As the eastern United States has experienced record flooding and the west is hotter and drier than ever, municipal bond investors should integrate the potential impacts associated with climate change into their credit analysis.
It’s become increasingly important for investors to incorporate climate risk into their overall credit assessment of municipal bond issuers as state and local governments grapple with the physical impacts of climate change. Between drought and destructive wildfires in the western United States and flooding and a very active hurricane season in the eastern United States, extreme weather events are increasing in both frequency and intensity. According to a report from the Environmental Defense Fund, the number of extreme weather events in the United States has increased by a multiple of four from 1980 to 2020, while the total economic cost of the destruction from these natural disasters has increased by a multiple of five. The US Government Accountability Office estimates that the United States has spent an average of $30 billion annually in federal disaster aid in the aftermath of extreme weather events from 2005 to 2019. No state has been insulated from these increasingly costly climate disasters, and each of the 50 states has suffered at least one $1 billion disaster since 1980. As the earth continues to warm, these disasters are projected to be more severe and the damage more costly.
The inundated east
On the eastern side of the United States, state and local governments are currently dealing with historical flooding and a very active hurricane season. Of the costliest extreme weather events in US history, the top five most expensive have been hurricanes, with Hurricane Katrina costing more than $125 billion in 2005 (estimated at $172 billion when accounting for inflation) and Hurricane Harvey amounting to more than $133 billion in damages in 2017. As a result, many coastal cities have invested in climate resiliency infrastructure. New Orleans, for example, spent $14.5 billion on a new levee system after Hurricane Katrina.
This investment appears to have paid off; the levee system held during Hurricane Ida, the most severe hurricane to hit New Orleans since Katrina. Though total damages in Louisiana, Mississippi, and Alabama from Hurricane Ida are currently projected at $27 billion to $40 billion, this is significantly lower than the cost of damages from Hurricane Katrina. However, the runoff from Hurricane Ida caused more destruction as it made its way up the Eastern Seaboard. Ida hit the New York City area with historic flooding and its first ever flash flood emergency declaration. Projected economic costs of flood damage in the Northeast are between $16 billion and $24 billion.
As part of the overall risk assessment of a municipal bond investment, it’s increasingly important to include these environmental risks in the investment decision-making process. This analysis should include whether the municipality has enacted any resiliency plans to combat risks from weather-related events, such as building seawalls and improving levee systems, elevating roadways to alleviate flooding, strengthening sewage and water storage systems, and requiring sturdier construction to withstand severe storms.
Move beyond talk and mitigate risk
In contrast to the east, the majority of the land west of the Rockies has been in drought conditions for over a year, and the US government recently declared the first ever shortage of water on the Colorado River. The main reservoir that feeds the river, Lake Mead, is currently measured at 1,068 feet below sea level, its lowest level since the Hoover Dam was built in the 1930s, and is projected to be even lower by early next year. This will trigger mandatory water cutbacks in several states that rely on the river for water, including Arizona, Nevada, California, Colorado, New Mexico, Utah, and Wyoming, and will impact farmers and agriculture most significantly. Water cuts aren’t expected to affect city and suburban residents and industrial businesses much, as water managers have been preparing for these conditions for many years.
From the perspective of municipal bond issuers, smaller water systems with low economies of scale, no diverse sources of water supply, and low liquidity will likely be the most negatively affected by these cuts. Larger, regional systems in this area are entering this most recent drought coming from a stronger financial position, with more water in storage now than a decade ago, providing a buffer against mandatory water use restrictions. In addition, many large regional systems have more diverse water sources than they did before entering the last 2012–2016 drought period. It’s important for investors to take all these factors into account when assessing the creditworthiness of an issuer. The current drought may see revenues impacted by water restrictions over the long term, with ratings potentially negatively affected as a result. This could increase borrowing costs for issuers not adequately prepared to face the challenges of climate change.
In addition to the severe drought conditions, the western United States continues to see more frequent and severe wildfires as the climate becomes drier. Of the major wildfires currently raging in California, the Caldor fire is on a path to be the most destructive in state history. Note that the only natural disaster–related default in the municipal market, Pacific Gas and Electric’s bankruptcy in 2018, was a fallout from the wildfires in California.
Despite increasing damage and costs from extreme weather events, municipal credit remains resilient. In addition, although economic losses from these disasters can be immense, most are covered by private insurance and federal disaster aid, which has muted the impact for municipalities. The Federal Emergency Management Agency (FEMA) often covers 75% of disaster-related costs for municipalities.
Although a natural disaster may not lead to an immediate default, it’s critical to incorporate these rising climate risks into the investment decision-making process. Over time, climate change could result in population shifts, declining tax bases, and increasing debt loads, which could lead to credit stress. Municipalities have been slow to adopt better reporting and disclosure practices to account for climate and environmental risks, and investors continue to push for better disclosure from issuers on these long-term risks. As investment managers, we actively incorporate key metrics related to the risks of climate change into the overall credit analysis of our municipal holdings.
The bottom line
With the frequency and damage of weather-related events continuing to rise, we believe incorporating climate risk into the credit-evaluation process for state and local issuers is becoming more critical for municipal bond investors.
