Widespread destruction has reinforced the value of climate assessment in credit analysis.

As the world experiences rising temperatures and shifting weather patterns, California has felt a substantial burden from climate change. The state’s vegetation-rich forests have become drier from years of higher temperatures and shorter winters that have lengthened wildfire seasons; strong winds and forest overgrowth have contributed to an environment in which fires can spread rapidly.

These conditions have resulted in more frequent and destructive fires across the state. In fact, 15 of the 20 most damaging wildfires in California history have come since 2015.1 If the longer-term climate picture does not improve, we believe the problem will become more severe, leading to credit issues across sectors within the corporate and municipal fixed income markets.

Challenges for Utilities

All of this has made it more difficult for investor-owned utilities to manage credit risk. Wildfires are frequently started when utility power lines come into contact with vegetation. Uniquely, California’s law of “inverse condemnation” holds utilities responsible for property damage regardless of negligence. The combination of climate change and liability creates a theoretically unlimited expense risk for utilities.

To address this issue, in 2019 the state passed a law establishing an insurance fund and liability caps for utilities. This offers a near-term benefit, but the insurance fund does not have a replenishment mechanism and without further liquidity infusions will eventually run out. Of course, it does not solve for climate change either.

To reduce the tail risk associated with wildfires, utilities are investing heavily in mitigation. Plans include “hardening” electrical systems through new poles and covered wires, removing high-risk trees near power lines, and setting up weather stations with HD cameras. An effective but controversial strategy is Public Safety Power Shutoffs (PSPS), where power lines are shut down completely. PSPS are not a long-term solution as customers become frustrated with frequent power outages, particularly given current dependence on reliable power. In addition, PSPS can have negative economic consequences, with power losses reducing productivity and potentially leading to population migration. We believe wildfire mitigation plans should reduce the need for PSPS over time, although it could take years to fully implement such measures. Among California utilities, one in particular is considered “best-in-class” on wildfire prevention strategy and technology, but started building its capabilities back in 2007. Others have begun far more recently, and may have larger and more challenging service territories to cover.

Municipal Cost/Revenue Implications

As a general proposition, wildfires and other extreme weather events can have significant impacts in the municipal fixed income sector as well. Lost property values associated with fires and flooding can affect general obligation and other property-based bonds, while revenues from water and sewer, electric utility, transportation and sales taxes may also fluctuate. For example, variations between wet and dry conditions may affect water usage, while the closure of airports and toll roads will reduce passengers and thus, revenues. For the most part, these impacts tend to be short-lived. Indeed, the influx of relief and stimulus after a natural disaster has often resulted in a material uptick in local economic activity, yielding not only new and better buildings and structures, but a jump in sales tax revenues driven by rebuilding. There are, however, exceptions, which we have seen in the wake of California’s wildfires.

Located in the Sierra Nevada foothills, the city of Paradise was devastated by the 2018 “Camp Fire,” which burned for 17 days across 153,000 acres in Butte County, killing 86 people, and cost $16.7 billion county-wide. In Paradise, the fire destroyed 95% of the town’s structures. Given the scope of the impact, recovery has been slow: Rebuilding did not start until five months after the fire and has slowed during the pandemic. After an initial 90% decline from its pre-fire population of 26,000, Paradise is now home to about 4,500 people.

The city is not a major issuer of bonds, but the potential for significant economic damage tied to natural disasters exists for many municipalities. In addition to the immediate impacts of the California wildfires and major storms, broader, more gradual trends tied to climate change, including rising sea levels, droughts and higher temperatures, could increasingly add to municipal cost structures. For example, droughts may make water generation and fire prevention more expensive, while the need to prepare for more severe storms may sap preparedness budgets and require more taxes to maintain credit quality.

Takeaways

The combination of legislative changes and improved wildfire safety practices has started to reduce investment risk in California, but mitigation plans, even when effectively implemented, cannot eliminate dangers altogether.

Our Municipal Fixed Income team has always taken into account disaster risk in its analysis, but given the urgency of climate change, the team has integrated a service called RisQ, which helps with the assessment of flooding and fire dangers by mapping the probability of events within specific geographies, and then estimates the value at risk and the portion of a given area that could be affected. The team employs this information not only for surveillance of existing holdings, but to further inform views on potential new purchases.

When researching investor-owned utilities, our Developed Market Fixed Income credit research teams not only evaluate sector fundamentals, but the size and scope of the utility’s operational territory, while monitoring wildfire safety progress. In addition, California’s regulatory and political environment will likely prove crucial to the state’s ability to safely manage through wildfire seasons to come. In our view, some investor-owned utility debt issuances may be unappealing at this point, given that they subordinate bondholder interests to future wildfire claims while providing minimal upside for investors. However, that is ultimately a matter of risk/return potential, and as part of our analysis we assess capital structures in the context of wildfire claims recovery tied to potential restructurings.

Overall, while we see constructive movement on wildfires in California, we believe that climate change will likely make challenges worse. Taking this into account, while understanding the nuances tied to location and the organizations affected, will be crucial for those who wish to consider investing in issuers within the state over time.