On January 10th 2024, I participated in a Senate Budget Committee Hearing focused on whether climate change poses a major threat to the $4 trillion dollar U.S Municipal Bond Market. I would like to share some links and some additional thoughts.
Here is a link to the Hearing and here is my written testimony.
Below I report my spoken 5 minute testimony. Academics might be interested in the following papers that form the basis for my remarks;
Jerch, Rhiannon, Matthew E. Kahn, and Gary C. Lin. "Local public finance dynamics and hurricane shocks." Journal of Urban Economics 134 (2023): 103516.
Jerch, Rhiannon, Matthew E. Kahn, and Shanjun Li. "The efficiency of local government: The role of privatization and public sector unions." Journal of Public Economics 154 (2017): 95-121.
Boustan, Leah Platt, Matthew E. Kahn, Paul W. Rhode, and Maria Lucia Yanguas. "The effect of natural disasters on economic activity in US counties: A century of data." Journal of Urban Economics 118 (2020): 103257.
Gyourko, Joseph, and Joseph Tracy. "The structure of local public finance and the quality of life." Journal of political economy 99, no. 4 (1991): 774-806.
Gyourko, Joseph, Matthew Kahn, and Joseph Tracy. "Quality of life and environmental comparisons." Handbook of regional and urban economics 3 (1999): 1413-1454.
Kahn, Matthew E. Climatopolis: how our cities will thrive in the hotter future. Basic Books (AZ), 2013.
“Land owners in coastal areas have strong incentives to protect their assets. I do want them to use their own $ to pay for such protection. Safe cities should not be cross-subsidizing the protection of at risk cities. As I ask in my 2010 Climatopolis, if Milton Friedman ran FEMA how would he operate this agency? “
Kahn, Matthew E. Adapting to climate change. Yale University Press, 2021.
Here is my Spoken Testimony (5 minutes to cover a fair bit of ground!)
Safeguarding Municipal Bonds from Climate Risks
Matthew E. Kahn
Testimony before the Senate Budget Committee
U.S Senate
January 10th 2024
Thank you, Ranking Member Grassley and members of the committee for inviting me to testify. I’m relentlessly optimistic about the ways cities can adapt to climate challenges.
Climate change is not a catastrophic threat to the municipal bond market.
Bond buyers have an incentive to do their “due diligence”. If a municipality faces rising climate impacts that imperil its ability to repay debt, bond buyers will recognize this and they will offer lower prices for bonds. Places that fail to adapt to new risks will pay higher interest rates and higher insurance rates.
To see why climate risk does not imperil the financial system via municipal bond defaults, let’s play out a hypothetical Doomsday Scenario. What does it take for a “climate event” to cause a financial crisis?
The year is 2034. Over the last decade, the climate has gotten worse, storms are more frequent. The city of Chicago issues new bonds each year. Chicago has huge public pension obligations. The city’s bonds are rated as barely investment grade quality.
Suppose a hedge fund buys these Chicago bonds, using money borrowed short term from several banks.
An unprecedented storm hits Chicago; Infrastructure is flooded and damaged. The City appeals to the Federal government for disaster relief but none arrives. Tax revenue plummets; A local economic depression ensues. The City defaults on all of its bonds.
The hedge fund who owns the bonds goes under. Banks who lent Chicago bond buyers money now own worthless collateral and they fail. Still, only a few banks have failed. Depositors at other banks, worried about hidden risks, run. The federal government does not bail out the banks or depositors. Finally, we have a crisis.
Elementary economics shows that this scenario is implausible.
Why?
First, local property owners seek to enhance the value of their assets. They have an incentive to lobby local leaders to invest in resilience to reduce default risk. Property owners recognize that a municipal default leads to lower local quality of life and higher property taxes.
Second, over the last 40 years, hurricane strikes have had a minor impact on municipal bond prices and their impact on default rates has been tiny. While federal disaster relief helps cities to recover from shocks and this reduces bond default risk, it is arguable that the federal government has been too generous with respect to state and local aid and this creates perverse incentives for local investment in resilience.
Third, portfolio theory warns against “putting all your eggs in one basket”. Municipal bond investors tend to be high net-worth individuals and pension plans. They do not hold concentrated investments in any one city’s bonds. A city’s default will not cause these investors to fail. They invest in spatially diversified asset portfolios.
Fourth, climate science progress offers ever improving real-time geocoded predictions. These models inform predictions concerning which cities face severe medium term climate risks. Cities predicted to face rising risk will experience rising insurance costs and they will pay higher interest rates on their long term debt than their short term debt. The expectation of facing higher insurance prices and higher interest rates provides an incentive for municipalities to invest in adaptation.
Fifth, as we grow richer, property owners are willing to pay more for products that enhance their safety such as anti-flood equipment, and stronger windows. Firms have a profit motive to design these climate resilient products. Competition in adaptation product markets leads to lower prices. As more of a city’s property owners make these investments, the overall local real estate capital stock becomes more resilient to disaster shocks.
Going forward, big city municipal bond risk will mainly be determined by public pension obligations and day to day quality of life concerns leading to suburban flight, not by a change in the frequency of bad weather events beyond that which cities and bond investors are already planning for.
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If I wanted to make the case for “doom and gloom” in municipal finance markets, I would embrace behavioral economics themes and argue that the municipal bond buyers and the credit rating agencies and the property owners and their elected municipal leaders do not know that they do not know the emerging risks posed by climate change. If they are SURE that there are no risks ahead then they will blissfully (and naively) not change their behavior in anticipation of this “known unknown”.
My 2015 piece explores this theme in detail.