 to 2019. This massive dataset allowed them to closely track changes in bond yields around key regulatory events.

Rather than looking at long-term trends alone, the study focused on specific EPA announcements, treating them as information shocks that reveal how investors update their expectations in real time.

EPA Announcements That Move the Market

The researchers identified two types of EPA announcements that have a measurable impact on municipal bond yields.

The first involves moments when the EPA proposes new ozone standards. These proposals signal the possibility of stricter future regulations, but they do not yet clarify what the final rules will look like. According to the study, bond yields tend to increase by roughly 1% to 4% following these proposals. This rise reflects increased uncertainty among investors, who begin to price in the potential costs of tougher environmental rules.

The second type of announcement occurs when the EPA finalizes those standards. Once the uncertainty is resolved, bond yields typically decline by about 0.5% to 1.3%. Investors appear to respond positively to clarity, even when the final rules remain strict.

The study also examined the EPA’s annual list of counties that are either in attainment or nonattainment. Counties that slipped into nonattainment experienced yield increases of nearly 1% more than counties that maintained compliance or newly achieved it.

Why Investors React This Way

From an investor’s perspective, environmental regulations introduce two major risks.

The first is financial strain. Counties that are out of compliance may need to invest heavily in pollution control, enforcement, or infrastructure upgrades. These costs can squeeze local budgets, making it harder to meet debt obligations.

The second is policy uncertainty. Environmental regulations can change over time due to political shifts, court rulings, or scientific updates. Investors dislike uncertainty, and when future rules are unclear, they demand higher returns as compensation for that risk.

The study links these short-term market reactions to longer-term changes in pollution levels and housing prices, suggesting that bond markets are not just reacting emotionally but are incorporating real economic expectations into pricing.

What This Means for Local Governments and Policymakers

The findings carry important implications for policymakers and local officials. While environmental regulations deliver substantial public health benefits—often measured in billions of dollars—this research highlights a hidden financial tradeoff. Higher borrowing costs can limit a county’s ability to invest in essential services and infrastructure.

For policymakers, the study suggests that regulatory design and communication matter. Reducing unnecessary uncertainty around rule changes could help limit unintended financial consequences, even while maintaining strong environmental protections.

Local governments, meanwhile, may need to factor environmental compliance more explicitly into their financial planning and debt strategies, especially in regions close to regulatory thresholds.

Why This Matters for Investors Too

For investors, the research challenges the assumption that municipal bonds are insulated from environmental risk. The study shows that environmental policy risk is a real and measurable factor in municipal bond pricing.

This insight may become even more relevant as climate and environmental regulations expand in scope. Investors who understand how policy changes affect local finances may be better positioned to assess risk and make informed decisions.

A Broader Look at Environmental Policy and Finance

This study fits into a growing body of research exploring how environmental factors influence financial markets. Beyond municipal bonds, environmental regulations can affect housing prices, commercial real estate, employment patterns, and local tax bases.

The authors of the study plan to continue exploring how environmental rules shape local finance, including impacts on commercial real estate markets. As governments increasingly rely on market-based financing, understanding these connections becomes more important.

The Big Picture

Environmental regulations remain one of the most effective tools for protecting public health and improving air quality. This research does not dispute those benefits. Instead, it adds nuance by showing that the costs of regulation are not limited to compliance expenses alone. They also show up indirectly, through higher borrowing costs driven by investor perceptions of risk and uncertainty.

By examining how financial markets respond to environmental policy, the study sheds light on the complex economic tradeoffs that accompany well-intentioned regulations. It serves as a reminder that policy decisions often ripple through systems in unexpected ways, affecting everything from bond yields to the cost of building a new school or hospital.

Research paper:
https://doi.org/10.1287/mnsc.2023.02340