The Bond Dealers Association recently held a series of webinars as part of their virtual 12th Annual Fixed Income Conference. These are my takeaways on a very thoughtful panel discussion that focused on the quantification of climate risk in the municipal bond market.
Panel members included Matt Boles of RBC, Lynn Martin of ICE, Tim Coffin of Breckinridge Capital Advisors, Tom Doe of MMA, and Bernard Bailey of Assured Guaranty. I won’t be quoting any of them directly, as the topic matter below is taken from my own notes and may or may not represent the opinions of the panelists.
Climate change, while still a controversial subject, is being increasingly recognized as a factor that could be the “next big thing” to strike the municipal bond industry. While the process of climate change will occur over the long term, taking decades to play out, the bonds issued by municipalities to fund their infrastructure projects are also often long term, with thirty or forty year maturities. As panelists pointed out, it’s likely that within the capital markets, the first tremors having to do with climate risk will be felt in the municipal market, as underwriters, issuers, and investors increasingly turn their attention to the risks associated with the long term viability of infrastructures underwritten by municipal bonds. Investors in longer term issues will begin (if it has not already started) to demand interest premiums as risks are identified. Issuers having exposure to hurricanes, flooding, and other climate risks may suffer widespread downgrades in the market, and the anticipation of future events, not the actual eventual occurrence of events, will cause the market to build in these premiums as more data on risk becomes available.
The “non-climate related” Covid 19 Pandemic has already demonstrated that an unanticipated widespread event can make re-examination of credit risk essential even before actual harm to debt service is realized. Markets are already beginning to examine and anticipate likely downgrades (and credit risk) that will result from the pandemic’s disruption.
Quantification of Risk
As climate change emerges as a risk factor within the industry, evaluation of that risk evaluation is becoming a highly sought commodity and an emerging business model.
A growing number of firms are already collecting data associated with known climate risks, and new areas of risk, such as forest fire risk and heat stress risk are being added to current models. The data regarding these risks is increasingly being used by investors to quantify and identify issuer risk in their commitment of capital. This data will also be useful in helping urban and infrastructure planners to attract that capital.
While there are currently some standards by which risk can be ascertained, (for example, using a measure of meters above sea level to measure the risk of certain coastal cities), risk data companies are investigating methods by which newly identified risks can be measured.
Difficulties in developing these risk models, including the vast variation of issuers and their individual risks present complexities of deal structure that may initially cause periods of information discrepancies.
Eventually, however, the industry may arrive at a uniform taxonomy, enabling issuers and investors to develop standards by which issuers can be compared, and to ascertain how risk exposure should be priced into the market. Valuations will be made, for example, on water systems that score higher than others, utilizing a uniform scale. Municipalities will then attempt to improve their “scores” in order to reduce borrowing costs.
Risk Magnification
Some risks pose problems not only for the issuer itself, but also for those affected downstream from the issuer. For example, heat stress, now being realized as a strain on electrical grids and other infrastructures, can have downstream effects on utility companies and those individuals and businesses dependent on them. Likewise, issuers facing risk of drought have downstream risk magnifiers- drought affects the not only the farmer and the tax base of a municipality but also the food chain and the economic benefits of employment and downstream business models.
These downstream risks, as more fully identified, will be incorporated into the risk models of issuers.
Effects of Climate Change on Municipalities
“Climigration” is a term already being used to describe how climate change may cause mass migrations over the next thirty to forty years. Populations may migrate from currently large urban areas to other smaller cities. While businesses and people may pack up their bags and leave, the city, and the infrastructure that composes it, is set in place. These possible population migrations will be taken into consideration by urban planners, and their static projects, meant to be used over many years, will be risk evaluated for long term viability. Population migration will also cause “tax migration”, as issuers subject to climate risk face reductions in their tax base.
Who Will Cause the Change to Green Bonds?
Investopedia defines a “green bond” as “a fixed income instrument designed specifically
to support specific climate related or environmental projects”.
While the issuance of bonds that would decrease risk are increasingly recognized as being important, they are not currently at the top of the list when issuers set out to fund projects. Economic realities limit the viability of these considerations; essential service budgets of issuers are already under stress.
However, economic realities may eventually be a catalyst in causing climate risk to be addressed when issuers discover that the costs of risk become higher than the alternative. Issuers may find that adaptation for climate change, such as transitioning to low carbon alternatives, could help lower, rather than raise, borrowing costs.
And, while economic factors may drive more issuers to consider lowering their climate risk, investors will also have a say. Investors are increasingly becoming “socially aware”, and changing their investment priorities. As a panelist noted, while it is currently hard to move these issues up the “essentiality ladder”, the movement is growing.
Bottom Lines:
- Municipalities are on the front line of this evolving issue, and integrating climate risk into underwriting and investing will grow in importance.
- The collection of risk data will increase and improve, becoming a commoditized item.
- To facilitate this new method of evaluation, improved disclosure and transparency will be required of issuers.
- Issuers will need help from underwriters in understanding how to communicate to investors the steps they are taking to mitigate climate risk.
- Investors will increasingly play a role of causing change, by “voting with their money”.
- New ideas and information will continue to emerge in this growing field.