The hidden cost of environmental policy uncertainty

Katelynn C Hipolito — Tue, 21 Oct 2025 15:30:50 +0000

The hidden cost of environmental policy uncertainty Katelynn C Hipolito Tue, 10/21/2025 - 11:30

Air quality standards do more than reduce pollution for noncompliant counties; they increase the cost of funding public infrastructure like schools, hospitals, and roads.

Air pollution regulations are meant to protect public health, but new evidence shows they also carry an unexpected cost: higher interest rates on the bonds counties issue to fund schools, hospitals, and infrastructure. When a county falls out of compliance with federal ozone standards, borrowing becomes expensive. The result is that the municipality faces higher costs to fund public infrastructure like schools, hospitals, and roads.

Stephen A. Karolyi

That is the central finding of a study published in Management Science, authored by Stephen A. Karolyi, a finance professor at Costello College of Business at ��, and co-authors Akshaya Jha and Nicholas Z. Muller of Carnegie Mellon University.

The study focuses on how the municipal bond market responds to the Clean Air Act, which sets thresholds for pollutants like ozone. The official term for exceeding the threshold for ozone pollution is “nonattainment.”

“If your county is not compliant with this federal standard, then there are repercussions. You have to create a plan to get back in attainment,” explains Karolyi. Prior work has shown how these federal standards generate significant health benefits relative to these compliance costs.

But for investors in municipal bonds, this raises two concerns: higher default risk due to strained county finances, and uncertainty about how regulations will evolve.

The researchers focused on two critical types of announcements. First is when the EPA proposes and finalizes new ozone standards. Second is when the EPA releases its annual designations of which counties are in or out of attainment. Together, these announcements create information shocks that allow researchers to track how bond markets update their expectations. The team measured changes in municipal bond yields surrounding the two types of announcements, analyzing more than 140 million trades between 2005 and 2019.

“Because municipal bond investors dislike uncertainty, one implication would be that policymakers should be concerned not only with the level of air quality standards, but also uncertainty over changes in air quality standards.”

The results reveal a consistent pattern. When new standards were proposed, yields rose by one to four percent, reflecting an increase in uncertainty perceived by investors. Once the final standard was announced, the estimated yields fell by about 0.5 to 1.3 percent, due to a corresponding decrease in uncertainty. When analyzing the annual compliance announcements, the authors found that counties that slipped into nonattainment experienced an increase in yields of nearly one percent, compared to counties that maintained their status or newly achieved attainment.

“Being non-compliant means that you’ll have to create and execute abatement plans, which bondholders expect to be costly,” explains Karolyi. Those expectations push yields higher, which makes it more expensive for counties to fund public infrastructure projects and services, though the current study does not explore all possible channels that are impacted.

The research shows that these expectations are well-founded. Karolyi explains, “When the bond market reacts more negatively to annual compliance announcements, we see larger decreases in house prices over the subsequent years. That’s consistent with the perceived cost of getting back into attainment. As a county, in order to get into attainment, one approach may be to restrict output, which may mean less employment and consequently a decrease in house prices.”

The implications are wide-ranging. For policymakers and local leaders, the findings underscore that environmental regulations also have repercussions for public finance. For investors, the findings highlight how traditionally safe assets like municipal bonds are sensitive to environmental policy risk.

Looking ahead, the researchers plan to extend their work to other areas where environmental rules intersect with local finance. Commercial real estate, for example, is an emerging area of interest as cities experiment with new sustainability requirements.

By examining how financial markets respond to environmental regulation, the team hopes to shed light on the hidden economic tradeoffs and potential unintended consequences of well-intentioned policies. To be sure, prior work has documented that more stringent air quality standards have generated billions of dollars in public health improvements. According to Karolyi, a key contribution of this paper is to show that these benefits come about in part due to investors anticipating the effects of standards and the costs of noncompliance.

“Because municipal bond investors dislike uncertainty, one implication would be that policymakers should be concerned not only with the level of air quality standards, but also uncertainty over changes in air quality standards,” Karolyi says.

In This Story

Stephen A. Karolyi

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