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Climate Risks to US Governments, Solving Wildfire Financial Threats with Securitization, Federal Flood Standard, and More

Adaptive capacity of state, local, municipal governments will determine creditworthiness as risks bite

S&P Global breaks down climate physical risks to US governments, a new paper suggests banks could securitize their way out of wildfire risks, the US Federal Flood Risk Management Standard rule is finalized by HUD, a top EU insurance regulator wants insurers to incentivize policyholders to take adaptation actions, and a mangrove support tool is Innovation of the Week.

Last week, Climate Proof covered J-ADAPT from Oxford University and the Howden Foundation, a data platform that wants to shake up how finance for climate resilient infrastructure is doled out in the developing world. Read the article HERE and become a premium subscriber to receive features like this every Thursday.

Premium subscribers now also get access to Climate Proof Data, which debuted last week with the S&P 500 Climate Physical Risk Signals data dashboard.

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Climate Risks are Coming for US State and Local Governments

The boffins at S&P Global are all over climate physical risk and adaptation —check out this report from earlier in the month on corporate adaptation planning for a taste of what they’re cooking.

Another landed just last week, quantifying the financial toll that physical risks could exact on US governments — state, federal, and local. For this analysis, S&P researchers looked at how 3,100 counties featured in the S&P Global Sustainable1 U.S. Muni Bond Climate Physical Risk (S1) Dataset would fare against nine types of climate shock: extreme heat, extreme cold, wildfire, drought, water stress, coastal flood, fluvial flood, pluvial flood, and tropical cyclones. They considered how these risks could manifest under four distinct climate scenarios to build up a comprehensive picture of potential exposures.

Assuming a “slow transition” scenario, the researchers teased out a number of national-level findings. One, the US is projected to experience almost 20 additional days of extreme heat by the 2050s each year relative to today — from a median of 42.5 to 61.5. Two, drought conditions are expected to lengthen in duration, with the median frequency of months suffering some drought increasing from 14.9% to 21.8%. Three, the number of wildfire-conducive days each year could jump from 11.6 days to 17.5. And four, exposure to “extreme flooding events” is set to rise across the board.

More useful, practically speaking, are the researcher’s findings on regional exposures. After all, climate shocks are not going to hit all areas with the same force or frequency. It’s worth knowing as a state, municipal, or local government what hazards to specifically keep an eye on as the world warms. 

S&P finds that hot places are projected to get hotter, and that these scorching regions are likely to have to contend with increased drought conditions and water stress, too. Wildfire-prone areas today are also likely to become more exposed as the years tick by, though regions with currently low levels of wildfire risk — like the Great Plains — are set to see their exposure ramp up significantly by 2050. Sea-level rise, meanwhile, is projected to lead to a higher number of coastal flooding events each year. For those counties in the Gulf of Mexico, there could be a four-fold increase in one in 100-year inundations by 2050.

Given the size of the US, nearly all counties are exposed to at least one climate hazard. Physical risks can pose a particular threat to the creditworthiness of many public finance issuers where locations are fixed, and the risk cannot be divested or diversified away.

Furthermore, there’s little that US lawmakers can do to head off these threats, as the researchers make plain: “Given the lock-in effect of historical emissions, many of the physical risks of climate change will materialize irrespective of today’s policy choices,” they write.

This should prompt local politicians to put more energy into adaptation measures as a matter of self-preservation. As the researchers point out, physical risk exposures can’t be magicked away by local governments. A city can’t uproot itself and move ten miles out of a flood plain, after all. Without adaptation, communities could see floods, fires, and droughts chip away at their infrastructure, push up maintenance costs for roads, bridges, and housing, and even require whole new programs to deal with water stress and heat stress. All these things demand financing, which may become harder to raise as climate shocks continue to mount.

Still, the S&P paper notes that insights from the S1 dataset will not drive credit rating changes to governments on its own. A number of additional factors will determine whether governments get downgraded, including the underlying economic strength and institutional resources of the communities they oversee.

In other words, it’s a government’s adaptive capacity that will determine its ability to raise money in a hotter, wilder future — not just its exposure to escalating climate shocks. Practically speaking, this means poorer areas with more cash-strapped governments are likely to struggle more than richer locations, even if they face a terrible array of climate risks. A “just adaptation” approach to public and private investment may therefore be warranted to prevent already frightening levels of inequality in the US soar higher.

Can Banks Securitize Their Climate Risk Exposures Away?

Mortgage securitization earned a bad rep in the midst of the global financial crisis, and understandably so. It was the bundling of hundreds and thousands of subprime mortgages into impenetrable financial instruments that allowed credit risk to propagate through the banking system in disguise. When the underlying loans started to blow up, many holders of mortgage-backed securities (MBS) found out that what they thought were virtually risk-free investments were anything but. 

Still, MBS and securitization survived the crisis, and for good reason. Securitization can move risks from entities that can’t or won’t hold them to those that do. In turn it can free up capital for productive lending and diversify risks in such a way that it makes certain lending opportunities possible which otherwise wouldn’t be considered.

Could climate-related financial risks be made tolerable via securitization? It’s a question that a recent working paper out of the National Bureau of Economic Research attempts to answer. Here, the authors look at securitization as a way to mitigate wildfire risks to real estate loan providers, like banks. They study the chain of transactions that lead from loan origination to MBS creation in the US to determine whether this financial technology enables “natural disaster risk adaptation.”

The authors conclude that it’s possible to pick-and-choose home loans to form “climate-resilient pools” of mortgages that can then be packaged in MBS. They find that these MBS produce financial returns that hold up against rising temperatures while also making it possible for lenders to continue financing loans in wildfire-prone regions. It’s a win-win.

Evolution of the Wildfire Propensity Score

The upper panel shows the average wildfire propensity score in sample, over the time period of the sample. The lower panel shows the projected change in the wildfire propensity score in 2050. Such change is used to forecast cash flows with increased wildfire risk. The wildfire propensity model is estimated using historical wildfire perimeters. The projected change in 2050 is estimated using the IPCC’s CMIP6 projected temperatures and the wildfire propensity model of this paper

Now there’s plenty of further questions to ask of these conclusions. First and foremost, what happens when you add other risks into the mix? Here the authors are only focusing on wildfire hazards. While they do consider the implications of multiple wildfires occurring simultaneously at different locations in their model, they do not consider additional climate-related risks, like floods, or so-called “compound events” — sequences of climate risks with the potential to amplify financial losses. As an example, think of a prolonged period of drought, followed by heavy rain causing flash floods.

Still, the paper does suggest that existing financial technology can keep credit flowing in a world blighted by ever-rising climate risks. This in turn implies that at-risk populations in parts of California, Colorado, Texas, and elsewhere could still receive home loans even as the threat from wildfires ramps up. 

However, the authors don’t say that securitization can manage such risks all on its own. In fact they make the point that securitization is complementary to other prudent risk management activities, like lenders demanding higher down payments from borrowers to lower their own exposure, rather than a substitute for such measures.

For structured products bankers, the paper could help with the design of credit risk transfer products that allow private investors to continue playing in the MBS space even as temperatures, and therefore wildfire risks, tick upwards.

Though it may sound esoteric, ultimately securitization could make the financial system, and the residential mortgage market, more resilient to climate shocks —something that should be welcomed.

Federal Flood Risk Standard Finally Finished!

Buildings financed by US taxpayers now have to be hardened against flood risks under new regulations finalized by the Department of Housing and Urban Development (HUD).

Last week, the agency completed work on a Federal Flood Risk Management Standard (FFRMS) that’s been nearly 10 years in the making. In 2015, then President Barack Obama issued an Executive Order (EO) “to improve the resilience of communities and federal assets against the impacts of flooding.” The EO was rescinded by President Trump, and reinstated by President Biden in 2021. Now, finally, the EO is being operationalized via updates to HUD’s rulebook.

Specifically, the regulations require federally financed constructions, or major improvements to such properties, to meet higher flood-proofing requirements and be built at elevations less susceptible to inundations. These measures should lower the exposure of taxpayer-funded buildings to billions of dollars of potential losses from coastal floods, heavy storms, and burst riverbanks. The rules also force HUD to improve communication of flood risk to HUD-assisted renters and homeowners.

This rule will ensure HUD supported properties have the best chance of being undisturbed when flooding occurs. It is the responsibility of the federal government to ensure that taxpayer investments are built to withstand foreseeable risk – and has the added benefit of reducing the cost of flood insurance for property owners.”

Marion McFadden, Principal Deputy Assistant Secretary for Community Planning and Development

Floods are already the most costly climate shocks in the US today, while the Congressional Budget Office projects that the expected annual flood damage to homes with federally backed mortgages will rise to around US$12.8bn by 2050. HUD estimates the flood-proofing mandated under the new rules will result in somewhere between $56.4mn to $324.3mn in savings over the lifetime of affected properties, from lower flood insurance premiums, reduced flood damage, and avoided losses to homeowners and tenants.

Federal agencies and private contractors looking to comply with the FFRMS can use the Federal Flood Standard Support Tool, a Climate Proof Innovation of the Week, to site projects at appropriate elevations

EU Insurance Regulator Advocates for Adaptation

Europe’s top insurance watchdog is sounding the alarm on climate shocks to the bloc’s underwriters.

In a conversation with the Financial Times, Petra Hielkema — head of the European Insurance and Occupational Pensions Authority (EIOPA) — said surging insurance costs across Europe are “a call for action” to insurers and policymakers to think big on combating climate risks.

Her proposed solutions include updating building codes to make them more resilient to flooding, creating risk pooling schemes across European Union member states, and strengthening ties between insurers and reinsurers.

EU insurers are grappling with the ever-growing cost of climate-related natural disasters. Losses across the bloc since 1980 are estimated to be over €650bn (US$696bn), of which a quarter were covered by underwriters.

In a speech on March 21 to the CRO Forum in Venice, Hielkema made the case for insurers supporting the take-up of adaptation measures by their policyholders, arguing in favor of “insurance provisions specifically designed to encourage consumers to reduce their vulnerability to climate-related risks.”

In the same speech, she also said EIOPA would promote the growth of catastrophe bonds, instruments that transfer natural disaster insurance risk from carriers to capital markets investors.

💡Innovation of the Week💡

Mangrove forests are among the world’s best natural defenses against rising climate risks. The unique ecosystems are effective shock absorbers, able to withstand and disperse the power of coastal flood events. They are also natural carbon sinks, making them indispensable to both climate resilience and climate mitigation goals. 

However, rising temperatures are taking their toll on these shaggy coastal guardians. Hence the World Wildlife Fund’s launch of the Climate-Smart Mangrove Support Tool, a workbook intended to help conservationists choose the right actions to reduce current and future climate risks to mangrove ecosystems.

The workbook guides mangrove protectors through the process of defining the characteristics of specific mangroves, assessing their climate threats, calculating their vulnerability, evaluating their adaptive capacity, and identifying and prioritizing actions.

These management actions can range from adding sediment to particular areas to provide a buffer against sea-level rise, to “enrichment planting” of climate-resilient plant species in existing forests.

The tool has so far been applied in Colombia, Fiji, Madagascar and Mexico, as part of the Mangroves for Climate and Communities project (2020-2025), and has also been piloted in the US.

The Fund ultimately wants to see the tool utilized across the important mangrove sites identified by this project, and to be embraced worldwide by mangrove communities and experts.

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