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Water risks and financial market

Overview and analysis
Water risks and financial market

This study explores the importance of water risks for the overall economy and the financial system and reviews the availability of data, models, tools and studies to assess the impacts of water risks on the real economy and the financial market (both institutional and systemic level is explored). In addition to the risk perspective, this study also explores, if there are alignment strategies, thus investment strategies aiming at contributing to international water goals or scientific findings on adequate use of water (quantity and quality).  

Water risks are not only felt in the real economy but also lead to implications in the financial system due to decreased revenues and increased costs within invested companies, and interdependency of affected financial institutions. We can distinguish between physical, regulatory and reputational water risks. These can have ripple down effects to individual securities and portfolios across all asset classes. However, the challenge is to understand materiality and timing of water impacts on specific asset classes, sectors and industries. In comparison with climate change, water conditions can strongly vary over time and location.

Climate change is strongly intertwined with water risk management and so are hydrological water cycles and biodiversity, which asks for a more holistic approach of managing water risks from a public-sector perspective. According to the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD), companies and investors alike should consider water-scenario analyses in their long-term strategy, growth and cost considerations. However, holistic scenarios and related water-risk associated mitigation paths are currently inexistent. Several multilateral environmental agreements have water at their core and water is highly ranked within the 2030 Agenda for Sustainable Development with a dedicated Sustainable Development Goal 6 ("Ensure availability and sustainable management of water and sanitation for all"). Therefore, water is connected across sectors, other natural resources and international agreements.

Figure: Direct and indirect effects of water risks and available tools (Source: South Pole)

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The study gives an overview and qualitatively evaluates 13 different databases, scenarios, models and tools to display water risks in the real economy and financial products, portfolios, financial institutions, and even the financial system. The amount as well as the variety of data and tools on water risks for actors both in the real economy as well as in the financial market is ever-growing. Since investors have only recently started to assess water risks, more water risk assessment tools have been established for the real economy rather than for the financial market.

Notwithstanding the growing number of available tools and their continuous development, the assessed tools show several shortcomings from a public policy perspective. They, for example, mainly cover physical risks, notably baseline water stress, while the equally important reputational and regulatory risks are neglected. Additionally, the quantified higher operating costs through shadow prices are mostly material over the long term, while both real economy and financial sectors are more interested in short term effects like a company losing access to key markets or locations either due to flooding, water scarcity or opposition from local communities. Therefore, the current tools and data are not necessarily suited to engage the private sector for alignment with public water policy goals.

We have not found any existing investment strategies that align investments with internationally agreed water-related goals or scientific findings on adequate use of water. In practice, several investment strategies or vehicles dealing with water risks have been developed but the focus is almost exclusively on water risk management and opportunity exploration from a pure business perspective and the strategies do not pursue alignment. Therefore, no clear alignment strategies to global policy goals or a scientifically proven consensus could be identified. It seems that this lack of alignment is not just related to preferences within the financial industry but also the general lack of well-known and internationally recognised policy goals or science-based targets on water. The closest to a benchmark for alignment are general recommendations within financial industry associations on how to deal with water risks. A potential future alignment approach could be to extend the basin-level concept of Water Stewardship from corporates to investors.

To download the full study,  please click here.

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