California wildfires: Staying ahead of climate risk in the muni market

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      By Bill Delahunty, CFADirector of Municipal Research, Eaton Vance Management and Lauren KashmanianMunicipal Portfolio Manager, Eaton Vance Management

      New York - As wildfires have raged in California, with mass evacuations, power blackouts and widespread property damage, the financial impact of climate change has become more acute. That's why we believe it's increasingly important for municipal investment managers to evaluate the underlying environmental and climate risks for state and local government issuers in their municipal portfolios.

      Of the major wild fires in California at the end of October, the largest has been the Kincade Fire in Northern California, which has so far burned 76,825 acres, 189 structures and 86 homes, forcing 200,000 people to evacuate. Other fires close to major population centers include the Easy Fire, burning over 1,800 acres in Simi Valley, and the Getty Fire, burning 745 acres close to Brentwood.

      Weather-related events and damages are rising

      Each year from 1980 to 2018, the U.S. experienced an average of six weather-related events causing at least $1 billion in damage.1 From 2016 to 2018, however, that yearly average more than doubled to 15. In 2018, for example, the U.S. was hit by 14 natural disasters meeting the $1 billion threshold — the largest being the wildfires in California, which inflicted over $24 billion in damages.

      Along with the increased frequency, the damages from these disasters have also been rising. Three of the five most expensive hurricanes were in 2017: Hurricanes Harvey, Irma and Maria had total combined damages of $268 billion.2

      Assessing risks for muni bonds

      Despite mounting damage from weather-related events, municipal credit has been resilient. We've seen only one natural disaster-related default in the municipal market with Pacific Gas & Electric's bankruptcy filing in 2018. While the economic losses from natural disasters can be immense, private insurance or federal governmental aid has dealt with most losses, which has muted their impact. For instance, the Federal Emergency Management Agency (FEMA) often covers 75% or more of all disaster-related costs for local governments.

      Even though a natural disaster may not lead to an immediate default, we believe it's critical to include the rising environmental risks into our investment decision-making process. Over time, climate change could result in population shifts, declining tax bases and increasing debt loads, which could lead to credit stress.

      We attempt to actively incorporate key metrics related to the risks of climate change into the overall credit analysis of our municipal holdings. This analysis includes whether the municipality has enacted any resiliency plans to combat risks from weather-related events — such as building seawalls, elevating roadways to alleviate flooding, strengthening sewage and water storage systems, requiring sturdier construction to withstand severe storms and so on.

      Ratings agencies taking a more passive approach

      Standard & Poor's (S&P) and Moody's aren't currently incorporating climate change risks into their credit ratings. Ratings agencies have warned the cities and states more susceptible to these risks that they must increase resiliency measures or face credit downgrades in the future.

      However, the ratings agencies have yet to downgrade a single issuer due to a lack of measures taken to protect themselves from the effects of climate change. We believe in being more proactive and prudent by including these metrics in our internal credit rating process today.

      Bottom line: With the frequency and damage of weather-related events continuing to rise, we're even more convinced that incorporating climate risk into the credit-evaluation process for state and local issuers is important for muni investors.