Drought as a credit risk in the municipal bond market

Published

May 2023

The insight

Over the next forty years, ICE’s analysis projects the duration and severity of droughts across the United States will likely increase due to climate change. The effects could be far-reaching and profound: in 2015, drought conditions in California caused over $1.5 billion in agricultural losses and over $2.5 billion in total losses.1 Drought conditions may also directly impact human health—dust and wildfires can worsen air quality and put people with lung diseases and asthma at higher risk of irritation and infection, and newly stagnant water creates mosquito breeding grounds that have been linked to outbreaks of West Nile Virus.2 Widespread food shortages and rising prices that result from drought can affect populations well outside areas directly affected.3

Droughts have already had significant negative impacts on issuers of municipal debt across the country. For example, in April 2016, Moody’s downgraded the Wichita Falls, Texas Water and Sewer Revenue Bonds to A3 from A1 (an action that affected $95.5 million of outstanding debt at the time), assigning these issuances a negative outlook and citing in part “the region's harsh drought conditions that have resulted in limited water supply.”4 More recently in 2021, the same agency put out a Sector In-depth Report on water utilities and climate risk in California, highlighting on the first page that “climate trends resulting in below-average precipitation and above-average heat point to long-term challenges.”5

The tools that power this visualization

ICE’s climate-conditioned drought model is underpinned by historical (1979-2010) river gauge observations of daily temperatures and precipitation from the United States Geological Survey. These time series, which are first processed and projected into the future using a statistical climate conditioning approach, are then used to compute key drought-related quantities like potential evapotranspiration—the amount of water that would be lost to plants and evaporation under conditions of ample water availability—and the overall water balance. ICE then uses a peer-reviewed framework called the Standardized Precipitation Evapotranspiration Index (SPEI)1 to calculate future drought metrics under two different Intergovernmental Panel on Climate Change Representative Concentration Pathways (RCPs): RCP 8.5 Scenario, often referred to as the “business-as-usual” future emissions trajectory (shown in the animation above), and RCP 4.5, a more moderate emissions pathway.

The final outputs of the model are statistical projections of the percentage of months in drought over a 30-year period and the percentage of those months that can be classified as either mild, moderate, severe, or extreme droughts under the SPEI framework for any geographical area of interest within the coterminous United States. To take one example, Fresno County, California—the state’s largest agricultural county with annual agricultural production values around $8 billion6 —could be in extreme drought conditions for 20% of months within a 30-year period by 2050 under the RCP8.5 scenario. See the projections in Figure 1 below. By then, extreme drought conditions could also exist for upwards of 35% of the months in the agriculture-heavy Texas panhandle. Based on these projections, many municipalities and utilities across the United States will likely face financial challenges related to increasing drought severity and frequency in the upcoming decades.

ICE drought model projections for Fresno County, California. Source: ICE Sustainable Finance, as of 2/15/2023.

1 Kerlin, K. (August, 18, 2015). Drought costs California agriculture $1.84B and 10,100 jobs in 2015. UC Davis Report

2 Health Implications of Drought (January 16, 2020), Centers for Disease Control and Prevention

3 Health Implications of Drought (January 16, 2020)

4 Rating Action: Moody's downgrades Wichita Falls, TX Water & Sewer Revenue Bonds to A3 from A1; negative outlook assigned (6 April, 2015), Moody’s Investors Service

5 Sector In-depth Report, Moody’s Investors Service (6 July, 2021)

6 California Agricultural Statistics Review, 2020-2021, California Department of Food and Agriculture