In this article, we will take a closer look at the impact of climate change on municipal & state governments and the progress towards evolving municipal debt landscape thus far.

Let’s start with the facts. According to the National Centers for Environmental Information, the United States experienced 27 separate billion-dollar disasters in 2024, costing a total of $182.7 billion and resulting in hundreds of deaths. Compare that with the 1990s, when the country averaged fewer than six such disasters per year.

Let’s look at three different municipalities in the United States where financial and emergency preparedness has evolved and turned more costly to grapple with increased frequency and intensity of natural disasters: In Boulder, Colorado, wildfire season is no longer confined to the summer months. The increasingly dry conditions and unseasonably warm temperatures have caused local officials to reassess both emergency response capabilities and long-term water infrastructure. Or Napa County, California, where a rising risk of drought and fire has increased pressure on water utilities and led to costly upgrades in wildfire prevention measures. Or think about Houston, Texas, a city already struck by three 500-year floods since 2015. Despite significant investments in flood mitigation, the combination of rapid urban development and intensifying rainfall continues to overwhelm infrastructure designed for a very different climate.

These communities are grappling with rising costs to preserve livability and safeguard public assets. To meet these demands, they depend heavily on the municipal bond market. However, a fundamental challenge shared by all these cities is whether their current revenue base is adequate — and growing fast enough — to support the additional debt required to address the mounting strain on public infrastructure driven by climate change.

Despite these growing threats, municipal bonds — used to finance nearly 75% of the nation’s infrastructure — continue to be priced without the climate change risks. In some issuances, these costs are priced at bare minimum levels, as it’s not something that investors are overly concerned about or question. Whether bonds were long term or issued during periods of heightened climate awareness, the results were consistent: no meaningful premium for physical risk.

In practical terms, that means a school district in coastal Louisiana facing regular hurricane evacuations may pay almost the same interest rate as a district in the Great Plains with little climate exposure.

In research published by Duke University, Nicholas Institute for Energy, Environment & Sustainability, found that increasing an issuer’s climate risk by 32 times only added 4.2 basis points to its yield. That’s a negligible difference for borrowers facing multimillion-dollar infrastructure repairs or resiliency investments. The research also states, “Climate risk has not traditionally been assessed in municipal credit analysis. When considered, climate risk assessment is increasingly conducted as part of professional investors’ Environmental, Social & Governance (ESG) analyses. To inform their decisions, professional investors are purchasing bespoke climate data sets to help them price such risk. In contrast, while race was historically considered explicitly in municipal investments, current market participants are presumed to be agnostic with regard to risk associated with race.”

This disconnect suggests a systemic blind spot in the market, despite the fact that rising temperatures, extreme weather, and insurance pullbacks are already hitting local budgets.

There may be a few reasons why climate risk hasn’t been fully priced into the municipal debt markets:

• Credit Rating Assessment: Rating agencies tend to primarily focus on short-term creditworthiness — metrics like budget balance, reserve ratios, and tax base stability — rather than long-term environmental exposure. For example, counties like Charleston (SC) and Palm Beach (FL), both highly exposed to climate risk, have maintained AAA ratings from major agencies. For investors, it may be worth investigating the revenue base and whether the climate impact risk has been factored into the rating criteria by rating agencies, and whether or not this risk will have a material impact on the current rating for these counties.

• Federal Backstops: Investors have grown accustomed to the federal government stepping in after disasters. From FEMA aid to National Flood Insurance Program payouts, the federal government’s long-standing safety net has created a perception for investors that someone else will always step in to provide a financial safety net for municipalities across the United States.

• Supply and Demand of Municipal Debt: The overall municipal debt markets aren’t as large as other asset classes, and the supply of new municipal debt is limited due to many reasons, including interest rates. However, the demand from tax-sensitive investors has always been high. This imbalance can mask underlying risk, as buyers compete for a limited supply regardless of climate exposure.

• Political Pushback: In states like Texas and Florida, new laws prohibit public entities from considering environmental, social, and governance (ESG) factors in investment or ratings. Florida even bans the use of climate-related objectives in municipal bond marketing. These policies create legal uncertainty around disclosing or acting on climate risk.

In 2021 and 2022, the Infrastructure Investment and Jobs Act and the Inflation Reduction Act pumped hundreds of billions of dollars into green and climate-resilient infrastructure. Even though municipal bond issuance did not experience a commensurate surge immediately, largely due to higher costs of raising capital because of interest rates to supplement federal funds, state and local governments are feeling the pressure to adapt. The aging public infrastructure, paired with more frequent disasters, means more borrowing to repair and reinforce infrastructure and greater financial strain on communities with limited tax bases.

Analysts at PIMCO and other major asset managers expect higher muni issuance in the coming years as federal funds flow and state budgets stabilize. But “borrowing to adapt to climate change presents a new kind of challenge: not just replacing old bridges or schools, but future-proofing them against a world that looks increasingly volatile.”

When assessing the dynamic between municipal debt issuers & credit rating agencies, it’s likely that climate realities will collide with market perceptions. An April 2024 S&P report found that 64% of U.S. counties already rely on economically significant areas facing at least one acute climate hazard. By 2050, more than a fifth will be exposed to two or more. When that happens, the very foundations of municipal finance — property values, tax revenues, population stability — may begin to falter.

Municipal debt investors must begin to evaluate their municipal debt investments from a dual lens encompassing both credit rating metrics and the environmental analysis. Here’s how:

• Assess exposure to specific risks — sea level rise, wildfire zones, flood plains — and monitor how local governments are responding.

• If private insurers pull back, municipalities may face increased disaster costs, further straining the budgets

• Assess whether the issuer is investing in building resilience or simply repairing damage for their capital investments. Capital plans that ignore climate adaptation may be red flags.

• Keep a close eye on the federal policy and understand that shifts in disaster aid, insurance rules, or ESG restrictions could reshape risk in unpredictable ways.

The world is changing, and the municipal bond market will eventually reflect that. The only question is whether investors will be ahead of the curve.

Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their investment professionals and advisors prior to making any investment decisions.