With FEMA withdrawing, states will have to fill in the gaps. But how?

State bond banks could be part of the answer

In the aftermath of the disastrous floods of 2023-24, FEMA is expected to provide over $200 million in capital assistance to Vermont's local governments. This won't be money for debris cleanup. These funds have been and will be used for concrete and stone, rebuilding storm drains and bridges. That $200+ million adds up, effectively, to "a generation of investment," Michael Gaughan, Executive Director of the Vermont Bond Bank, told me recently. The federal funds equal almost 40 percent of Vermont's total outstanding debt burden (~$640M) for the 170 local governments the state's Bond Bank serves, money that has been borrowed over decades.

If FEMA is "phased out” as President Trump plans, states that don't have other resources to draw on will be scrambling to fill gaps. Given the massive costs involved in repairing or replacing infrastructure, states will be highly likely to continue to rebuild exactly what's been knocked down, according to Gaughan, rather than investing in structures built to withstand future climate effects—like roads on higher ground, or more substantial culverts, or new communities away from floodplains.

What's a local government looking for abundant, inexpensive capital supposed to do? Well, federal government assistance aimed at climate adaptation may be a thing of the past, but the municipal bond market (which includes state bonds, despite the name) remains highly attractive to investors—thanks to an apparent Congressional inclination to keep the exemption of bond interest from federal taxation in place. Record-breaking numbers of muni bonds are being issued these days. And Gaughan wants everyone to consider what state-level public finance agencies can do for local governments when it comes to adapting to the ferocious physical effects of climate change.

"Bond banks have the back of local governments as they face ongoing climate challenges," Gaughan says. "At the end of the day, we want our cities, towns, and villages to be successful," he adds. "So that's why we're so vested in trying to figure this thing out." He's implying that relying on individual towns to figure out adaptation, each on their own, won't work.

How could state bond banks—there are only about 14 of them—step in to assist municipalities? To start, they can act like a powerful financial uncle, by pooling borrowing needs, taking advantage of the state's stronger credit guarantee, and attracting a diverse portfolio of projects, then passing along to municipalities the money they're able to borrow at lower interest rates than many cities, particularly smaller ones, could access on their own.

Right now, the bond system is working well when it comes to mobilizing capital for infrastructure. But at the moment, even though money is flowing, no component of this system is responsible for taking long-term physical climate risks into account.

Investors' outsize appetite for steady, federal-tax-free interest payments—tangible, consistent cash flow—often makes them willing to pay a premium. (So, for a $1,000 face value bond offering 5% interest, an investor might pay anywhere from $1,010 to $1,200.) Bond issuers are happy to have the extra cash to work with, and often retain the power to "call" a long-term bond—the option to pay back bondholders the face value of the bond—after 10 years if interest rates go down. This familiar structure—premiums bringing in more cash upfront, plus resetting the whole arrangement every few years—likely causes both issuers and investors to focus mostly on shorter-term financial cycles, which can de-emphasize physical climate risk.

Credit rating agencies are paid by issuers to rate their bonds, an inherent conflict of interest that may put subtle pressure on them to be cautious in downgrading issuers facing physical climate risk. (Following the Great Financial Crisis of 2008, the Dodd-Frank Act increased oversight over the credit rating agencies, and required more disclosures, but the fundamental "issuer-pays" model stayed in place). Gaughan's view is that the rating agencies are "good on evaluating physical risks and management's responses" because they are the actors that will do in-depth interviews and examine capital planning by local governments to address climate change. He notes, though, that there are few examples of rating agencies downgrading credit ratings because of anticipated physical climate risk. Rating agencies likely think that other financial resources issuers have will offset climate-related damages. .

FEMA's withdrawal will be a big change for Vermont, Gaughan says—and likely other states as well. The state has above average personal income levels and solid financial management that, in the past, would have been considered bulwarks strong enough to withstand changes due to climate impacts. Without FEMA assistance, "That's a huge liability that previously states haven't had to face," Gaughan says.

The difference that will drive attention to adaptation is state-level planning and prioritization, steps for which FEMA wasn’t pushing. Gaughan thinks FEMA's withdrawal—and the risk that money may become more expensive to raise in the future—will speed up the urgency of policy development: "The potential changes to FEMA just accelerate everything we were already thinking about," Gaughan says.

There's a tricky balance to be struck between strong centralized planning and prioritization for adaptation funding and keeping a state bond bank itself financially viable. Strong state bond funds serve all viable comers regardless of their climate exposure, Gaughan says, so that they stay diversified. The bond bank, after all, is trying to be the place towns go to raise money—because they can get it more cheaply and easily than on their own—and the place investors go for reliable, highly-rated loans that will pay interest as promised.

Gaughan cautions that it's important for a state not to make loan applications too difficult. "You don't want a race to the bottom," Gaughan says, in which safer borrowers reacting against overly prescriptive terms go elsewhere to get financing and the state ends up with only the riskiest applicants. That could jeopardize the bond bank's overall financial health and its ability to maintain low rates for everyone. To encourage the widest portfolio of projects, it may make sense to be "fairly open in what you're willing to finance," says Gaughan. "But for adaptation projects, you [could] further drive down the [interest] rate for some public policy purpose." Imagine a bond bank normally offering loans at 2.5% interest. For a project meeting particular adaptation metrics, it might offer loans at 1.5% or 1%. The idea would be that the long-term benefits justify the state making less money on the loan.

It remains to be seen whether Vermont, or any other state, will be able to quickly take the steps needed to make adaptation funding effective:

Does the state have a clear, widely-shared data picture of its future? Or are different agencies doing different analyses and relying on different assumptions?

What are the metrics or benchmarks for adaptation—what is the measurement of success?

Does planning set clear priorities for investment? Or are projects scattered in PDFs around many agencies?

Climate adaptation is everyone's problem, but no one's responsibility. Right now, very few places in America have any idea how they're going to pay for the enormous costs of adjusting their operations, continuously, in order for residents to live safely. As the federal government retreats, state bond banks could provide part of the answer.