On World Day to Combat Desertification and Drought, Raj Singh of the Natural Capital Finance Alliance looks at how the global finance sector is dependent on water, and what the new drought stress testing tool can reveal about the exposure of banks’ portfolios to the effects of drought.
As the planet heats up, rainfall is expected to decrease in many parts of the world. This is expected to have serious consequences for farmers, hydroelectric plants and other water users, with significant knock-on effects on companies and therefore banks’ loan portfolios.
The potential for losses is huge, according to a recent analysis of portfolios of major banks, carried out by the Natural Capital Finance Alliance (NCFA), in partnership with Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH, and global modelling experts RMS. By piloting the Drought Stress Testing Tool on bank portfolios in Brazil, China, Mexico and the US, it’s clear that while an array of corporate sectors are hit differently depending on the scenario that plays out, drought has the potential to pose a systemic financial risk to financial institutions.
For the most exposed portfolios, extreme droughts could increase loan default losses ten-fold. And even in less extreme drought scenarios, most companies in the analysed portfolios see their credit ratings downgraded.
The most affected sectors are water supply and agriculture. In countries like Brazil, which are reliant on hydroelectricity, drought can also have a huge impact on power generation. Other water-dependent sectors such as food and beverage production may also be hard hit. The report also found that sectors that are less water-dependent, but highly sensitive to general economic strength, such as petroleum refining, are also affected by the economic impacts of drought.
Drought and desertification are often caused by degradation of natural capital. For example, in the Amazon basin, trees generate much of the rainfall that feeds the agricultural bread basket of Southern Brazil and the La Plata Basin. Deforestation is expected to increase drought, which may in turn increase forest degradation.
The Drought Stress Testing Tool, available free to download, reveals that drought and desertification are not just ‘environmental’ problems, but issues with severe economic consequences for the world’s largest financial institutions. It is in banks’ primary financial interest to direct money towards investments that protect water resources, and preserve vital natural capital such as forests and wetlands.
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The Natural Capital Finance Alliance is a finance sector initiative jointly run by Global Canopy Programme (GCP) and the United Nations Environment Programme Finance Initiative (UNEP FI).
The Drought Testing Tool project was financed by the Federal Ministry for Economic Cooperation and Development (BMZ), and developed jointly by the Natural Capital Financial Alliance (NCFA) and the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH. A consortium led by global modelling experts RMS designed, developed and implemented the tool and the framework which underlies it.