Warning to Local Governments: Adopt Climate Adaptation Strategies or Face Credit Downgrades

November 29, 2017

Credit rating agencies have gained a reputation for downplaying the impacts of climate change on local governments. While cities have seen their credit ratings suffer after experiencing devastation from storm-related flooding and winds, jurisdictions have not faced a credit downgrade for failing to address climate risks before the damage is done.

The time when the bond markets begin to take climate change more seriously may be on the horizon. Moody’s Investors Service, one of the big three credit rating agencies, released an in-depth report on Tuesday that explains how it takes climate change into consideration when analyzing the financial health of state and municipal governments.

Bonds are loans for projects that governments and utilities receive in exchange for interest they pay back to creditors over time. Municipal bonds, due to their tax advantages, are generally the only major kind of bond more popular with individual investors than with institutions. Ratings agencies such as Moody’s analyze the ability of the bond issuer — the government entity, in the case of the Moody’s report — to meet its debt obligations.

The growing effects of climate change, including climbing global temperatures and rising sea levels, are forecast to have an increasing economic impact on state and local governments in the United States. “This will be a growing negative credit factor for issuers without sufficient adaptation and mitigation strategies,” Moody’s noted in a statement released in conjunction with the report.

Moody’s, which also provides research and ratings on bonds issued by corporations, explained in the report that extreme weather patterns exacerbated by changing climate trends include higher rates of coastal storm damage and more frequent and severe droughts, wildfires, and heat waves. Climate shocks or extreme weather events have “sharp, immediate and observable impacts” on state and municipal governments’ infrastructure, economy, and revenue base, Moody’s said.

These impacts are factored into Moody’s analysis of a state or local government’s economy and fiscal position — as well as how well political leaders can implement strategies to drive recovery after a severe weather event.

Accurate credit ratings in the climate change context, for both bond markets and corporate debt, are important because overstated credit ratings threaten not only investors and markets, but ultimately the global economy, according to the Center for International Environmental Law. Inaccurate credit ratings also contribute to over-investment in activities that cause climate change, threatening ecosystems and the people who depend on them.

“While we anticipate states and municipalities will adopt mitigation strategies for these events, costs to employ them could also become an ongoing credit challenge,” Moody’s Vice President Michael Wertz said in a statement.

In 2015, analysts from Fitch Ratings, one of the other top-three credit rating agencies, explained that “to date, sea level rise has not played a material role in Fitch’s assessment of the fundamental credit characteristics of any of its rated issuers.” Disasters tend to be good for credit due to cash infusions from the Federal Emergency Management Agency’s (FEMA) Disaster Relief Fund, Fitch said.

“People continue to want to be there and will rebuild properties, usually with significant help from federal and state governments, so we haven’t felt it affects the credit of the places we rate,” Amy Laskey, a managing director at Fitch Ratings, told Slate.

The rating agencies — Standard & Poor’s is the other member of the big three — assign ratings (AAA, for example) to states and municipalities. The objective of a rating agency is to assign a municipal bond a credit rating to make it faster for market participants to evaluate risk. A bond’s credit rating is the rating agency’s opinion as to the creditworthiness of the government entity.

In its report, Moody’s explained that its rating methodologies for states, local governments, and publicly owned utilities do not explicitly address climate change as a credit risk. However, the credit challenges that climate change poses are captured in the rating agency’s analysis of economic strength, among other credit factors, Moody’s said.

“Local governments that face a higher risk of climate shocks are specifically asked by analysts during the rating process about their preparedness for such shocks and their activities in respect of adapting to climate trends,” the rating agency said.

Hurricane Katrina, for example, significantly disrupted New Orleans’ economy. In May 2005, prior to the disaster, Moody’s rating on the city’s $496 million of unlimited general obligation tax debt was Baa1, which is a low rating but still in the range of investment grade. The rating agency subsequently downgraded the city to Ba1 — a non-investment grade rating — in large part due to the unprecedented disruption to the city’s economy and revenue that Hurricane Katrina caused, as well as concerns over the city’s ability to fund ongoing operations.

At the same time, Houston experienced some economic benefit from absorbing about 150,000 evacuees following Hurricane Katrina. While the city estimated its initial costs for disaster-related expenditure at $165 million, it also anticipated that FEMA and other sources would reimburse 100 percent of the costs to help the evacuees from New Orleans. Therefore, Houston’s rating was not negatively impacted by the hurricane, Moody’s said.

The resilience of local governments to credit risks caused by long-term changes in climate trends and immediate climate shocks can be a function of economic strength, fiscal flexibility, debt affordability, and governmental policies and planning, according to Moody’s.

An example of this analysis was used in the wake of Hurricane Irma in Florida in September. Analysts focused on the ability of local jurisdictions to access funds to repair infrastructure damage, as well as receipt of FEMA assistance in areas that had been declared a federal disaster. The size and diversity of the local economies was also a key component in assessments of credit quality by Moody’s after the storm

Florida airports, seaports, and toll roads maintained their credit worthiness thanks to cash on hand and steady revenue streams, Moody’s said in a statement soon after Irma struck the state.

In 2012, Hurricane Sandy, a storm that most experts believe was made worse by climate change, caused billions of dollars of economic damage. The storm’s impact was exacerbated by the effects of rising sea levels. According to the National Oceanic and Atmospheric Association, sea levels along the coast hit by Hurricane Sandy have risen by more than one foot since the mid-19th century, primarily due to an increase in ocean volume stemming from rising temperatures.

Despite significant economic disruption, New York City maintained its rating and outlook following Hurricane Sandy due to its resilient, large, and diverse economy; solid financial position underscored by strong liquidity; and financial support via federal disaster and rebuilding aid, according to Moody’s.

“The interplay between an issuer’s exposure to climate shocks and its resilience to this vulnerability is an increasingly important part of our credit analysis, and one that will take on even greater significance as climate change continues,” Moody’s said.

Mark Hand

Climate and environment reporter @ThinkProgress.

Tags: building resilient communities, climate change responses, disaster recovery strategies, environmental policies, local government