EXPOSURE Magazine Snapshots: Water Security – Managing the Next Financial Shock

This is a taster of an article published by RMS in the second edition of EXPOSURE magazine.  Click here and download your full copy now.

EXPOSURE magazine reported on how a pilot project to stress test banks’ exposure to drought could hold the key to future economic resilience, as recognition grows that environmental stress testing is a crucial instrument to ensure a sustainable financial system.

In May 2016, the Natural Capital Finance Alliance (NCFA), which is made up of the Global Canopy Programme (GCP) and the United Nations Environment Programme Finance Initiative, teamed up with Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH Emerging Markets Dialogue on Finance (EMDF) and several leading financial institutions to launch a project to pilot scenario modeling.

Funded by the German Federal Ministry for Economic Cooperation and Development (BMZ), RMS was appointed to develop a first of-its-kind drought model. The aim is to help financial institutions and wider economies become more resilient to extreme droughts, as Yannick Motz, head of the emerging markets dialogue on finance, GIZ, explains.

“GIZ has been working with financial institutions and regulators from G20 economies to integrate environmental indicators into lending and investment decisions, product development and risk management.”

But Why Drought?

Drought is a significant potential source of shock to the global financial system. There is a common misconception that sustained lack of water is primarily a problem for agriculture and food production, but in Europe alone, an estimated 40 percent of total water extraction is used for industry and energy production, such as cooling in power plants, and 15 percent for public water supply.

Motz adds “Particularly in the past few years, we have experienced a growing awareness in the financial sector for climate-related risks.  The lack of practicable methodologies and tools that adequately quantify, price and assess such risks, however, still impedes financial institutions in fully addressing and integrating them into their decision-making processes.

“Striving to contribute to filling this gap, GIZ and NCFA initiated this pilot project with the objective to develop an open-source tool that allows banks to assess the potential impact of drought events on the performance of their corporate loan portfolio.”

Defining the Problem

Stephen Moss, director, capital markets at RMS, and RMS scientist Dr. Navin Peiris explain how drought affects the global economy and how a drought stress-test will help build resilience for financial institutions:

Water Availability Links Every Industry:  Stephen Moss believes practically every industry in the world has some reliance on water availability in some shape or form.  “With environmental impacts become more frequent and severe, there is a growing awareness that water as a key future resource is starting to become more acute.” adds Moss.

“So, the questions are, do we understand how a lack of water could impact specific industries and how that could then flow down the line to all the industrial activities that rely on the availability of water? And then how does that impact on the broader economy?”

Interconnected World:  Dr. Navin Peiris acknowledges that the highly-interconnected world we live in means the impact of drought on one industry sector or one geographic region can have a material impact on adjacent industries or regions, whether those adjacent are impacted by that phenomenon or not. This interconnectivity is at the heart of why a hazard such as drought could become a major systemic threat for the global financial system.

“You could have an event or drought occurring in the U.S. and any reduction in production of goods and services could impact global supply chains and draw in other regions due to the fact the world is so interconnected.” comments Peiris.

Encouraging Water Conservation Behaviors:  The ability to model how drought is likely to impact banks’ loan default rates will enable financial institutions to accurately measure and control the risk. By adjusting their own risk management practices there should be a positive knock-on effect that ripples down if banks are motivated to encourage better water conservation behaviors amongst their corporate borrowers, explains Moss.

“Similar to how an insurance company incorporates the risk of having to payout on a large natural event, a bank should also be incorporating that into their overall risk assessment of a corporate when providing a loan – and including that incremental element in the pricing.” he says. “And just as insureds are motivated to defend themselves against flood or to put sprinklers in the factories in return for a lower premium, if you could provide financial incentives to borrowers through lower loan costs, businesses would then be encouraged to improve their resilience to water shortage.”

Read the full article in EXPOSURE to find out more about the new drought stress-test.

Stephen Moss: Modeling Drought Reveals Surprising Range of Impacts
Stephen Moss, director, capital markets at RMS, said droughts affect far more than agriculture and can affect financial portfolios and supply chains. Moss spoke with A.M. BestTV at the Exceedance 2017 conference.