When ratings agency Standard & Poor’s (S&P) downgraded the creditworthiness of the largest municipal utility in the United States, some experts warned it could signal early cracks in the historically stable municipal bond market. But the wider consensus is that municipalities—in both the U.S. and Canada—are awakening to climate risk, a shift many see as a positive development.

In Canada, cities like Toronto, Montreal, and Vancouver are leading the way in disclosing climate-related financial risks and leveraging municipal green bonds, fixed-income investments issued by cities to finance infrastructure resilience and climate initiatives. Toronto alone had raised more than US$1 billion in green bond issuances as of November 2023, writes the World Economic Forum (WEF).

But the heightened risk is still out there. On January 14, in an industry first, S&P Global Ratings downgraded the Los Angeles Department of Water and Power (LADWP) two notches from a very secure AA- rating to an A, which remains secure, but with vulnerabilities.

S&P cited the “increasing frequency and severity of highly destructive wildfires within LADWP’s service territory.” One week earlier, ferocious urban firestorms had broken out across Los Angeles County. At least 29 people died, and damage estimates ran as high as $275 billion.

Safe Haven No Longer

The immediate impact of the downgrade was that “bond values fell, default risk rose, and some bondholders sold at a loss,” E&E News wrote in February. But JP Morgan remained optimistic on long-term impacts: On February 18, the bank published an analysis titled “Municipal bonds today offer U.S. taxpayers a rare, compelling opportunity.”

“We do not forecast any payment defaults to occur for any city, county, or school district adversely impacted by the Los Angeles fires,” North America’s largest bank wrote—a green flag for the individual investors who own 40% of U.S. municipal bonds, earning a yield that, for now, is exempt from federal taxes.

U.S. Senator Chuck Grassley (R-IA) expressed similar confidence one year earlier at a Senate Budget Committee hearing on climate risks to municipal bonds. The $4 trillion municipal bond market, which is said to finance 70% of U.S. infrastructure—including schools and water and sewer systems—“is very resilient,” Grassley said in January 2024.

“Where there have been defaults in municipal bonds, it’s been in places that have been mismanaged for decades,” he added, citing the city of Detroit as an example.

Grassley added that he was sure U.S. municipalities were up to the challenges climate change poses: “Climate doomsday isn’t around the corner,” he said, adding that municipalities understand the risks and “are uniquely qualified to so adapt.”

But LADWP’s downgrading may herald “the beginning of a crack” in the country’s municipal bond market, Alice Hill, who served as U.S. National Security Council senior director for resilience policy in the Obama administration, told E&E. “We know that with climate change, there’ll be bigger and worse disasters that will affect communities’ abilities to repay those bonds.”

Municipalities in Climate’s Crosshairs

At the same Senate hearing, environmental data analyst Chris Hartshorn expanded [pdf] on how climate impacts can strain municipal finances, warning of the delayed onset of harms following disasters like wildfires or hurricanes.

Five years after a fire, affected communities are “25% more likely” to experience a budget deficit due to declining revenue and increasing expenditures, while hurricane-stricken municipalities can see financial blowback up to a decade later, Hartshorn said.

Chronic impacts like heat—“a critical issue across much of the municipal U.S.”—can add to the financial grind, he added. K-12 schools are a particularly urgent concern, with an estimated $40 billion of new air conditioning installation required to keep schools safe and productive for children in the U.S.

Meanwhile, insurers are retreating from “higher climate risk,” Hartshorn said, citing states like Florida and California. The withdrawal has a domino effect on property values, which in turn reduces the property tax stream that underpins municipal debt servicing.

The diminishing of this “historically critical pillar of past disaster recovery” will heighten financial pressure on the municipal system after disasters, Hartshorn warned.

FEMA Backstop Pulled

At the hearing, Senator Sheldon Whitehouse (D-RI) compared municipal bonds to the 30-year mortgage, calling them “a bedrock” of the American economic system.

For decades, the U.S. Federal Environmental Management Agency (FEMA) has reinforced this bedrock by stepping in to fund disaster recovery, municipal market analyst Thomas Doe told E&E.

“FEMA money would come in and provide the support for the rebuilding, and everybody’s made whole and the world goes on,” Doe said.

That status quo was more fragile than it might appear, Doe warned at the Senate hearing. “An industry pivot could be hastened if FEMA changes its criteria and raises more hurdles between disasters and federal aid, undermining traditional views of FEMA as a credit stabilizer.”

Now, making good on his presidential campaign promises, and his threats after the LA wildfires, Donald Trump is taking the axe to FEMA. Hundreds of FEMA staff have been laid off, and more losses are to come, especially among those who work on climate and resilience, wrote the Natural Resources Defense Council in February.

Canadian Cities Awaken to Climate Risk

In Canada, awareness of climate-related financial risk is gaining momentum. Gaby Kalapos, executive director of the Clean Air Partnership, sees a growing number of Canadian municipalities disclosing these risks as part of their financial planning.

A decade after the G20 created the Task Force for Climate Related Financial Disclosure (TCFD), and four years after Canada’s pledge to integrate TCFD into financial reporting across the economy, cities like Toronto, Montreal, and Vancouver are “leading the pack,” Kalapos told The Energy Mix.

Toronto’s $1 billion will finance its goal of achieving net-zero emissions by 2040, writes WEF. Funded by the Green Debenture Program, eligible capital projects will boost renewable energy generation capacity, energy efficiency, and green building projects in the municipality.

Such positive developments are occurring even as climate damages rapidly worsen, Kalapos said.

“It is not a matter of if climate impacts affect municipalities credit rating, but when,” she warned. “The risks are real, and repeated impacts will greatly reduce a community’s ability to recover.”

Strengthening Climate Resilience

Ujala Qadir, director of strategic programmes at the United Kingdom-based Climate Bonds Initiative, sees the sector-wide focus on climate risk as a positive shift, citing the move by S&P as the “shakeup” everyone needed to recognize that “the risks we thought were 20 years away are actually starting to materialize already.”

Qadir told The Mix the conversation must now turn to “future-proofing” both municipalities and municipal bonds. This will naturally create a “virtuous circle” that builds resilience for both communities and bond markets.

Municipalities that embrace climate adaptation through green municipal bonds—as Toronto is doing—will further secure their credit ratings even as they protect households, businesses, and infrastructure from destructive climate impacts.

“There’s a lot you can do right? There’s so much evidence that investments in resilience and adaptation can actually prevent major losses,” Qadir said.

The Climate Bond Initiative is at the forefront of the green bond market’s evolution, with Qadir herself working to develop a “resilience bond,” the rigorous parameters of which would require issuers to “demonstrate a clear impact on reduction of climate risk.”

“We see this as a huge opportunity to expand the market of green and climate bonds to explicitly include resilience and really integrate that across the board,” she said.