California wildfires start early, but will they scorch the state's budget?

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      By Bill Delahunty, CFADirector of Municipal Research, Eaton Vance Management and Raya McAnern Senior Municipal Analyst, Eaton Vance Management

      Boston - Starting earlier than usual in 2020, the wildfire season is already historic. Numerous fires have scorched a record 3.4 million acres in California so far this year.

      Increasing frequency of wildfires and other natural disasters

      On average over the last five years, annual wildfires in California have burned 309,675 acres, so this season's fires have already covered over 1,000% more acreage than in a typical year. Outside California, roughly a million acres have burned in Oregon, the state of Washington has seen over 800,000 acres burn and substantial fires are also raging in Montana, Colorado and Utah.

      Apart from wildfires, other weather-related events are consistently causing more damage across the United States. Each year from 1980 to 2019, the US has averaged 6.6 weather-related events that caused at least $1 billion in damage.1 From 2015 to 2019, however, the average more than doubled to 14 per year. Through this past June, there were already 10 climate events with damages exceeding $1 billion. We expect this will escalate significantly, considering the wildfires that are now burning throughout the Western US.

      With the increasing frequency of more damaging natural disasters, we believe it is important for municipal investment managers to evaluate the underlying environmental and climate risks for state and local government issuers in their municipal portfolios.

      Helping municipal credits remain resilient

      Despite the massive economic losses generated by these natural disasters, we have only seen one natural disaster-related default in the municipal market — namely, the utility Pacific Gas & Electric (PG&E) serving the northern two-thirds of California. The most destructive fire in California's history — the Camp Fire in 2018 — burned down 18,804 structures in the town of Paradise. Destruction from the Camp Fire drove a 50% decline in the assessed value of the property supporting the Tax Increment Financing bonds for Paradise, which would have resulted in the assessed value being lower than in the base year, and a possible technical default.

      In 2018, however, California authorized a backfill in property taxes to a number of counties involved in wildfires, allowing up to $31 million in financial support for three years through fiscal year 2022. Both the town of Paradise and the Paradise Redevelopment Agency are eligible for the support payments. This aid from the state should allow Paradise Redevelopment Agency bonds to be paid on time and avoid a default through 2022 — assuming no additional fires hit the community.

      Maintaining credit quality despite natural disasters

      Heading into the current recession, California's credit quality was in much better shape than in 2008. Liquidity has been much more robust, with $47 billion in liquidity resources, up from just $14 billion before the previous recession. The state's financial flexibility is also much stronger, as California currently has no short term Revenue Anticipation Notes (RANS) outstanding, which compares favorably to the $17 billion in RANS that were outstanding in 2010. Importantly, the state has not needed to issue any RANs since 2014, and thanks to its robust liquidity position, no RAN issuance is expected during fiscal year 2021.

      While liquidity is strong, California still has to close a massive budget gap of $54 billion for the fiscal year started in July 2020. The large budget gap has been brought into balance through various means, including deferring school funding, using cash reserves, cutting millions to the University of California and California State Systems, reclassifying pension payments and eliminating some tax breaks, among other things. Notably, Governor Newsome stated that the budget does not cut "investments in wildfire protection and disaster response."

      Waiting for more fiscal assistance

      Many of these solutions are temporary one-time fixes while California waits to see if they will receive additional fiscal aid from the federal government. While the state did receive $8.5 billion in aid through the CARES Act, these funds can only be used to cover costs related to the COVID pandemic and are not available to plug budget deficits.

      At this point, it is unclear whether lawmakers in Washington DC will provide any further aid to states. Without that, it is likely that California would have to make mid-year adjustments to bring its budget into balance. We are encouraged that California's tax revenues have exceeded projections by 9.2% in July and August, the first two months of the state's fiscal year. This should help to provide a buffer if revenues trend down for the remainder of the year.

      Bottom line: The wildfires have resulted in an estimated 34 deaths across California, Oregon and Washington State — our first thoughts will always be focused on the human costs of natural disasters. However, from a credit perspective, as the frequency and damage of weather-related events continue to rise, we believe incorporating climate change factors into the credit evaluation process for state and local issuers is important for muni investors.

      Further, if federal disaster relief or private insurance is diminished in the future, the risks to municipal credit will increase. Historically, in the wake of natural disasters, any negative impact to municipal credit has been fleeting. While we believe that will still be true, the massive devastation from the fires burning on the West Coast may test the resiliency of municipal credit.

      1 Damage figures are inflation-adjusted, based on the Consumer Price Index (CPI) as of August 31, 2020.