Could a credit downgrade be worth it?

A cost-benefit analysis of debt financing for climate infrastructure

In recent years, extreme weather events and natural disasters have impacted cities across the United States: Hurricane Sandy caused billions of dollars in damage to New York and New Jersey in 2012;1 the Missouri River floods in 2019 drove billions in economic losses;2 and 2023 flooding in Vermont left much of the state capital underwater.3 Today, California’s wildfire risk is so high that some large insurers are no longer issuing homeowners policies in the state, and losses from wildfires in the greater Los Angeles region in early 2025 may exacerbate this trend.4,5 Other areas of the country are facing the more chronic climate-related stressors of increasing heat, water stress, and droughts.

These climate-related events can have long-term impacts on the affected communities. Hurricane Katrina, which caused over 1,000 deaths in New Orleans in 2005,6 also led to a mass migration of city residents. Other cities have experienced economic hardship: the city of Clyde, Texas, recently defaulted on its water and sewer system bonds and cited ongoing drought conditions in the area as one of the reasons for its financial difficulties.7 Five years after being ravaged by a wildfire in 2018, the town of Paradise, California, defaulted on previously issued refunding bonds in 2023.8

In the face of these chronic and acute risks, many towns and cities are updating their climate adaptation plans. Some are considering land-use and zoning changes, while others are weighing the costs and benefits of larger-scale infrastructure projects like raised highways, levees, sea walls, and oyster reefs. Because the upfront costs of climate adaptation infrastructure are high — a proposed sea wall for Charleston, South Carolina, has an estimated price tag of around $1.3 billion9 — many local governments are turning to the municipal bond market for financing options. This trend is likely to accelerate. According to a report by Municipal Market Analytics in March 2024, municipal bond issuance may grow by as much as $800 billion by the 2030s due to climate infrastructure needs alone.10

However, individual municipalities may hesitate to issue the large amounts of debt required to finance these projects because credit ratings agencies incorporate liabilities into their ratings assessments. S&P, for example, states in their methodology that debt and liabilities represent 20% of an issuer’s credit profile.11 Incorporating debt and liability considerations in credit rating methodologies makes sense: too much leverage can often be associated with default, as was the case with Puerto Rico and Detroit, Michigan.12

At the same time, ratings agencies have published reports explaining that climate change may represent an increasingly negative credit factor for issuers that do not have sufficient mitigation and adaptation strategies in place.13 From the issuer perspective, this presents a difficult trade-off: large amounts of debt may be necessary to build climate mitigation and adaptation infrastructure, but that same debt could lead to negative implications for their credit rating. Issuers are left weighing three different considerations: vague encouragement from credit agencies to invest in climate adaptation; specific information about the negative consequences of being over-leveraged; and the potential economic and life-saving benefits of climate adaptation infrastructure.

Below, we show that the fear of being over-leveraged may be short-sighted. When the full costs and benefits are considered, funding climate adaptation infrastructure may be worth it — even with a downgrade.

Case study: Virginia Beach

For the past several years, coastal Virginia has experienced the highest rate of relative sea-level rise on the entire U.S. Atlantic Coast.14 In 2021, in response to growing concern about recurrent flooding, voters in the coastal city of Virginia Beach approved a $567.5 million flood mitigation municipal bond. The bond prioritized 21 flood mitigation projects, including drainage improvement projects such as culverts, road elevations, and pumps, as well as natural infrastructure projects like marsh restoration.15

In the lead up to the vote, Old Dominion University published a report analyzing the potential impacts of the flood mitigation projects. The report found that, with no intervention, the value of losses from floods from 2021 to 2069 would be projected to amount to $4.6 billion (in 2021 dollars). This number does not include the estimated net present value of declines in economic output due to flooding, projected to be an additional $6.5 billion loss over the same time frame (in 2021 dollars).16

The report also examined the potential benefits of the projects, estimating that their construction could raise economic output by over $371 million and create ~3,300 jobs in the next decade.17 The costs to residents are relatively modest in comparison: to pay for the bonds, the city is increasing its real estate tax by 4.3 cents per $100 of assessed house value, an increase of ~$115 per year for the median homeowner.18

Table 1. Breakdown of approximate debt service costs for an issuer with a AAA-rating and an issuer with a BB-rating for a hypothetical $567.5 million issuance with a 30-year maturity. Source: ICE Pricing & Reference Data as of 1/6/25.

Table 2. Breakdown of approximate debt service costs for an issuer with a AAA-rating and an issuer with a BB-rating for a hypothetical $5.245 billion issuance with a 30-year maturity assuming the average yields included in the table. The aggregate principal amount was estimated by taking the projected debt financing costs for the next five years ($874.2 million) in the city’s 2024-2025 Capital Improvement Plan and assuming the same rate of annual debt-financed investments over a 30-year period. Source: ICE Pricing & Reference Data as of 1/6/25.

Borrowing hundreds of millions of dollars to build climate adaptation infrastructure could save the municipality and its residents hundreds of millions of dollars in the long run, even if the city were to lose its AAA credit rating as a result.

Cost-benefit analyses should include debt affordability

Other cities across the United States are currently weighing the costs and benefits of climate adaptation infrastructure. The city of Charleston is working to build tunnels, pump stations, and raise its current sea wall to protect itself against increasing flood risks.34 New York City is already funding climate adaptation projects across several boroughs to protect itself from coastal flood risks, many of which were initiated in response to the substantial damage caused by Hurricane Sandy in 2012.35 A neighboring coastal community to Virginia Beach, the city of Norfolk, is commissioning the Norfolk Coastal Storm Risk Management Project, funding a floodwall, storm-surge barriers, and other climate adaptation projects, with projected annual net benefits of $122 million once completed.36

Figure 3. Obligor boundaries with areas less than 10,000 square miles and ICE Flood Scores greater than 3.5. Source: ICE Climate as of 9/5/24.

Virginia Beach illustrates the importance of viewing the costs and benefits of climate adaptation projects through as broad of a lens as possible — explicitly considering the potential effects of a downgrade as well as the projected costs of inaction. The risks of being over-leveraged should be evaluated quantitatively against projected costs associated with physical climate risks. In some cases, the protection provided by climate adaptation infrastructure may be worth the risk of a downgrade. Going forward, credit rating agencies may need to clarify how they weigh the protective effects of climate adaptation infrastructure against the credit risk of debt liabilities.

Importantly, these high-profile examples of climate adaptation projects and proposals tend to be in densely populated and well-funded municipalities (Virginia Beach had a median household income of over $87,000 in 2022, well above the nationwide average).37 Low-income and rural areas may often face an entirely different set of challenges, including a lack of financial resources to conduct cost-benefit analyses and solicit proposals, high per capita costs for infrastructure, larger land areas, and prohibitively high borrowing costs. Protecting communities in these areas will likely require federal and state involvement through bond banks, credit enhancement programs, direct loans, or grants.

While a downgrade may be worth it for some cities, many of these rural areas lack a credit rating entirely. Given the increase in frequency and severity of climate events, our analysis demonstrates that when the full costs and benefits are taken into account, investing in climate adaptation infrastructure can often be crucial for protecting vulnerable communities – even with the possibility of a downgrade.