Many Municipal Bond Investors Overlook Climate Risk

A changing environment affects municipalities’ finances, such as tax bases and debt levels. Water is a particular threat to bond ratings.


The effects of climate change could translate into losses for municipal bondholders. Yet not many muni bond investors include climate risk in their analysis.

Severe weather and rising sea levels pose a threat to thousands of U.S. cities and towns, as well as their utilities, water authorities and other issuers of municipal bonds. These risks are not purely environmental; they could affect investors’ bottom lines, making climate risk an important criterion for bond analysis. Still, muni bond fund managers and analysts lag corporate stock and bond investors in considering how climate change might impact their portfolios. A municipal bond issuer’s tax base, debt levels and management quality should all be considered in relation to climate risk, according to a recent white paper penned by CDP, a London-based nonprofit focused on sustainable business and investment, and Breckinridge Capital Advisors, a Boston-based fixed-income manager with an environmental, social responsibility and corporate governance (ESG) platform.

The thinking goes like this: A municipality’s tax base could shrink if its businesses and citizens are forced to leave the area, and its debt level could rise as it funds projects to mitigate climate risk or cleans up after a severe weather event . And whether or not the powers that be are paying attention to these issues can serve as an accurate gauge of how capable they are in general.

“ESG analysis gives us a better understanding of those in management, their priorities as well as their effectiveness,” says Robert Fernandez, vice president of credit research at Breckinridge. “There are certain key risks out there, such as climate, and if they’re not paying attention to these risks, does that speak to how well they’re managing the city overall?”

Whereas issues like how carbon emissions regulation will eventually affect utilities and other polluters do come into play, it is water — either too much or too little — that poses the biggest threat to municipal bond issuers. The three major ratings agencies don’t explicitly cite climate change in their municipal bond ratings methodology, though there is consideration of severe weather effects in coastal areas. Standard & Poor’s is updating its methodology for water and sewage utilities, however, and did include climate risk in a recent request for comment.

“We need to recognize what’s going on in the sector, and it’s definitely a risk,” says Ted Chapman, a senior credit analyst in S&P’s infrastructure group in Dallas. He cites the example of water supplies. If a municipality lacks ready access to safe drinking water, public health is the top issue. Losses to bond investors are another major issue.

Chapman says institutional investors in the water infrastructure sector are definitely paying more attention, especially in the Southwest, where water supply has become a perpetual concern; California is entering its fourth consecutive year of drought.

That awareness hasn’t translated into climate risk analysis across the muni sector, however. Part of the reason for this could be the fact that climate risk as it relates to severe weather is difficult to measure without a crystal ball — harder to measure than, say, a company’s energy efficiency or whether carbon emissions regulation will affect its bottom line. Even in the case of California’s drought, we won’t know for sure whether it’s a temporary condition or a permanent change brought on by increasing temperatures until later. Moreover, cities and towns that experience severe weather qualifying as a national emergency receive Federal Emergency Management Agency funding, so there is an expectation that the federal government, as well as insurance companies, will pick up the tab. But, some say, investors would be remiss in believing that will always be the case.

“There is a fair amount of thinking that insurance companies or FEMA will come in, but I doubt many muni bond investors always know what an issuer’s full insurance coverage is or what the risk to cash flow would be in some of those cases,” says R. Paul Herman, CEO and founder of HIP Investor, an impact investing advisory firm based in San Francisco. Herman created the HIP (human impact plus profit) ratings system in 2004, which the firm uses to analyze a variety of stocks and bonds, including muni bonds. In 2013 HIP collaborated with Seattle-based SNW Asset Management to offer clients impact-rated portfolios for municipal bonds and fixed income, now worth more than $240 million. He says that although issues like the effects of climate change haven’t been built into investment education — such as MBA studies — that will change over time as the risks become more evident.

“Many people still consider climate change as a political issue rather than a scientific issue,” Herman says. “They think that if you talk about the environment or climate change, that you’re talking about hugging a tree rather than the risk and return of your portfolio, and the reality is, they connect.”

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