Why does the financial sector need to think about water risks?

By Lylah Davies and Sophie Trémolet, OECD Environment Directorate

Developed and developing economies alike are exposed to water risk.

The numbers are staggering. 2.2 billion people, a quarter of the world’s population, do not have access to safely managed water supply and 1.7 billion people’s water is polluted with faecal matter. 

At least half the global population (4 billion people) already live with water shortages for at least one month of the year. A study in the United States found that nearly half of its 204 freshwater basins may not be able to meet the monthly water demand by 2071.

At the same time, more than 1 in 8 people (1.2 billion globally) are affected by flooding. As the impacts of climate change increase, we are seeing more severe cases of flooding, such as in Central Europe in 2021 that is estimated to have caused economic losses amounting to USD 54 billion.

Water pollution is also a critical challenge, which in turn reduces the availability of clean water. Globally, water is being contaminated by agricultural run-off and emerging contaminants including pharmaceuticals, hormones, industrial chemicals, detergents, cyanotoxins and nanomaterials. In a study of 258 of the world’s rivers, over a quarter of these were found to have concentrations of active pharmaceutical ingredients that exceeded safe limits.

Our economies are contributing to increasing water risk

Climate change is one driver of water risk, but so too are the overexploitation of resources, land-use changes, pollution and invasive species. Urbanisation and economic activities create competition for existing resources, and if uncontrolled, lead to increased pollution and depletion of freshwater sources.

Water has often been treated as an infinite resource, even in locations where it is scarce. A striking example is Spain, one of Europe’s largest agri-food exporters. The province of Almeria in the South is one of the driest regions in continental Europe; it is also referred to as the Orchard of Europe due to its abundant fruit and vegetable production that powers the local economy. The groundwater reserves that this sector relies on are depleted and overexploited and are under additional pressures from climate change impacts. Spain is just one example where climate change is accelerating the need for improved water management and strategic planning of future investments to account for increasingly uncertain water availability.

Globally, many water challenges are linked to our fragmented approach to water management, which leads to uncontrolled consumption and pollution of water, and decision making based on short-term and localised benefits that do not ensure long-term water security. Efforts are underway to improve management of water resources and adapt to climate change. For example, in the European Union, the Water Framework Directive and associated directives require that Member States work towards ensuring good status for Europe’s water bodies, including through the development of river basin management plans and implementation of programme of measures contained in such plans. But progress is slow and hampered by many factors including the political economy of reforms.

These water risks are destabilising our economies

Households, corporates, governments and financial institutions are all exposed to water risks. The costs are high. In developing economies, lack of basic water and sanitation is estimated to cause economic losses of USD 260 billion every year.

Critically, the lion’s share of our agriculture is exposed to water risks. Rainfed farming makes up 80% of the world’s cropland. The remaining 20% is dependent on irrigation notably from groundwater, which must also meet other growing needs, such as urban water supply. Increasing water risk can have critical impacts on the price and availability of food, the productivity of regions which rely on these agricultural activities, and the livelihoods of farmers.

When risks materialise, they can often be uninsured, which means that society bears the costs. For instance, flooding in 2021 led to USD 82 billion in economic losses globally, of which only USD 20 billion were insured.

Increased corporate disclosure is helping to shed light on the scale of businesses’ exposure to water risk – and it is in the billions. In 2022, companies reporting to CDP (formerly the Carbon Disclosure Project) disclosed USD 13.5 billion in stranded assets and a further USD 2 billion at risk of being stranded due to water stress. The most exposed activities are linked to extraction of metal and mineral reserves, electricity production and the oil and gas sectors. Reporting in 2023 points to a further USD 77 billion at risk in supply chains.

The financial sector needs to understand impacts and dependencies on water

The financial sector can play an important role in directing investment towards activities that exacerbate water risks or towards those that support resilience. Increasing data and information on the impacts and dependencies of investments on water and freshwater ecosystems is essential for enabling (and encouraging) investors to make decisions that support water security.

Understanding how economic activities depend and impact on water can also help the financial sector manage its exposure to water-related risks. These risks can have various economic impacts on households, corporates, financial institutions and governments, such as through capital destruction or disruption of activities and value chains. These impacts can then be transmitted to the financial system in the form of credit, market, liquidity, business and underwriting risks (Figure 1).  For example, banks can be exposed to credit risk if drought-vulnerable sectors make up a large share of their portfolio. A recent stress test in Morocco highlighted that over a third of bank loan portfolios could be exposed to climate physical risks and notably drought, largely linked to lending to the agricultural, food processing and tourism sectors, and to households in vulnerable areas. For insurers, flooding events can generate liabilities that significantly exceed earned premiums. This can lead to underwriting risks, particularly in cases where the scale and frequency is unexpected, such as for the July 2021 flooding in Central Europe.

Figure 1 – How water risks transmit to the economy and to the financial system

Source: Adapted from Davies & Martini (2023) Watered down? Investigating the financial materiality of water-related risks in the financial system

At large scale, water-related risks can lead to dramatic shifts in the way a country, industry or market operates. Such structural macro-economic changes can have implications for the financial system (Figure 1). A good illustration of this is the Netherlands Central Bank (DNB) stress test of a major flood event which found significant capital impacts for Dutch banks if densely-populated western regions of the Netherlands were hit by extremely severe flooding, highlighting a potential risk for financial stability, a priority area for central banks. 

Collaboration between environmental and financial stakeholders is essential

Banks, asset owners, asset managers and central banks are gradually becoming more aware of the importance of water-related risk, but for many of these financial actors, the starting point is low. A recent OECD Environment Working Paper explored the financial sector’s understanding of the concept of financial materiality as a lever for decision making. A review of current practices shows that water risks are not fully captured by current approaches to assessing financial risks. For instance,  a review of Eurozone banks in 2021 found that only two-fifths had performed a mapping of climate and environment risk exposures, including water-related risks.

We need better tools, data and critically more proactive engagement to identify and manage how investments impact and depend on water and freshwater ecosystems.  Initiatives such as the Network for Greening the Financial System (NGFS), a network of central bank and financial supervisors, and the Taskforce on Nature-related Financial Disclosures play an important role in creating frameworks for considering climate and nature risks across the financial sector. Only by working together will the environmental community, central banks, financial regulators, and financial institutions develop robust frameworks to adequately assess and manage water-related risks.

On 14 May, the OECD Environment Directorate will hold a Green Talks Live webinar to discuss the evolving landscape for assessing water risk to the financial system. This webinar is based on the OECD Environment Directorate’s work on assessing the financial materiality of water-related risks, including the recently published paper “Watered down? Investigating the financial materiality of water-related risks”.

OECD Policy Analyst and author Lylah Davies will present key findings and recommendations from the report and will be joined by experts to discuss relevant initiatives underway. The webinar will be moderated by Mathilde Mesnard, Deputy Director of the OECD Environment Directorate.

Further reading

• Watered down? Investigating the financial materiality of water-related risks in the financial system
• OECD work on water
• OECD Forum on Green Finance and Investment (2023): Assessing water-related risks and impacts | Session replay