This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.
In the United States, infrastructure and municipal finance operate far from the spotlight. From Wall Street’s perspective, municipal bonds occupy a sleepy corner of the nation’s capital markets, offering low default rates and typically placid market conditions. From Main Street’s perspective, apart from school budget votes and the occasional municipal bond referenda, public infrastructure projects tend to be the stuff of town board meetings. Absent a crisis or proposed tax increase, communities tend rely upon their elected and appointed public officials to ensure that their “public works” – e.g., water, sewer, roads, bridges –work themselves out.
But then disaster strikes – a hurricane (Puerto Rico, Houston, New Orleans), storm-fueled wild fires (the Camp Fire in California), or a pandemic (COVID-19) – revealing a fundamental truth: Reliable infrastructure is a matter of life or death, especially during times of crisis, but it is not a given in the United States in the year 2020. Across the United States, our infrastructure is crumbling and our public health and safety services are stretched thin, leaving us ill-prepared for the disasters that regularly befall us.
Although threats to infrastructure and state and local government budgets are legion, this note and companion article focus on climate change. Put simply, as extreme storms and other climate change impacts become more frequent and more intense, state and local governments are facing mounting infrastructure-related risks and costs. Mindful of these developments, Wall Street has begun to take climate risk into account in credit rating determinations and pricing when state and local governments issue municipal bonds, making it harder and more expensive for some subnational governments to access the municipal securities market for needed capital. Over time, rising infrastructure costs have the potential to overwhelm our current system of municipal finance, a system which places the financial burdens of public infrastructure largely upon state and local governments. And, unless we figure out a more reliable and sustainable strategy for funding infrastructure in the face of climate change, we will put public health and welfare at ever-increasing risk.
Why is Climate Change a Municipal Finance Issue?
Fundamentally, climate change is an issue for municipal finance in the United States because we have chosen to place the lion’s share of the burden of paying for non-defense public infrastructure upon state and local governments. State and local governments, in turn, depend upon the municipal securities market to raise the capital needed for this work.
Consider, for example, water and transportation infrastructure outlays. According to a report issued by the Congressional Budget Office (“the CBO Report”), in 2017, state and local governments spent more on transportation and water infrastructure than the federal government does, on both a percentage basis and as a matter of absolute dollars, during the measured period.
Notably, state and local spending on transportation and water infrastructure exceeded federal spending in all measured categories:
Not surprisingly, given the dollar amounts involved, state and local governments cannot rely exclusively upon own-source revenues (e.g., taxes) to pay for infrastructure, and depend principally upon the municipal securities market to raise capital for infrastructure projects. Data from the U.S. Survey of State and Local Government Finances provide insight into the extraordinary burdens that these funding and financing activities can place upon state and local government budgets.
There is very little that subnational governments can do to mitigate these financial burdens. Compared to private businesses, for example, state and local governments have far fewer, and far more limited, options for raising capital: They cannot, as a practical matter, issue equity securities, nor can they easily leverage or sell off assets. Subnational governments also may be subject to tax caps or other limits on levy power or indebtedness. There may be practical or political constraints on the taxing power of state and local governments, as well, especially in financially distressed municipalities. And, although the privatization of public infrastructure has been touted by some as a way of providing infrastructure or health and safety services more efficiently or cheaply, there is reason for caution, as demonstrated by the recent failure of two privatized dams in Michigan. Likewise, although the merger, consolidation or dissolution of subnational governments, or shared services agreements, or some combination thereof, have the potential to generate cost savings or improved service delivery, residents generally have not embraced these approaches, and savings are not guaranteed.
State and local government also cannot easily cut costs or obtain relief from debts. For example, subnational governments cannot easily disaffirm commitments made to current or former public employees in collective bargaining agreements to cut costs. Nor can they easily obtain relief from liabilities or debts through financial distress regimes, either. As sovereigns, state governments are not eligible for bankruptcy protection under chapter 9. While non-state entities (cities, counties) may be able to seek bankruptcy protection under chapter 9, there are meaningful eligibility requirements (including state authorization), involuntary bankruptcies are not permitted, liquidation is not an option, and the issuer’s power (and obligation to) to continue operating (and in some cases make payments on debt) are not always affected. Even if municipal bankruptcy is an option, relief comes at a cost, often in the form of cuts to public services and infrastructure spending.
Market-driven and political realities also limit access to debt relief. A municipal bankruptcy filing can make it difficult for the debtor (or other issuers within the state) to access capital markets in the future. In the wake of Detroit, Michigan’s bankruptcy filing – the largest municipal bankruptcy filing in U.S. history – other Michigan municipalities reportedly were forced to delay planned offerings. A March 2019 decision in Puerto Rico’s bankruptcy roiled markets, as investors reconsidered risks associated with bankruptcy. More recently, in the wake of the Camp Fire in California, commentators expressed concerns over whether the communities impacted by the fire would be able to access the municipal bond market in a timely or cost-effective way, given the near total destruction of the property and retail tax base in some locations.
Finally, state and local governments face challenges in limiting exposure to risk, especially when it comes to climate change. As the Third National Climate Report (NCA3 Report) observes, climate change poses risks to every category of critical infrastructure in the United States. According to the report, rain, snow, and runoff patterns are changing, and resulting increases in droughts and flood frequency and severity linked to climate change have the potential to “affect critical water, wastewater, power, transportation and communications infrastructure,” potentially resulting in interconnected and casting cascading failures” that will “affect human safety and health, prosperity, infrastructure, economies, and ecology in many basins across the U.S.” The report also finds energy production and delivery facilities to be at risk, and because “so many components of U.S. energy supplies – like coal, oil, and electricity – move from one area to another,” disruptions in one region can ripple across the nation. With changing weather patterns, rising sea levels and storm surges, and an increase in the number and intensity of severe weather events, the reliability and capacity of U.S. transportation network is at risk as well.
Private insurers faced with these sorts of risks have options. If an insurer believes that climate change is increasing the risk of loss with respect to insured properties, for example, the insurer can increase policy premiums, only cover certain properties or customers but not others (for example, commercial but not residential, or only high-end properties), or exit a market entirely. This is why private flood insurance is not readily available in certain coastal areas, for example, or available only for certain customers or types of properties.
State and local governments cannot mitigate or offload risks in this fashion. For practical and legal reasons (such as restraints on levy power, limits on indebtedness, and political consequences of tax increases, as noted above), a local government cannot easily increase “premiums” (property tax, sales tax, use fees) in response to climate risk, nor can it provide infrastructure or services to some residents but not others based on climate risk assessment. Local governments also are not free to exit the market for infrastructure or municipal services. They are obligated to provide at least basic infrastructure and health and safety services for all residents at all times, and, they cannot just exit the market because risks are increasing, or costs are high. Finally, municipal securities issuers cannot easily move public infrastructure out of harm’s way to reduce risks or costs. If a municipality’s sea wall is damaged during a hurricane, for example, the municipality likely will have to repair it to prevent further losses; there is no point in moving a sea wall to a less risky location, and it may be costly or otherwise not feasible to move properties or assets at risk if the sea wall fails.
Developments in the Municipal Securities Market
In the face of these developments, Wall Street has (finally) begun to take notice of climate risk in the municipal securities market. At the urging of institutional investors, credit rating agencies have been pressing bond issuers to get a handle on climate risk and community resiliency for several years now. As early as October 2017, for example, S&P Global Ratings issued a Credit FAQ entitled “Understanding Climate Change Risk and U.S. Municipal Ratings” (S&P FAQ). The S&P FAQ observed that, “[i]n addition to episodic event risk from natural disasters . . . it is important to consider the current long-term credit implications of the physical impact of climate change that municipal debt issuers must contend with.” In considering these long-term credit implications, S&P recognized the profound and wide-ranging potential impacts of climate change upon municipal issuers, including both costs of extreme weather events, land use implications, risks to critical infrastructure associated with long-term temperature changes and precipitation.
One month later, in November 2017, Moody’s released a research report entitled Evaluating the Impact of Climate Change on US State and Local Issuers (the Moody’s Report). The Moody’s Report observes that climate change is expected to cause more frequent and more severe extreme weather events and associated impacts (“heatwaves, droughts, nuisance flooding, wildfire and more damaging coastal storm surges”), and further observes that such events are likely to heighten “U.S. exposure and vulnerability to economic loss across industries and geographic regions.” The Moody’s Report states that credit risk resulting from climate change is a key factor in credit risk analysis for municipal bond offerings, and suggests that a municipality’s resilience to climate change – or, alternatively, its failure to engage in resiliency planning – could have an effect upon the pricing and rating of the municipality’s bond offerings.
Investor awareness of climate risk is starting to affect credit determinations and pricing in the municipal bond market. For example, PG&E’s credit rating was cut to near junk status over concerns that the company’s insurance would not be sufficient to address losses associated with the Camp Fire and other catastrophic blazes; the company ultimately filed for bankruptcy protection on January 29, 2019. While some municipal bond issuers reportedly have continued to receive top ratings despite risks and threats associated with climate change, commentators are being increasingly vocal about the potential for downgrades due to perceived or demonstrated climate risk.
Market Response and Recommendations
To date, market-focused stakeholders have tended to emphasize improving the quality of due diligence and disclosure around climate risk in the municipal securities market. This makes sense; the municipal securities market is less liquid and more opaque than markets for corporate equity securities, U.S. Treasury securities, and even futures and foreign exchange markets. It is a dealer market, meaning there is no centralized, organized exchange where municipal securities are listed or traded, and there is not a formal, two-sided quotation system, either. There are large number of issuers and highly disparate offerings as well. And, limits on disclosure requirements associated with the exempt status of municipal securities under the federal securities laws also tend to reduce the quality of disclosure. For all of these reasons, the municipal securities market does not have the same degree of price transparency as do markets (e.g., corporate equities) with more actively traded securities. Improving price transparency in the municipal securities market, whether through regulatory reform (which seems unlikely, given the exempt status of municipal securities and associated limits on the SEC’s rulemaking authority) or through evolving best practices (more likely) is a good idea.
But disclosure-focused reforms address only part of the problem, because even if disclosure rules were perfect, and even if we could perfectly and efficiently price climate risk in the municipal securities market, we would still face a fundamental, structural problem – i.e., who should pay, and where should the money come from, to address the risks and costs to infrastructure and human health and welfare associated with climate change?
In my article, I review a number of different strategies for risk spreading and burden-sharing, including the following: (i) re-establishing the federal government’s important role as a sponsor of and clearinghouse for climate science research and infrastructure siting, design, and construction best practices guidance; (ii) formalizing and strengthening the federal government’s role as source of capital or credit assistance, or both, especially for critical infrastructure projects that struggle to access public markets at reasonable cost; and (iii) continuing to leverage knowledge and strategies developed at the state and local levels to address local, state-wide, and regional challenges.
At the end of the day, there are no easy answers. Stakeholders – taxpayers, bondholders, current and former public workers, and others involved in the state or municipal enterprise – all have compelling, but often competing, claims on public resources. Even so, we do not have the luxury of standing by in the face of climate change. The risks to public health and welfare are just too great, and we are all, ultimately, in the same boat.
Christine Sgarlata Chung is a Professor of Law and Director of Business Law Programming at Albany Law School. She also serves as Director of the Albany Law School Institute for Financial Market Regulation and Editor of the Bloomberg Law Municipal Securities Portfolio.
This post is adapted from her paper, “Rising Tides And Rearranging Deckchairs: How Climate Change Is Reshaping Infrastructure Finance And Threatening To Sink Municipal Budgets,” which is published in the Georgetown Environmental Law Review (32 Geo. Envtl. L. Rev. 165 (2020)) and available here.
 See Robert A. Fippinger, The Securities Law of Public Finance Vol. 1 § 1.2.1, 1-7 (noting that while there is nothing in the securities laws that prevents public corporations from issuing equity securities, the municipal securities market in the U.S. is a debt market for historical reasons and as a “by-product of the economics of capitalism.”) (3d. Ed. (2018).
 To be eligible for chapter 9 relief, an entity must meet the five criteria listed in § 109(c). 11 U.S.C. § 109(c). Specifically, the entity must 1) be a municipality, as defined by the Code; 2) be specifically authorized to be a bankruptcy debtor; 3) be insolvent as defined by § 101(32)(C); 4) genuinely desire to effect a plan to adjust its debts that exist as of the commencement of the case; and 5) satisfy one of the four alternative statutory requirements for negotiating with its creditors before filing its petition. Id. The debtor bears the burden of establishing that it meets each of these statutory requirements. See, e.g., In re Cnty. of Orange, 183 B.R. 594, 599 (Bankr. C.D. Cal. 1995). With respect to the “specifically authorized” criteria, fewer than half of the states authorize municipal bankruptcy petitions, assuming the filing municipality meets certain conditions.
 See 11 U.S.C. §§ 301, 904 (2012).
 11 U.S.C. § 943 (2012)
 For example, despite the automatic stay provision of the Bankruptcy Code, 11 U.S.C. § 922(d) allows municipalities to continue paying pledged special revenue, or revenue bonds without obtaining the court’s permission or notifying other creditors. By comparison, corporate reorganizations occur in the content of the potential liquidation of the debtor. See id. § 1123(a). Likewise, because § 928 of the Bankruptcy Code provides that special revenues obtained by a municipal debtor after a bankruptcy filing are subject to liens granted prior to the bankruptcy filing, eligible (revenue) bondholders may be entitled to receive revenue pledged to them notwithstanding the filing of a chapter 9 bankruptcy petition. See 11 U.S.C. § 928. The Bankruptcy Code also provides that payments received by holders of municipal bonds or certain note obligations within ninety days of a municipal bankruptcy petition are not preferences subject to claw-back. See 11 U.S.C. § 926.
 Pacific Gas and Electric Company, Docket No. 3_19-bk-30089 (Bankr. N.D. Cal. Jan 29, 2019).