Municipal bonds continuing on despite physical climate risk

There may be a deal to be done using the federal tax exemption, but no one except the people who live here in the future will like it

Bloomberg.com, Jan. 24, 2025

Mainstream media has gotten the story of skyrocketing insurance premiums linked to physical climate risk in America. The inventory of risky homes sitting on local markets appears to be climbing. It's almost chic these days to talk about insurance crises driven onward by accelerating climate change.

Now there's another market that is beginning, very gradually, to reflect climate risk: Recent municipal bond stories from Los Angeles show that credit ratings for bonds in risky geographic areas will begin to point downward. But overall the signals of different levels of risk in the market are faint: cautious downgrading moves slowly, and investors are so driven by their tax-planning priorities that demand for municipal bond issuance continues to outrun supply, whatever the bonds are for and whatever the rating agencies say. At the same time, given federal reconsideration of FEMA's role, cities and states will likely need more and more capital to invest in climate adaptation.

We are just at the beginning of this tension-filled story. Cheap money is still available to fund adaptation changes at the local level, but it may take sharp incentives to spur investors to focus on funding genuinely transformative changes.

Here's an idea: What if a portion of the federal tax exemption, the engine that drives this entire machine, was made contingent on demonstrated action—not just planning—to lower physical climate risks? In other words, what if the exemption was risk rated, just as each American home’s federal flood insurance is risk rated?

For a brief moment this past month, people noticed that the market for investing in loans sought by local government entities in Los Angeles—city governments, public utilities, local library systems—wobbled. Tom Doe of Municipal Market Analytics told Bloomberg News he thought the LA fires would be a "tipping point," meaning that LA would be a test case for overall bond market sensitivity to physical climate risk. S&P Global Ratings downgraded Los Angeles Department of Water and Power water and sewer bonds, reflecting concerns about the utility's potential liability for the fires, and put the city's bonds on a "credit watch," which has negative implications. S&P also put bonds issued by the Altadena Library District—and backed by a special property tax collected in that district—on a credit watch. Moody's followed suit. The market noticed: the LADWP and library bonds went down in value.

Then, even before the fires were completely contained, the "what about climate risk?" stories stopped coming. "Based on trade data, the sell-off in Los Angeles/California-related credits [bond offerings] has subsided," J.P. Morgan told Keeley Webster of The Bond Buyer last week. Investors view municipal bonds as safe haven assets with tax benefits, and ran toward them recently as tech stock values fell.

That's the way the $4 trillion municipal bond market functions these days. Driven by investors' insatiable demand for the federal tax exemption that shields the interest payments flowing toward them, new bond issues keep spinning out into the world. Bond offerings hit a record $508 billion last year, with big jumps in housing and transportation issuance. Issuers know that the tax exemption makes the machine work, and have been rushing to get loans out into the marketplace before that exemption is re-examined by the Trump administration—which included the tax-exempt status of municipal bonds on a 50-page list of targets that could be eliminated in order to provide additional public revenue ("Eliminate Exclusion of Interest on State and Local Bonds").

The entire mechanism is mostly insensitive to physical climate risk, with only wisps of alarming signals beginning to waft into the investor environment.

Whether borrowers are required to disclose physical risks to their lenders/investors depends on whether they view these risks as important (from a lawyer's perspective, only "material" risks need to be disclosed) and the disclosures they do make are idiosyncratic and difficult to parse. Credit rating agencies are paid by the issuers, the public entities borrowing money, for their ratings, so have little incentive to say "that's a risky bond." Their ratings usually reflect their assessment of the chances of defaults in interest payments over the next couple of years—not the risk of climate effects over the next ten to twenty years. Demand driven by tax advantages may be insensitive to physical climate risk because it's often informed only by a quick look at those simplified, short-term credit ratings. The actual default rate for high-rated municipal bonds has historically been extremely low.

And there's even more squelching of risk-rating: Market prices, once set at the time of issuance, may not always reflect reality because many bonds rarely trade. It's impossible to "short" the bonds themselves because no one (other than the original tax-exempt issuer) can offer a buyer the tax exemption that drives the whole transaction—so no short-seller can borrow a municipal bond from an owner, sell it at a high price, and then repurchase the bond in the market at a lower price when everyone else figures out how much mispriced risk is inherent in the bond.

More liquid reinsurance and insurance markets are already repricing to reflect physical risks. But the presence of the tax exemption in the municipal bond ecosystem skews things, making the entire market deaf to risk signals: demand routinely outstrips supply and there are few penalties for failing to adapt to ferociously accelerating climate change, even though the strength of these bonds relies on property taxes being regularly paid by people who can, if they have adequate resources, move away at any time as life becomes uncomfortable.

So when S&P revised its "outlook" for some Los Angeles-related bond issues, adding utilities doing business in Pasadena and Glendale to the list, that was an important, if dim, signal of risk. Very dim. An "outlook revision," S&P says, "reflects our view that there is at least a one-in-three chance that we could lower the ratings by one or more notches during the outlook period, which typically spans two years." Might happen, a long time from now...

The market's overall sense of climate-driven concern is transient in these go-go days. Los Angeles is such a huge place, and so important to the state's economy, that analysts believe the state and the federal government will ensure that these debts will be paid promptly. And now that the LA fires are no longer the focus of vast media attention, any mainstream momentum to require or promote better physical risk pricing in municipal bonds overall has largely dissipated.

What will shake up this story? President Trump's musings about FEMA and the current risk to the federal tax exemption that drives the muni bond system may provide avenues for bigger thinking. MMA's Weekly Outlook suggests this week that Trump's argument that "states should bear more of the burden for weather catastrophe recovery" gives "the municipal industry an opportunity to demonstrate the value of the exemption."

If states will be carrying the burden of paying to protect their citizens from the effects of climate change, they should certainly get that exemption. Perhaps, though, the tax exemption itself should be more sensitive. It's a subsidy, after all.

What if city bonds that cover geographic areas that are known to be physically risky but where the issuer has inadequate plans to adapt to climate change were granted just a portion of the exemption? What if there was a higher subsidy, a full federal tax exemption, given for the places that had done the best job in acting (on an ongoing, continuous basis) to lower physical climate risks?

Examples could be: requiring all buildings in wildfire-risky areas to comply with fire-protective measures, like removing nearby vegetation and wooden fences, and generally closing down avenues for embers to set buildings on fire, or stopping development in flood-prone areas. The details would be difficult, but just as the national flood insurance program was capable of risk-rating every home in America (with the help of insurance industry data), so too could standardized ratings for risk in local areas—perhaps at the county level—inform the appropriate proportion of tax exemption made available to investors there.

Removing the exemption altogether would starve cities of capital for infrastructure, at a time when the federal government seems poised to push much more responsibility onto the shoulders of local government. But tempering it, titrating it, might drive better decisions in light of our new reality of constant, tumultuous climate-driven change.

Spending money to lower risks now rather than later will be far less expensive in the long run—government efficiency in a nutshell. Providing incentives so that private investors care more about physical-risk-lowering local government investments would align planning efforts in a nonpartisan, market-informed manner.

It's worth thinking about. If we were capable of time travel, we’d appreciate this move.