The Financial Risks of Climate Change - Sustainability: Environmental

The Financial Risks of Climate Change

By Kurt Forsgren, Ted Chapman and Lisa Schroeer of S&P Global Ratings | Posted: Wednesday, February 28, 2018 1:00 pm

The U.S. municipal market has always faced credit exposure to weather-related and natural catastrophes – such as fires, hurricanes, floods and earthquakes.

However, what were previously viewed as one-off implications for creditworthiness – transitory storms, for example – can increasingly be analyzed through the lens of climate change risk. As such, there are possible risks faced by U.S. municipal issuers as a result of a rapidly changing climate.

Recent years have seen an uptick in sustainable development. Transport and buildings are not only becoming more energy efficient but also more resilient to the increasingly severe consequences of global warming. This new, sustainable infrastructure is the result of both greater political ambition to decarbonize and increased funding through debt issuance (private and municipal).

However, while advancements are combating climate change, municipal issuers continue to face environmental risk on two fronts: first, from the growing cost of extreme weather events; and second, from more gradual changes to the environment affecting land use, employment, and economic activity that support credit quality.

What is climate change risk?

By definition, climate change risk is difficult to pin down; as the climate continues to change with global warming, so does the associated set of risks.

For a start, we can differentiate between natural disaster risk and climate-related risk. Natural disaster risks include naturally occurring phenomena such as earthquakes, tsunamis and some fires. They can also include climate-related events such as hurricanes, tornadoes, severe thunderstorms or snowstorms. Data from the American Meteorological Society indicate that extremely violent tornadoes, for example, constitute less than 1 percent of all natural disasters, and have not shown an increase in occurrence in the more than 50 years of that type of record keeping.

Yet, regardless of their cause, according to global insurer Swiss Re the financial cost of these natural disasters has increased, and various studies have identified population growth and development in high-risk affected areas as a key factor. While the precise impact of climate change on extreme weather events is still uncertain, different studies are pointing toward an increase in the financial impact of these events. Hurricane Harvey, for example, is the most expensive hurricane on record – costing around 1 percent of America’s Gross Domestic Product (GDP) – with mitigation and adaptation efforts continuing in the form of enhanced drainage and flood infrastructure.

Therefore, in the context of U.S. public finance, we see climate-change-related risks as the near-term exposure to increasingly costly and possibly more frequent extreme weather events – as well as the long-term accumulation of negative impacts on society from a changing environment. This includes the costs of mitigating and adapting to those changes that can affect the service delivery or physical assets of local governments, state governments, and municipal enterprise infrastructure owners – such as in the case of flood defenses post-Hurricane Harvey.

The impact on municipal credit quality

The implications of climate change for municipal credit quality can be broad. Most visible are the direct costs of increasingly expensive extreme weather events. Other implications are longer-term, such as the viability and variability – economic or otherwise – of coastal land use. For instance, rising sea levels can exacerbate coastal flooding and increase high tides, which in turn can reduce the property tax base that many public finance entities rely on.

In addition, high and extreme temperatures – as a result of climate change – can have a diverse range of effects. These range from increased electricity loads in many regions to the softening of pavements and roadways, making them more susceptible to wear and tear. In other cases high temperatures can cause or contribute to droughts and desertification. And, all else being equal, warmer weather will have an effect on utilities: those facing peak demand in the winter will have to contend with lower sales, whereas those with summer peaks (driven by greater need for air conditioning) could see an increase in demand, potentially imposing additional capital costs.

In U.S. public finance, the effects on credit because of climate change thus far have largely focused on the fallout from natural disasters – and S&P Global Ratings’ research has shown that (with some exceptions) there has been limited impact on municipal ratings. Downgrades have been isolated and less common, even as the affected areas increasingly include large and growing population centers. And – not surprisingly – issuers that have prepared for natural disasters by maintaining healthy liquidity and building resilient infrastructure have seen credit stability. Local governments have received federal disaster relief and insurance as a means for offsetting costs associated with extreme weather events and the probability of many extreme weather events are measured in 1 in 100, 250, 500 or even 1,000 year terms.

However, several local governments and municipal enterprises in the New Orleans area and Galveston, Texas, were downgraded following hurricanes Katrina, Rita, and Ike. In these instances, the economic and financial damage from the hurricanes was long-lasting and severe enough to change S&P Global Ratings’ view of many issuers' medium-term growth prospects and ability to generate sufficient tax revenues before exhausting external liquidity – as well as affect their long-term viability at their pre-disaster rating levels. As costs of recovering from these events grows and the potential for large-scale federal assistance decreases in the future, local governments and other infrastructure providers may not experience the same rating stability.

Municipal mitigation

Some municipal issuers – led by the state of California – are recognizing, measuring, and reporting their impact on the environment. While the practice is not yet widespread, we have observed issuers documenting how operations and capital planning are changing in response to global warming. California in particular has undertaken extensive efforts to understand how climate change affects all core functions of government, including energy, land use, emergency management, public health, transportation, water, and agriculture.

There has also been growing recognition of these environmental risks by many issuers particularly exposed to coastal flooding and king tides – which now occur not only during extreme weather events, but are increasingly common during regular high tide. Virginia Beach, Norfolk, Virginia and Miami Beach are already under duress; the tiny towns of Isle de Jean Charles, La., and Newtok, Alaska, are already preparing to abandon their waterfront locations and move to higher ground. In Newtok there is particular urgency: the town has lost its port, landfill, and sanitary sewer lagoon and believes the loss of its drinking water supply is imminent.

As awareness of climate risk continues to rise with the tide, some state and local governments are recognizing the value of enhancing infrastructure's climate-change resilience and adaptability – where adaptation is defined as adjustments to natural or human systems in response to actual or expected climate change. This is most often associated with raising river or coastal barriers, building higher bridges, and increasing the capacity of storm water systems.

As these measures are implemented, S&P Global Ratings continues to monitor the effects on impacted municipal issuers within our credit ratings methodology. Governments' and municipal enterprises' planning for these types of risks is embedded in our criteria across all sectors, and we expect this will be more critical for credit quality as the cost of infrastructure adaptation and regulatory compliance increases.

Climate in credit ratings

The choices that municipal management teams make today could have long-term rating implications. Investment in infrastructure assets exposed to coastal flooding and rising sea levels illustrate this most clearly – where the true value of sustainable development and public investment in resilient infrastructure often only becomes obvious after natural disasters, when the human costs and property damage are tallied.

S&P Global Ratings believes that organizations demonstrating current and long-term plans – and reasonable attempts to fund them – will be better prepared for these episodic risks. Preparing for climate change and mitigating the associated risks is one component in our credit analysis and our opinion regarding the adequacy of management's plan is one of many factors that determine a rating.

While the effect of climate change on municipal issuer ratings has been minimal so far, the future now depends on good management, and strong mitigation and adaptation initiatives. In turn, this can protect municipalities and their communities from the worst consequences of climate change where possible – and help their economies to recover effectively in the event of climate-related damage.

This article was written for Sustainable City Network by Kurt Forsgren, managing director in the infrastructure practice; Ted Chapman, senior director and sector lead for U.S. municipal utilities; and Lisa Schroeer, senior director and sector leader for U.S. local governments, all with S&P Global Ratings.