California has begun another year with extremely high rainfall and widespread flooding. We view these rain events as a chronic physical risk and factor them into our rating analysis when it could materially affect an issuer's credit fundamentals. However, while the rain in 2024 has been unrelenting up to this point, so far we do not see it having an immediate effect on California local governments' credit quality. We will continue to monitor rainstorms and their related damage, as compounding events could pressure reserves and liquidity over time and affect long-term credit quality.

Natural disasters, including intense rainstorms that lead to flooding, mudslides, and property damage, can have a severe financial impact on municipalities, which may need to tap into emergency reserves or other available general fund liquidity to cover unexpected expenses, including for damage to facilities, streets, and infrastructure or for overtime costs for personnel that support cleanup and recovery efforts. While some costs may eventually be reimbursed by extraordinary aid from the state or the Federal Emergency Management Agency (FEMA), the initial outlay will likely come from available reserves. Furthermore, receipt of reimbursement can vary from a few months to 12 months or longer. These liquidity pressures immediately following an exogenous shock highlight the importance of maintaining sufficient reserves and liquidity in the short term to cover operations and debt service payments. An in-depth view of California issuers that we rate and their respective reserve positions is shown in Tables 1 and 2.

Flood Insurance Coverage Is Not Universal, Increasing The Importance Of Liquidity

California counties, cities, and school districts are not required to purchase flood insurance, although they may be covered under FEMA's National Flood Insurance Program (NFIP). Some municipalities, particularly those in flood-prone areas and designated flood zones, opt to purchase insurance, while many do not given the high and increasing premiums. We view insurance coverage as one form of financial buffer that can help offset costs associated with extreme weather. In the absence of insurance, we could consider higher reserves and liquidity as a good risk-management practice to fill the gap between initial expenditure outlays and FEMA reimbursements.

Despite The Continued Extreme Rainfall, California Counties Remain Financially Well Positioned To Absorb Near-Term Costs

In late January, a storm caused historical levels of flooding in California, primarily in Los Angeles County (AAA/Stable), San Diego County (AAA/Stable) and the city of San Diego (AA/Stable). Subsequent heavy rainstorms in the form of an atmospheric river hit the southern portion of the state beginning on Feb. 4. This system was similar to an event in 2023. A third storm system began affecting California on Feb. 20, and we are monitoring how flood damage and its compounding effects could affect municipalities that we rate in this region.

In early February 2024, California's governor declared a state of emergency in eight counties, primarily in southern California, in response to the severe rainfall, namely Los Angeles, Orange, Riverside, San Bernardino, San Diego, San Luis Obispo, Santa Barbara, and Ventura. S&P Global Ratings has ratings on all eight counties (Table 1) and on 122 cities within them, nearly all of which maintain very strong reserves and liquidity (Table 2). Generally, strong reserves and liquidity are sufficient to absorb the short-term financial effects of a disaster. However, when multiple events occur in close succession, as has happened recently, the financial stress may be more material to the issuer's credit profile.

Table 1

January 2023 Atmospheric River Update: Tulare County

California municipalities are quickly becoming accustomed to extreme weather events, the potential associated damage, and the subsequent financial costs. For example, Tulare County (AA-/Stable) experienced flooding and infrastructure damage following storms in January 2023, including to its roads and bridges, which required emergency repair. Based on the county's fiscal 2023 audited results, an unbudgeted increase of about $13.4 million, or 28% in general government spending, was related to these storm costs. The county identified approximately 225 locations that sustained damage, much of it street infrastructure. Given the magnitude of damage, the county applied for, and received, FEMA disaster relief funding, and the vast majority of affected sites were repaired over several months, with only a handful remaining to be fully repaired. Despite the unplanned event, the county's general fund reserves and liquidity levels increased in fiscal 2023 to $132 million, or approximately 15% of general fund expenditures. Total governmental cash and investments reached approximately $850.7 million, or 77% of total governmental fund expenditures, in fiscal 2023.

Flooding Events Are Unlikely To Abate And Could Require Additional Operational And Financial Preparedness

According to the World Meteorological Organization, there is now a 66% probability that the global temperature will exceed the 1.5-degree Celsius Paris Agreement threshold over the next five years. S&P Global Ratings believes that surpassing this threshold could result in more frequent and severe physical climate hazards, such as heatwaves, floods, storms, and wildfires. S&P Global Sustainable1's Climate Change Physical Risk dataset shows increased exposure to flooding for California's counties over the next 30 years (chart 1). The data provide insight into the change in probability that flooding from extreme rainfall could occur more frequently than a 100-year flooding event. The scenarios reflect Shared Socioeconomic Pathways from the Intergovernmental Panel on Climate Change and incorporate broad changes in socioeconomic systems that reflect a set of scenarios for projected greenhouse gas emissions and temperature changes. The chart presents findings for the 2020s and 2050s under SSP3-7.0, a moderate-high-emissions scenario that implies a global average temperature rise of 2.8 to 4.6 degrees Celsius by 2100 compared with the pre-industrial period. The data show that, over the 30-year period, the expected frequencies of severe rainfall events will increase for California counties, in some cases by 30% or more, indicating that flooding could become an increasingly difficult risk to manage, absent adaptation.

In our view, adaptation may include all or some of the following: bolstering finances to ensure continuity of operations following an acute event or disruption, evaluating stormwater infrastructure to address increasing flood waters, or installing flood gates or moveable walls to redirect water to protect exposed buildings and other municipal assets. We believe adaptation falls under risk-management efforts that could help stabilize credit quality for issuers that face climate hazards.

Table 2