As we all have witnessed, climate change has increased the number of weather-related disasters over the past several years. Because of this, climate change is costing the United States $150 billion a year.1 This reality was starkly framed by Mark Carney, the former Bank of England Governor, in his 2015 “Tragedy of the Horizon” speech, highlighting how the financial market, and in our case the municipal market, tends to underestimate climate risks because the perceived timing lies far into the future, beyond the normal investment horizon for most investors.
Now as we begin to understand the effect of climate change on the municipal market, it becomes clear that strategic measures, such as the use of municipal bonds and Environmental, Social, and Governance (ESG) principles, are important in securing a sustainable future for our communities. In this blog, I’m going to discuss the climate effects on the municipal market, the role of municipal bonds in addressing the urgent need for resilient infrastructure, and the broader implications for investors and the communities they serve.
Thoughtful financing plans are a superpower when building climate-resilient infrastructure. Working through the complex menu of available federal programs, grants, the bond market, and private and alternative sources of funding (and, importantly, their various requirements, benefits, and limitations) can be a barrier to implementation.2
Whether it be sea levels rising, hurricanes, wildfires, floods or heat events, residents impacted by these events must rebuild their communities and that takes time. Revenues of municipalities (e.g., sales taxes or property taxes if Assessed Value (AV) goes down, which is even more critical to local communities) are reduced during those rebuilding times, exposing those municipalities to potential unexpected budgetary shortfalls.
Higher climate risk states like Florida, Louisiana, and California are having insurers withdraw from those markets, and those that remain are ramping up policy premiums, an outcome that will inevitably lead to a decrease in coverage and increase in assistance from both the federal government and local municipalities.
As these climate events increase in both the number of events and amount of damage per event, the economic reality of the cost of climate change is here and now as opposed to down the road.
Currently, the federal government responds to catastrophes via the Federal Emergency Management Agency (FEMA). This is a reactionary response once the catastrophe occurs. To date, municipal issuers and investors have downplayed climate issues because of:
The Infrastructure Investment and Jobs Act (IIJA), also known as the Bipartisan Infrastructure Law (BIL), includes funds to protect against droughts, floods and wildfires, in addition to a major investment in weatherization.3 The IIJA will provide $973 billion over the course of five years from fiscal year 2022 through fiscal year 2026. 4
On November 14, 2023, The Biden-Harris administration released the “Fifth National Climate Assessment (NCA5).” In coordination with the release of NCA5, President Biden announced more than $6 billion in investments to make communities across the country more resilient to the impacts of climate change, including strengthening America’s aging electric grid infrastructure, reducing flood risk to communities, supporting conservation efforts, and advancing environmental justice. The Administration is also releasing new resources to boost climate resilience efforts.5
To lower municipalities’ exposure to climate risk or mitigate the physical and financial impacts of climate-related events, actions such as purchasing disaster insurance and building climate-resilient infrastructure should be part of a municipality’s overall strategy.6
Municipal bond issuance can also be used to finance infrastructure that can be put in place to eliminate/reduce climate event damage.
Environmental, Social, and Governance (ESG) bonds are debt instruments issued by municipalities to fund projects with positive environmental, social, and governance impacts. ESG bonds offer investors the opportunity to target specific securities that meet the purchasers’ social guidelines.
ESG bonds fall into several common categories:
One might argue that all three components of the ESG are inherent in municipal bonds.
A few of the most common municipal ESG issuances include renewable energy, clean transportation, green buildings, sustainable water, and wastewater management.
Municipal bonds have financed seventy-five percent of US public infrastructure. They provide low-cost capital for state and local infrastructure projects. Since 2019, the municipal market has raised an annual average of $433 billion for a variety of purposes, including climate-based infrastructure projects.
Examples of municipalities issuing ESG bonds:
In a recent Munichain Matrix podcast episode, Tom Doe, President at Municipal Market Analytics, Inc., one of the participants of the Senate Subcommittee on Municipal and Climate hearing, delved into the role of the municipal bond market in financing adaptation projects for state and local governments, specifically addressing climate risk. Here are the highlights:
Municipal bond primary issuance is expected to exceed $600 billion per annum over the next decade to address deferred infrastructure needs.
There is a notable need for efficiency in raising capital and improving communication among deal participants engaged in financing municipal bonds.
Rating agencies will implement dynamic criteria to assess climate risk separately, placing greater emphasis on budget impacts related to climate risk.
Climate change introduces not only new opportunities for sustainable infrastructure funding, but also novel challenges in disclosure practices, budget management, and credit evaluation.
In general, issuers are required to disclose information to potential investors that allows for “an informed investment decision.” Potential effects of climate change should be disclosed to help investors make investment decisions.
The Official Statements7 should discuss municipalities' climate risk considerations because climate risks are considered “material” information to the credit decision of a potential purchaser.
Example: Miami-Dade County, Florida Subordinate Water and Sewer System Revenue Bonds, Series 2021 included the following disclosure:
In a Bond Buyer article dated October 19, 2023, David Sanchez, head of the Securities and Exchange Commission's Office of Municipal Securities said, “on the disclosure front, the emerging issue of climate change-related risk should be fairly straightforward. When there is a weather event and damage to a city and people are saying 'What did the issuer say before?' (sometimes) the answer is not good.”
He continues, "If you're a city within L.A. County and L.A. County is disclosing a particular issue, you should seriously consider whether you also should disclose it. You must look at your neighbors. There's very public information about flood risks, sea levels rising that affect specific areas. It's very well-known so you can't stick your head in the sand." He warned that climate risk disclosure is "very easy for us (SEC) to check on — very easy.”
In May 2023, the California Green Bond Market Development Committee designed the “Recommended Approach to Municipal Green Bond Disclosure.” The purpose of this paper is to provide municipal bond issuers with concise, easy-to-follow guidance about what investors look for when evaluating the environmental attributes of a Green Bond issue.
When debt is issued, either general obligation or revenue, the debt service coverage is based on an expected revenue stream that is dedicated to repaying the debt service. In other words, the budget must have enough money to pay off the debt service. Adding additional debt service to pay off climate risk reduction debt would increase the municipality’s budgeting obligations.
Catastrophes can be limited, not eliminated. For that reason, after a climate event, revenues drop for a period until the municipality and its residents fully recover. The time it takes to recover can be from 1 – 10 years and during that period the municipality’s budget can be stressed.
In an October 2023 Bond Buyer article, Nora Wittstruck, senior director, ESG sector leader, S&P Global Ratings said, "There could be a point where the materiality of this (climate) risk is greater than the ability to prepare or the ability to manage it. It becomes material to credit quality and could result in a change to the rating or a change in your outlook.”
Additional issuance of debt to help alleviate climate risk will add additional stress to municipalities’ budgets, leading to potential downgrades or being put on credit watch.
S&P Global, the parent company of S&P Global Ratings, is looking at new ways to calculate the climate risk of all issuers, including municipalities. For insight on how they are analyzing climate exposure, review their article, Better Data Can Highlight Climate Exposure: Focus on U.S. Public Finance.
In the article, they use the Trucost's Climate Change Physical Risk data which assigns normalized scores from 1 (lowest risk) to 100 (highest risk), which represent exposure of a given location to different climate hazards including heat waves, cold waves, flooding, hurricanes, sea level rise, water stress, and wildfire. The physical risk score is intended to represent the relative level of risk for each hazard at each location relative to global conditions.
As a hypothetical example (Martysville):
|
Composite Exposure Score |
77.1 |
|
Extreme Heat |
16.2 |
|
Drought |
38.8 |
|
Water Stress |
100 |
|
Fluvial (Rivers & Streams) |
14.3 |
|
Tropical Cyclones |
1 |
|
Wildfires |
1 |
|
Coastal |
1 |
|
Pluvial (Rainfall) |
29.7 |
In this example, Martysville has high exposure to water stress which includes both river/stream overflows and rainfall.
It's evident that the challenges posed by climate change are multifaceted, impacting not only the physical infrastructure, but also the financial support of municipalities. The increasing frequency and severity of climate-related disasters, underscored by the sobering cost to the United States, demand an important shift in how municipalities approach financing and investment.
*I would like to thank Rick Tilgham, Managing Director, Mischler Financial Group, Inc. for all his help in creating this blog.
Sources:
1 Climate Change is Costing the US $150 Billion a Year - CNN (cnn.com)
2 Megan Kilgore, City Auditor at City of Columbus, and one of the participants of the hearing by a Senate Subcommittee on Municipal and Climate
4 The Structure and Funding of the IIJA - ACG (acgadvocacy.com)
7 The Official Statement (OS) is the document with the information required by an investor to make an informed decision on whether to buy the bond and includes all information relevant to the issuer that is deemed necessary to be shared with the bondholders by the Securities and Exchange Commission (SEC) and essentially protects investors’ interests. source: Understanding an Official Statement for Municipal Debt (municipalbonds.com)
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