Drought is quietly pushing American cities toward a fiscal cliff

The city of Clyde sits about two hours west of Fort Worth on the plains of north Texas. It gets its water from a lake by the same name a few miles away. Starting in 2022, scorching weather caused its levels to drop further and further. Within a year, officials had declared a water conservation emergency and, on August 1 of last year, they raised the warning level again. That meant residents rationing their spigot use even more tightly, especially lawn irrigation. The restrictions weren’t, however, the worst news that day: The city also missed two debt payments.

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Municipal bond defaults of any kind are extraordinarily rare, let alone those linked to a changing climate. But, with about 4,000 residents and an annual budget of under $10 million, Clyde has never had room to absorb surprises. So when poor financial planning collided with the prolonged dry spell, the city found itself stretched beyond its limits.

The drought meant that Clyde sold millions of gallons less water, even as it imported more of it from neighboring Abilene, at about $1,200 per day. Worse, as the ground dried, it cracked, destroying a sewer main and bursting another, quarter-million dollar, hole in the town budget. Within days of Clyde missing its payments, rating agency Standard & Poor’s slashed the city’s bond ratings, which limited its ability to borrow more money. Within weeks, officials had hiked taxes and water rates to help staunch the financial bleeding.

“There’s more to a drought than just the cost of water,” said Rodger Brown, who was mayor at the time and is now interim city manager. “It tanks your credibility.”

Drought, of course, isn’t the only climate-driven disaster hitting places like Clyde. Hurricanes, floods and fires are bankrupting cities across America. After flames ripped through Paradise, California in 2018, the town’s redevelopment agency defaulted on some of its obligations. Naples, Florida resorted to selling $11 million in bond to rebuild its pier after Hurricane Ian in 2022. Earlier this year, the Los Angeles Department of Water and Power had a harder time raising money after massive fires swept the city. Kerr County, Texas is in the midst of raising taxes after devastating floods in July.

Each episode underscores how climate shocks once seen as exceptional are now straining local budgets. But drought may be the most insidious of these threats. Compared to other types of disasters, it often hits everyone in a community, affects large areas, and can last months, if not years. There are also fewer defenses and relatively limited government assistance. Experts worry that drought could ultimately prove an enormous risk to the $4 trillion municipal bond market that underwrites everything from roads and schools to the water running through millions of taps.

“I personally think this is a dark horse in the conversation right now,” said Evan Kodra, the head of climate research for the financial data company Intercontinental Exchange, or ICE. “It should be a bigger deal.”

This year alone has seen droughts in at least 43 states, from Vermont to California, affecting 125 million people. And ICE projects that more of the currently outstanding municipal debt will be located in areas prone to drought by 2040 than hurricanes, floods and wildfires combined. The financial effects of prolonged water woes can mount in ways not seen in one-off events, said Jeremy Porter, the chief economist at First Street Foundation, a nonprofit climate research firm.

“Drought is one of those things, if there is an impact, there’s a step-function impact,” he said. “You just don’t have the capacity to cover the risk.”

Also unlike with its headline-grabbing cousins, drought has a much weaker federal safety net when something does go wrong. The Department of Agriculture offers some aid to farmers, but there’s little funding for individuals or municipalities. The Federal Emergency Management Agency, or FEMA, hasn’t issued a drought-related emergency or disaster declaration in the United States since 1993, despite states requesting aid. “There is no adapting to drought,” said Porter. “The federal government is probably not going to come in.”

As the planet warms, the dry conditions that sent Clyde into the financial abyss are only set to become more frequent and more intense. Intercontinental Exchange researchers found that even in a ‘best-case’ climate scenario, drought, heat stress and water stress will place billions of dollars of municipal bonds at risk by 2040. Under a worst-case situation, that number could reach hundreds of billions. While Clyde’s default was relatively tiny, municipal debt is the bedrock of everything from hedge funds to retirement accounts, making a string of such events potentially catastrophic for the economy.

But well before dramatic rolling defaults, the financial pressures of drought will likely alter daily life in many regions. That’s already the reality for one community in Arizona, where the rush for water has turned into a years-long financial and political standoff.

Rio Verde Foothills lies on the outskirts of Scottsdale. Residents there have been trucking water in from its larger neighbor ever since the unincorporated, “wildcat” development was founded in the early 2000s. The arrangement worked well until 2021, when a severe drought gripped the area and Scottsdale decided it could no longer spare the dwindling resource. Cut off residents of Rio Verde scrambled and eventually signed a $12 million contract with the state’s largest private water company, Epcor Utilities, to build a permanent supply line.

Three years later, though, the feud continues. Scottsdale agreed to keep providing water through the end of this year while Epcor Utilities built new infrastructure. But construction is months behind schedule and Scottsdale is sticking to its deadline — leaving the foothills once again facing a cutoff. (Epcor remains confident this won’t happen.)

Even when the new line is connected, Rio Verde Foothills residents could see their water bills double or triple. Hikes like that are going to be a far wider concern across the West than outright disconnection, says Sara Fletcher, an environmental engineer at Stanford University who works on water scarcity issues. “Water prices are going up, and up, and up,” she said. “They are going to go up much faster than inflation for the past decade.”

The irony of drought is that as people conserve water to combat it, there is less money for the utility, whose costs remain relatively fixed. That results in “drought surcharges”, or other fees, for customers. It’s a cycle that was on full display in Clyde.

By August, 2023, the wave of aridity that hit West Texas had stretched for months, and officials in Clyde declared a stage 2 water emergency, which targets a 20 percent decrease in demand. By the following year they raised it to stage 3, or a 30 percent decline — one step below mandatory rationing. The measures worked, but at a cost. “Water sales are one of the main things that a city, almost any city, has,” said Brown. “That’s big for a city’s revenue generation.”

According to Clyde’s financial statements, it sold 7 million gallons less in 2023 than the year prior. It also had to import water from nearby Abilene at a premium of around $3 per thousand gallons. While Brown didn’t know exactly how much Clyde bought, he said it wasn’t as much as in some previous droughts but still significant. The bigger blow came when the parched ground split, shifted, and ruptured a major sewer line. The roughly $250,000 repair bill turned the cracks in the town’s finances into crevasses

“You can’t have people out here without the services. So we had to fix it,” he said. These new liabilities and dwindling income came on top of millions of dollars in debt that Clyde had amassed over the years, despite having kept taxes or utility prices relatively flat. It created what Brown called a “perfect storm.”

On August 1, 2024, the city missed two bond payments — one for $354,325, another for $308,400 — and filed a claim on its bond insurance to cover them. By the end of the year Clyde had failed to meet a total of $1.4 million in liabilities. Standard & Poor’s slashed the ratings of the bonds with missed payments from A- to D, and the city’s creditworthiness to B, moves that will raise future borrowing costs for the city.

So far residents have absorbed the added costs, which has allowed the city to continue to operate. But the spiral from expensive, inaccessible, or nonexistent water could have been much worse. High bills can lead to compromises in daily life, whether that be letting parks wither or skipping showers. Over time, those inconveniences could make a town a less desirable place to live, which, in turn, might result in lower property values, a dwindling tax base, and, consequently, more financial troubles.

“If you don’t have water, if you don’t have a functioning city, there is a vicious cycle dynamic that could come into play,” said Kodra at Intercontinental Exchange. “Once your property tax base is decently lower than it was, then it’s harder to borrow money to dig out of that hole.”

“We haven’t hit the point yet where people can’t get access to water,” said Porter. But there are inklings of that future, especially in the West. In Arizona, for example, water supply requirements for new developments are already beginning to halt some new construction.. According to Fletcher, “the fraction of the population that will face unaffordable water in the future is likely to increase unless we do something major.”

First Street also provided Grist with county-level data showing how the risk of prolonged water scarcity will change over the next 30 years. Of the 10 counties with the largest jump over that timeframe, seven are in Texas and three are in Florida. By 2055, more than 20 counties across the West will have a one in five chance of being in severe drought for at least 11 months out of the year. Over 500 counties could see 6 or more months.According to Fletcher, “the fraction of the population that will face unaffordable water in the future is likely to increase unless we do something major.”

Solutions won’t be easy to come by, and certainly won’t be painless. One logical conclusion might be that municipalities that are at risk of climate-impacts — like Clyde with drought or Tampa Bay with hurricanes — should simply pay more for their debt. In most sectors risk and interest rates traditionally correspond but, according to multiple studies, that’s not the case with municipal bonds.

“Climate poses a systemic credit risk to the municipal industry, of which it has never experienced,” said Thomas Doe, founder of Municipal Market Analytics. “[But] the marketplace is not pricing climate risk into bonds.”

The conundrum arises from the fact that people primarily buy municipal bonds to receive tax-exempt dividends. Demand, therefore, isn’t particularly sensitive to the price of the bond, but rather the risk of default, which remains extremely low. Another major bulwark against climate-pricing has been the federal government, which pumps billions of disaster aid into communities across the country — money that would have otherwise come out of state or municipal budgets.

“Bonds initially dip in price on the news of the event. Then they end up recovering because the federal government essentially rebuilds,” explained Doe. That support is in jeopardy with President Donald Trump’s deep cuts to government spending and that could eventually trickle into the municipal market. In the absence of aid, Doe says, bonds could start being priced in accordance with the risk.

Not all climate-debt, however, is bad.

This fall Norfolk, Virginia is planning to break ground on a $2.6 billion flood protection system, featuring a nearly 9-mile long seawall. The city is responsible for roughly $1 billion of that cost and is expected to issue new debt to help cover it. But Doe says that this type of climate-adaptation debt is generally considered good and should be encouraged, explaining that, “if it’s proactive, credit ratings look favorably.”

While you can’t build a wall against drought, the same principle applies for the admittedly limited tools that are available. Cities could, for instance, spend money making their water system more efficient, or building grey water recycling projects. Green infrastructure can also help keep rain from running off. More drastic steps might involve relocating people, or repurposing especially dry land for other uses, such as clean energy.

Although Clyde isn’t yet at a point where it’s climate-proofing its infrastructure, Lake Clyde is spilling over this year. That has provided the city a respite during which it can financially heal. Brown says the city has repaid its bond insurer, is back on track with debt payments, and is slowly rebuilding its emergency funds. The hope is that higher prices making the city’s recovery possible will mean less pain the next time the water runs low.

“We haven’t dug completely out,” said Brown. “But we’re still digging.”

This article originally appeared in Grist at https://grist.org/cities/drought-is-quietly-pushing-american-cities-toward-a-fiscal-cliff/.

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