In response to growing interest from investors and others, rating agencies are increasingly incorporating climate risk into their municipal credit analysis. In 2017, Moody’s, Standard & Poor’s and Fitch published comments explaining their approaches to assessing climate risks for state and local government bonds.
Recognition of climate change as a credit variable is a positive step. However, we believe current rating agency approaches fall short in three key areas: transparency, materiality and understanding of natural disaster risk.
Under their current methodologies, the agencies assess climate risks primarily through their evaluation of an issuer’s management practices. Specifically, the agencies seek to assess the extent to which exposure to extreme weather events is addressed in disaster preparedness and long-term planning documents. In our view, this approach lacks sufficient transparency. The rating agencies provide very limited guidance on how they measure the baseline level of a municipality’s climate exposure, on whether there may be other factors that can outweigh management’s preparation and when these risks might become material enough to warrant rating action. Notably, the agencies have cited limited examples of rating changes attributed to climate risks.
Where rating agencies have made public the metrics they use to assess climate risks, the materiality of the metrics is not always clear. Notably, quantitative factors that Moody’s has introduced for U.S. states have limited value in narrower contexts. For example, Moody’s identifies California as having elevated climate risk due to the outsized economic contributions of its coastal counties. But this tells us little about the difference in the risk profile of a city in Los Angeles County relative to a similar-sized city in neighboring Orange County. This is significant because we have found that municipalities within the same geographic region can have varying degrees of climate-risk exposure. While we recognize the rating agencies are relatively new to ESG research and analysis, we believe that a greater focus on justifying materiality of selected metrics would strengthen the validity of the ratings provided.
In our view, rating agencies also seem somewhat sanguine about natural disaster risk. Climate change is likely to exacerbate the severity and frequency of intense weather in the future, which warrants rethinking the durability of federal aid programs. Indeed, as the incidence of extreme weather grows, federal funding norms around disaster recovery are likely to change. However, the agencies seem to overlook this possible change in federal funding policies, instead citing the current availability of federal disaster aid as a catalyst for recovery and a key component of credit resiliency in the wake of a storm. We believe that this approach fails to capture the overall credit risk of certain communities, especially if they have not prepared for obvious risks at the local level and, as such, could be exposed to negative credit developments when future disasters strike.
At Breckinridge, climate risk is incorporated into our fundamental analysis of a municipal borrower’s overall credit profile. We utilize proprietary, sector-specific sustainability frameworks featuring metrics that gauge climate risk at the issuer level. These include measures of air and water quality, drought severity and greenhouse gas emissions.
Breckinridge continues to seek new ways to improve how we assess climate risk. We recently partnered with Climate Central to develop a quantitative approach for assessing risks associated with coastal flooding and sea level rise. In our opinion, these risks affect issuers differently, even when located in the same geographic area. Although rating agency opinions rarely cite these risks as a material credit factor, our new tool permits analysts to identify the municipalities that we think are most at risk and thus, prompt further examination of their mitigation efforts. We believe this provides important color on the overall creditworthiness of the municipalities in which we invest.
We expect that the rating agencies’ approaches to assessing climate risk will evolve over time. Going forward, we are interested to see if these risks are explicitly cited in rating reports as material credit factors. We are also curious as to whether the rating agencies are likely to begin to incorporate more-quantitative measures of climate change vulnerability. Regardless, growing threats related to climate change will continue to be a key component of credit analysis at Breckinridge.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
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