Water Utilities, Climate Change, Bond Ratings and Insurance: Connections and Implications

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By Erica Brown

The managers of two large utilities recently remarked to me that in recent discussions with bond rating agencies, the questions that arose about climate change dove much deeper than in recent memory. In both cases, rating agencies wanted to know specifically about what climate related risks the utilities were considering in their planning as well as what they were doing to manage those risks. The Association of Metropolitan Water Agencies (AMWA) has been tracking and reporting to its members about the interest of insurance companies and bond rating agencies in climate change and extreme events and has indeed observed that this interest has been steadily growing for the past several years.

AMWA recently released a whitepaper describing how changing perceptions of climate risk in the insurance, bond rating agencies and bond investor space pertain to water utilities. This article briefly describes this landscape and also discusses how the importance of these issues for bond rating agencies and the insurance industry is rapidly evolving. More detail is available in the paper, which is available online at amwa.net/primer.

The acknowledgement of climate change in ratings criteria and discussions of creditworthiness by bond rating agencies has increased as the number of utilities and other municipalities offering green bonds has increased and, in the market overall, as products like climate bonds and resilience bonds have gained traction. In the insurance marketplace, the ripple effects of climate impacts on tightening property insurance markets and liability policies, as well as how utilities are connected to insurance companies as investments, are important to understand. The growing interest in climate change by the financial sector is of consequence to water utilities and enterprise risk management.

Bond Rating Agencies’ Interest in Climate Risk

For the bond rating agencies – S&P Global Ratings (S&P), Moody’s Investor Services (Moody’s) and Fitch Ratings – climate change is an acknowledged risk for cities and municipalities. Climate risk is generally assessed as part of a review of the utility’s operational risk management and financial management.

For example, S&P’s 2016 ratings criteria for U.S. municipal waterworks, sanitary and drainage utility systems consider specific climate risk assessment strategies, such as supply planning and flood protection, in its assessment of asset adequacy and identification of operational risks. S&P also considers the impacts of climate change in its financial risk management assessment, which is part of its credit quality evaluations. Similarly, a Moody’s 2018 report to subscribers, Environmental risk: Evaluating the impact of climate change on U.S. state and local issuers, states that its analysts weigh the impacts of climate risks against the mitigation, preparedness and planning of municipalities. Reflecting its growing interest in climate change, Moody’s acquired a majority stake in climate data and analytics company Four Twenty Seven, Inc. in July 2019.

Similarly, all three rating agencies have acknowledged that consideration of triple bottom line management principles – i.e., environmental, social and governance (ESG) factors – have increased in prominence in discussions of global credit markets and individual credit rating decisions. The nexus between environmental stewardship and preparing for climate change and extreme events, such as hurricanes and drought, is a natural one.

Why the Insurance Industry Perspective Matters for Water Utilities

Climate change connects insurance companies and water utilities in two ways. First, insurers issue utility policies that can address or be impacted by climate change. Secondly, as a group, insurance companies purchase a large percentage of U.S. municipal bonds as capital for claim payouts. Many utilities, of course, issue municipal bonds to finance capital projects. Therefore, as the insurance industry’s approach to climate change evolves, the water utility community should be prepared to adapt.

More than 10 years ago, the insurance industry was not thinking too much about climate change impacts to its business. But that changed dramatically in 2011 when major flooding in Thailand affected global commerce in ways not previously anticipated by the global financial markets, including the insurance industry. Thailand was a critical supplier for the auto and electronics manufacturing industries and the floods severely impacted the global supply chain of these industries. Insurance companies, in assessing their multi-billion-dollar losses due to these global supply chain disruptions recognized that climate change is a risk that needs to be assessed in their underwriting as well as considered in their own solvency investments.

There are three reasons water utilities should be aware of the changing perspectives of insurance carriers and underwriters regarding climate change. First, climate change will affect utility insurance premiums and the types of insurance available. As climate-related disasters increase, the insurance industry will be forced to better manage its exposure and consequently guard against the risk in the form of increased premiums. As a result, there will likely be tighter property underwriting in coastal, convective storm, wildfire and drought-prone regions due to these changes in the market.

Second, utilities may also experience substantial exposure to litigation arising from the alleged failure of public entities to give climate change sufficient resources. This was the rationale for a lawsuit that Farmers Insurance initiated in 2014 against the Metropolitan Water Reclamation District of Greater Chicago, the City of Chicago and its suburbs, although the lawsuit was subsequently dropped.

Third, as the insurance industry is one of the largest institutional buyers of U.S. municipal bonds, insurance companies are beginning to ask whether climate change will degrade the value or increase the default risk of certain bonds, and they may soon seek more clarification directly from the agencies whose bonds they hold. Regulators and rating agencies for insurance carriers are asking similar questions.

Considerations for Anticipating and Managing Future Risks

As a result of the rising interest in climate change by bond rating agencies, insurance companies and, by extension, investors, water utilities may be required to provide more information to these entities about how they are preparing for climate change and to disclose more information related to ESG considerations to provide more assurance of the reliability of the bonds they issue.

Utilities should not only understand how climate change and extreme events might impact their facilities, operations and finances but also consider other business risks across its operations. Risk management will for many be a combination of structural, financial and planning tools and strategies. Utilities may also consider insurance or other financial instruments as part of a risk management solution. Compared to a built infrastructure solution, financial instruments, such as insurance policies and policy add-ons, can be easily modified to adapt to changing circumstances, as these contracts are updated and renewed at much shorter intervals than structural solutions.

Utility resilience reflects the ability to maintain a successful operation in the short run by making preparations to respond to unexpected or extreme events, and, over a longer time horizon, by adapting to change. Utilities can do many things now to prepare themselves, such as developing a risk assessment that includes consideration of financial impacts to understand their risk tolerance and appetite. Utility managers should consider inviting to a risk assessment conversation a diverse staff outside of those traditional considered the risk management staff, including financial staff, planning staff, resilience staff and other outside experts and advisors. Using a risk identification and risk assessment process, utilities can assess how risks should be managed to help the organization meet its core objectives.

Diversification of risk, such as looking for opportunities for operational flexibility, including redundancy in structural assets or increasing the number of vendors to mitigate potential supply chain disruptions, is always advisable.

While utility managers cannot affect the weather or the climate, they can affect their own resilient posture by mitigating and adapting to climate risks and telling their story to rating agencies who are already asking the climate question and to investors who are increasingly interested in knowing how public and private utilities are responding.

Erica Brown is chief strategy and sustainability officer for the Association of Metropolitan Water Agencies (AMWA) in Washington, D.C., the organization representing the largest publicly-owned drinking water systems in the United States. Brown develops strategies to support and promote policies and innovations that enable these drinking water agencies to enhance their resilience.

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