A green roof in Germany.

Climate change is increasing the frequency and severity of extreme and costly weather events such as storms, hurricanes, extreme rains and heat waves. These are increasing costs and risks to cities, in turn threatening their credit rating and their cost of borrowing money.

To date, the potential impact of adopting smart surface strategies on city credit rating has been largely overlooked. Our analysis demonstrates that cities that choose to not adopt smart surfaces will experience significantly increased climate related losses, increased risk of credit rating reductions and associated increases in city borrowing costs.

Over time, these combined threats will increase risk of insolvency for cites that do not adopt resilience strategies such as smart surfaces. This work is part of the Smart Surfaces Coalition, comprised of 30 partners, including the National League of Cities and the American Institute of Architects.

This three-part series provides rigorous description and quantification of the costs and benefits of city climate change mitigation strategies on their credit risk. In Part One, the authors explored the background of smart surfaces and their impact on a city’s credit and risk management.

Part Two, the authors dove deeper into the impact increased severe weather events had on a city, looking at heat waves and flooding as prime examples.

In this conclusion, Part Three, the authors discuss several benefits to having a smart surface strategy in place to increase climate change resiliency and decrease costs for a city.

How Smart Surface Strategies Can Reduce Risk for a City

Future risks from climate change depend substantially on decisions made now.

The Fourth National Climate Assessment observes that the integration of climate risk into decision-making and the implementation of adaptation activities have significantly increased since 2014, including in areas of financial risk reporting, capital investment planning, development of engineering standards and disaster risk management.

Over a single year, differences in whether or not cities adopt smart surface resilient strategies is unlikely to measurably affect the risk or cost of severe weather events.

Greg H. Kats, CEO, Smart Surfaces Coalition

Additionally, it is unlikely to result in changes to credit rating over a few year period; however, over the period of one or several decades, these strategies would cumulatively increase the resilience of cities while lowering the risk, cost and severity of these extreme events.

As Moody’s makes clear, future credit rating will depend not only on actual investment in resilience, but on city policies that show commitment to addressing resilience and climate change related needs.

Cities that do not adopt mitigation and resilience strategies tend over time to experience reduced credit rating. The same conditions also tend to increase insurance premiums, placing further financing burden on the city and in turn adversely affecting credit.

There are a several thresholds of credit risk that cities could experience, depending on how they respond to worsening climate change risks and severe weather events. Enhanced city resilience and lower risk would result from adoption of high albedo (e.g. highly reflective) surfaces, such as green roofs and porous, reflective pavements.

Over time, cities that invest in smart surfaces enhance their resilience by reducing risk of flooding and extreme heat, becoming less vulnerable to climate change and improving air quality and livability.

This investment in resilience would both lower experienced losses/costs. It would demonstrate to credit rating agencies an acknowledgement of the scientific reality of climate change risks and the responsible engagement of cities in addressing climate change risks.

As Moody’s has spelled out, investment in resilience enhances city credit risk, contributing to a higher credit rating and a lower cost of borrowing.

Over the period of a decade or more, that is likely to result in lower actual costs and relatively better credit rating and lower cost of borrowing – as well as lower direct losses.

Adopting smart surfaces strategies city-wide will lower the vulnerability of cites to flooding and lower excess summer heat and would enhance air quality and make cities less vulnerable to worsening weather events driven by climate change.

As discussed at some length in Part Two, credit rating agencies already view cities that fail to invest in resilience as increasingly at risk of losses and are now clear that this will contribute to determining their credit rating.

Against this background, delays in adoption of city-wide smart surface strategies will increase insured and uninsured losses and hurt city credit rating in several ways.

In contrast, cities that adopt city-wide smart surfaces strategies will better manage their physical risks, help stabilize the cost of flood insurance, reduce losses, enhance credit risk and protect their credit rating.

Quantifying the Financial Impact of Credit Rating Reduction

As discussed, failure to invest in smart surfaces and resilience over time will result in increased losses and damage from severe weather events, as well as increased insurance costs and a reduction in credit rating — with a corresponding increase in the cost of borrowing.

This process would be marked by a gradual step-by-step downgrade in credit rating e.g. from double A to single A rating.

A recent World Bank study on the cost of country credit downgrade to junk bond status is telling. The World Bank examined 20 countries that have been rated by the three major credit rating agencies (Fitch, Moody’s and S&P) between 1998-2015 to evaluate impact of credit rating downgrade or borrowing cost.

The World Bank noted: “The study found that a downgrade to sub-investment or ‘junk status’ by one major rating agency increased treasury bill rates by 138 basis points [1.38 percent] on average.”

Unlike recessions, which are cyclical and come to an end, climate change-driven higher temperature, rising oceans or increased hurricanes are long term worsening trends, and so offer no reprieve — no prospective bounce back in property values.

Credit risk benefits for cities that choose to become smart surface cities will strengthen relative to business as usual cities (e.g. cities that persist in installing dark impervious surfaces).

As climate change risks and direct costs grow, e.g. from flooding and more extreme heat and rainstorms, declining property and business taxes would also, over time, contribute to and/or trigger lowered credit ratings that increase borrowing cost and reduce borrowing capacity.

In turn, this will limit the capacity of city services to respond to costlier clean up, repair and maintenance needs after increasingly frequent climate change-driven costly weather events.

So, How Rapidly Will Changes in City Surfaces Affect Credit Rating?

Moody’s  warned in 2017 that “the interplay between an issuer’s exposure to climate shocks and its resilience to this vulnerability is an increasingly important part of [its] credit analysis, and one that will take on even greater significance as climate change continues.”

Rob Jarrell, analyst, Capital E

In April 2019, the multi-trillion-dollar asset manager BlackRock warned that “within a decade, more than 15% of the current S&P National Municipal Bond Index (by market value) would be issued by MSAs suffering likely average annualized economic losses of up to … 1% of GDP … This would have big implications for the creditworthiness of MSAs — and their ability to fund adaptation projects.”

Bloomberg summarized: “BlackRock Inc., the world’s largest asset manager, says that within a decade, more than 15 percent of debt in the S&P National Municipal Bond Index will come from regions that could suffer losses from climate change adding up to as much as 1 percent of gross domestic product annually.”

Moody’s provides further guidance on expected time to impact in two recent reports: “Cross Sector — Global: Moody’s Approach to Assessing the Credit Impacts of Environmental Risks” and “Environmental Risks: Heat Map Shows Wide Variations in Credit Impact Across Sectors.”

It found that:

1. “Global sectors … with approximately $2 trillion of rated debt — are experiencing material credit impacts or are likely to start doing so over the next three to five years. For these 11 sectors, the consequence of regulatory or policy initiatives for carbon reduction and other air emissions is the most frequently cited issue impacting creditworthiness.”
2. “A further 18 sectors — with approximately $7 trillion of rated debt — face the potential of changes in their credit profiles that could be material due to environmental considerations, but over a longer period of 5 years or more.”

Cities are generally more diverse and at less structural risk than these sectors, so we can expect the period over which cities without smart surfaces to experience a change in credit profile will be longer than 3 to 5 years.

For the purpose of developing a reasonable estimate for credit risk impact at an individual city level, we are estimating likelihood of credit rating erosion across a large number of cities.

Thus, we deal with probabilities, rather than a prediction about a specific city.

Based on the accelerating climate trends and rising market rate changes to low lying properties, increasing losses and other factors discussed above, we address the credit rating risk as follows:

We estimate that, on average, over one decade, there would be a difference of one credit rating level between Business as Usual (BAU) cities (predominantly installing dark impervious surfaces) vs smart surface cities (e.g. cities that adopt smart surfaces as baseline city-wide policy).

That is, over a period of four decades and across a large number of cities we estimate that the average change in credit rating to smart surface city vs BAU would be expected on average to result in a difference of one credit rating per decade (e.g. the difference between AAA and AA).

As climate change accelerates and city capacity to respond is stressed, and the gap between revenue and costs widens, this will compress the period of credit rating risk reduction, perhaps compressing toward the length of 5 years.

It is impossible to predict what event will trigger a city credit crisis.

Referencing climate change impact on home values in Florida, the chief economist of Freddie Mac, Sean Becketti hypothesized that the catalyst for a city credit crisis might be a bank refusing to issue a mortgage, an insurer refusing to issue a policy, or, he asked, “Will the trigger be one or two homeowners who decide to sell defensively?” and “Will the value of the house decline gradually as the expected life of the house becomes shorter? … Or, alternatively, will the value of the house — and all the houses around it — plunge the first time a lender refuses to make a mortgage on a nearby house or an insurer refuses to issue a homeowner’s policy?”

Over the period of four decades covered in this analysis, we estimate that each decade a city waits to switch from dark, impervious surfaces to smart surfaces would, on average, expose a city to one reduction in credit rating.

As noted, on average this increases cost of borrowing by 0.35 %, or 35 basis points.

If a one-step credit rate reduction drops a city from “investment grade” to “junk” status, the average increase in borrowing cost is 0.65% or 65 basis points.

Stephen Bushnell, co-founder, Sustainable Disaster Response Council

For a city borrowing a billion dollars through the bond market, a reduction of a single level of credit rating from investment grade to junk status would add $3.5 million in additional interest costs per year or $70 million over 20 years.

Two credit rating reductions that include dropping city bonds from investment grade to junk grade would add $10 million per year to borrowing costs or $200 million over 20 years for a $1 billion bond. For a $100 million bond, a 1% increase in cost of borrowing would add $20 million over 20 years.

Increased city borrowing and higher interest obligations further erode city credit.

And many institutions limit or cap how much of their investments are in junk bonds.

Given the reality of economic cycles, this creates another risk for cities that are not prudent in managing their climate change risk and associated credit risk. As the Financial Times noted, an economic “downturn could trigger downgrades on the large number of bonds that just scrape into the investment-grade ratings, leading to wave of forced selling by funds that cannot hold below BBB.”

For cities experiencing declining real estate values and associated lower tax base, lower tax revenue would happen at a time of greater need for and cost of city services. This is a prescription for declining credit rating and higher borrowing costs.

The most serious potential outcome would have cities going into a credit death spiral resulting from rising climate-change-related costs that are driving down property values and city tax revenue. They would also be increasing the cost of borrowing, making cities less able to invest in capacity or fund climate damage repairs, in turn hurting property values and reducing taxes revenue further.

City revenue is substantially based on real estate taxes, which are largely driven by property value. Value of real estate is determined by market supply and demand, and the irreversible nature of climate change and the feedback loop, making city revenue, cost and credit risk systematically very vulnerable to climate change.

As the City of Coral Gables, Fla., Mayor Jim Cason put it, if property values start to fall, banks could stop writing 30-year mortgages for coastal homes, shrinking the pool of able buyers and sending prices lower still. Those properties make up a quarter of the city’s tax base; if that revenue fell, the city would struggle to provide the services that make it a desirable place to live, causing more sales and another drop in revenue.

Increasing losses and costs to cities, combined with declining revenues from business interruptions and lowered real estate tax base combined with a credit rating agency’s negative assessment of cities that fail to respond to climate change will put cities at growing risk of lowered credit ratings.

This delay will be very costly, because the process of changing out surfaces such as roads, parking lots and roofs will take several decades.

Ripping up new roads and replacing new roofs is very expensive, so surface changes are generally made at the surface’s end of life.

Maintaining a “stupid” surface strategy locks in a worsening heat, flooding and risk profile for cities that fail to adopt smart surfaces.

Cities that move slowly to address climate change increasingly flirt with the risk of a future cycle of higher costs, declining housing value and revenue, and exposure to legal liabilities and damages.

The adverse impact on credit rating and rising cost of borrowing will exacerbate risks and costs to cites that fail to adopt smart surfaces and other available resilience measures.

The Ultimate Goals of Climate Change Resiliency

There are large and growing risks and costs for cities that ignore climate change and fail to adopt available, cost-effective solutions for enhancing city resilience and managing sun and rain.

Over time, city investment in resilience strategies such as smart surfaces will increasingly determine whether city credit ratings improve, stabilize or decline. As Moody’s warns, climate change “will be a growing negative credit factor for issuers without sufficient adaptation and mitigation strategies.”

As extensively documented by the Smart Surfaces Coalition, cities now have highly cost-effective strategies and technologies for lowering climate risks and costs and for enhancing city resilience and livability.

In the longer term, e.g. over a decade or more, cities that fail to invest in resilience measures such as smart surfaces will be increasingly at risk of one or more credit downgrades. These risk dimensions of climate change for cities has, to date, been largely overlooked but is of fundamental importance to the medium- and long-term financial viability of cities.

City managers do not have the luxury of pretending science is not true — they are judged on results and their decision must be based on facts — to make informed and responsible city management decisions. How cities manage their sun and rain will largely determine how they manage — or fail to manage — extreme heat events, extreme rainfalls, flooding and other increasingly common and severe climate change driven events.

It will also have a large impact on city livability because it directly affects quality of life issues such as heat, air quality and walkability.

Will Wynn, former mayor of Austin, TX

Former mayor of Austin, TX Will Wynn added: “Cities that commit to climate mitigation policies — including smart surfaces strategy adoption — clearly will save their taxpayers money and reduce risk. Cities that fail to adopt smart surfaces will experience rising climate related losses, eroded confidence of residents, businesses and credit agencies, and worsening heat, flooding, and air quality that will inevitably degrade their credit rating and capacity to borrow money to finance essential city services.”

Changing out dark, impervious surfaces such as a roads or roofs for highly reflective, porous or green surfaces is far more expensive before the end of life of a pre-existing surface, e.g. 10 years into a roof with a 25-year life span.

In contrast, changing from dark, impervious surfaces at the end of life of outdated surfaces, e.g. as a replacement, is very cost effective. Cities that delay adopting smart surfaces are locking themselves into long-term unnecessary risks and costs.

Cities that fail to act promptly to protect their populations from climate change are, in effect, making the decision to expose their citizens to worsening air quality, higher temperatures, greater risk of flooding and another adverse conditions.

And this in turn would impose a growing risk of credit rating reductions and legal liabilities for cities due to increasing risks to health, property and other costs that could have been mitigated or avoided through cost-effective, available smart surface and other resilience strategies.

Cities that fail to shift promptly from “stupid” surfaces to smart surfaces do so at their own peril. &

Here’s How Cities Can Reduce Climate Change Risk

Climate change is increasing the frequency and severity of extreme and costly weather events, but cities have an opportunity to mitigate the risks.

The Connection Between Climate Change and Credit Risk: A Deeper Look at the Cost of Severe Weather Events

A deeper dive into the impact increased severe weather events have on a city’s credit risk, looking at heat waves and flooding as prime examples.

How Smart Surface Strategies Are Increasing Resiliency for Cities Faced With Climate Change Risk

A smart surface strategy can increase climate change resiliency and decrease credit risk and its costs.