Measuring climate risk
By David Scalzetti, CFA - Senior Regulatory Products Director, ICE Data Services
Welcome to my first non-liquidity blog in our data-driven risk management series. This one focuses on a new data set at ICE Data Services that I’m super excited about. And it feels like truly next generation stuff… using data to manage financial risk as a result of climate change.
First, a little background: ICE Data Services has recently collaborated with risQ to provide cutting edge climate risk data to the municipal bond ecosystem. For individual municipal bonds, this collaboration allows us to offer risQ calculated value-at-risk (VaR) forecasts for various time periods into the future for a number of climate-related hazards, including wildfire risk, coastal flooding risk, hurricane risk, etc. These VaR metrics are available to measure overall exposures but can be tailored for specific vulnerabilities of the municipality including GDP, job creation, retail sectors, property values, etc.
What is most interesting about this from a data-driven risk management perspective is that this data is not yet factored into how municipal bonds trade in the secondary market, thus ”A Tale of Two Munis”:
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair….” Charles Dickens, 1859
What better analogy than Dickens to illustrate the impact of climate risk on municipal bonds? Let’s take these two municipal bonds from Figure 1 below, seemingly similar, yet a ‘climate world’ apart…
Middletown Unified School District in California and Red Bluff Unified Elementary School in California. Both are school district muni bonds - a short 2+ hour drive apart (even in California traffic). From a bond perspective, they couldn’t be more similar: 5% coupons, same maturity date and expected call date, similar credits, and thus are priced on top of one another in the market. As of February 2020, both bonds were priced in the mid $120’s price with a yield that is a mere one basis point apart.
|Description||CUSIP||Coupon||Maturity||MDYS||S&P||Price To Date||Eval||Yield||Wildfire Property VaR (2027)|
|Security #1||MIddletown Unif Sch, CA||596877FK1||5||8/1/2048||AA||8/1/2027||120.675||2.155||10.76%|
|Security #2||Red Bluff Unified Elem Sch, CA||756377AE7||5||8/1/2048||AA-||8/1/2027||120.594||2.165||2.22%|
Figure 1: For illustrative purposes only
However, the untold part of the story is the difference in wildfire property VaR measured to 2027: The first security in Middletown is at a much higher risk of wildfires with a 10.76% VaR whereas the latter bond in Red Bluff only has a 2.22% VaR. Nearly five times the wildfire property damage risk, yet today, this is not factored into the bonds’ valuations in the market.
As new alternative data sets such as this become more readily available to the market, I expect that risks such as these will start to be factored into the market’s view of fair value. I have “Great Expectations” for these times:
“We changed again, and yet again, and it was now too late and far to go back, and I went on. And the mists had all solemnly risen now, and the world lay spread before me.” Dickens, 1861