November 1st, 2018
Climate change is now well recognized as a key risk factor for state and local credits. Yet, the municipal market continues to view it as a marketing opportunity rather than a risk management issue.
There is currently no hotter issue in the municipal market than climate change (bad pun quite intended), with pictures of the devastation from Hurricanes Florence and Michael still fresh on our mind. And not a week goes by without another global scientific body sounding the alarm about the potential ecological and economic devastation that could ensue. Yet, one would be hard pressed to see such concerns reflected in municipal credit pricing. Is the municipal market just paying lip service to this issue at this point?
Just to be clear, as credit analysts, we're approaching this issue purely from a risk identification and risk mitigation standpoint. Current industry efforts on climate change, and on ESG ("Environmental, Society & Governance") in general, tends to focus either: (a) identifying potential investment opportunities stemming from environmental remediation; or (b) re-positioning the municipal asset class as the "impact investment" of choice (as reflected in the efforts by groups such as The Impact Coalition). While such marketing efforts are certainly laudable, we believe there hasn't been enough discussion about the actual credit and investment implications of climate change as a risk factor. The tax-exempt market is, after all, a credit market, and our priority should be on the risk side of the equation.
The simplest reason for this apparent disconnect is because, up until now, much of the economic impact of major natural disasters has been effectively nationalized through federal disaster relief. In fact, municipal market participants have been conditioned to view hurricanes in the Gulf Coast and wildfires on the West Coast as non-events from a credit standpoint. Paradoxically, in many cases, natural disasters have actually resulted in a short term economic boost for the affected areas, due to the stimulative effect of federal aid and reconstruction efforts.
FEMA was reportedly overwhelmed by last year's admittedly historic hurricane season and Congress has been content to respond to short-term post-disaster humanitarian concerns without addressing the long term fundamental issues, such as reforming the federal flood insurance program. With the rising frequency of natural disasters in recent years, one wonders how much longer the federal government can continue to shoulder the financial burden without eventually making state and local governments accountable for their own land use and real estate development practices.
As human beings, we also have a problem dealing with slow-moving train wrecks, such as climate risk. Take the public pension funding problem, for example: the unfunded pension liability issue for state and local governments is not new, and many of us have written about it as far back as 10-15 years ago. Yet, the issue did not capture the market's imagination until pension funding started to crowd out other public essential services and create current budget problems for public entities.
Furthermore, climate risk has yet to be clearly identified and reflected in municipal credit ratings, as discussed in a recent Bloomberg article. In all fairness, the rating agencies have been trying to lead the charge on identifying climate change as an increasingly important risk factor. However, their efforts to date have consisted merely of raising a yellow flag, without much discernible impact on the actual ratings they confer to municipal issuers.
As our friends at Breckinridge Capital Advisors also pointed out in their article, "Rating Agencies and Municipal Climate Risk", the rating agencies have been content to focus on the issuer's resilience management practices, without providing much transparency into what internal benchmarks they use in such assessment. To some extent, this "softball" approach is attributable to their reluctance to call out issuers for something that is still considered a long term problem without any immediate fiscal impact. This allows them to publicly acknowledge the obvious investment concerns while keeping their paying clients, the issuers, happy. How else would you explain the fact that the City of Miami Beach, FL, a poster child for sea level rise risk, continues to enjoy a G.O. rating of Aa2/AA+ by Moody's and S&P?
One potential solution for the rating agencies is to institute a term structure for their ratings. There is already a precedent in the tax-exempt market: for tobacco settlement issues, the agencies are explicitly giving higher ratings to shorter maturities than to longer ones, in recognition of the much higher probability of default on the back end of the curve. In a similar fashion, climate change factors could be assigned greater weight in an issuer's long term rating model versus its short-to-intermediate rating model.
As we mentioned in past columns, measurement continues to be a major hurdle to pricing climate change risk. Several large institutional investors have responded by building their own proprietary climate risk framework. Such an approach may play well from a marketing and asset-gathering perspective, but it doesn't solve the investment problems stemming from the absence of a generally accepted climate risk benchmark. As a trader or portfolio manager, you may have picked credits that you view as relatively immune from climate risk, but how would you monetize that from a performance standpoint? You can only hope that, eventually, the "market" will come around to your view of the credit.
A few new and not-so-new entrants in the market are trying to address this measurement problem. As far as raw data is concerned, Toronto-based ACRe Data can provide a data feed on air quality, water risk and sea level risk. For a more comprehensive effort in creating an actual climate risk score for municipal entities, we would refer you to the team at Four Twenty Seven. led by French expert Emilie Mazzacurati.
Improved disclosure of climate change risk by state and local bond issuers will also help the market incorporate environmental concerns into trading levels.
Far from being the poor, helpless victims of climate risk, governments are also getting in on the action by going after corporate bad actors, hoping to find the next global settlement_a la Tobacco Master Settlement_to replenish their coffers. This past week, New York's Attorney General flied suit against Exxon Mobil, claiming "the company defrauded shareholders by downplaying the expected risks of climate change to its business."
Ironically, by raising the issue of disclosure with regard to private corporations, public officials are inviting scrutiny into their own climate risk disclosure practices. Steve Winterstein from Wilmington Trust reminded me that, earlier this year, a few coastal communities in California, including Marin County and the cities of San Francisco, Oakland, San Mateo and Santa Cruz, filed suit against a slew of energy companies, only to be called out about the lack of climate risk disclosure in their own bond offering documents.
At the end of the day, at the risk of mixing up sports metaphors, we're all playing the long game here in terms of climate change and we're probably still in the early innings. Nevertheless, given that many municipal issues come with maturities as long as 30-40 years, it's never too early to take a hard look at your municipal bond holdings and to start weeding out the most vulnerable credits.
Conveniently enough, since many of these issues are relatively highly-rated coastal credits in specialty states (such as CA and NJ) and probably trade at nosebleed levels, investors may not have to give up much yield at all to climate-proof their portfolios. Residents of these specialty states also need to decide if the double tax exemption (which has been over-hyped as a result of the new cap on SALT deductions) is a worthwhile trade-off for a lack of geographical diversification. Current market conditions are actually providing you with a window of opportunity to reduce climate risk in your municipal holdings.
The rather dour issue of mitigating climate risk may not blend well with the municipal market's cheery efforts to jump onto the impact investing bandwagon, but sooner or later, it will have to be dealt with by municipal investors. As usual, those who are prescient enough to take advantage of current market conditions to restructure their portfolios will stand to benefit from, or at least be insulated from, the eventual market reckoning.