Water scarcity is one of the major environmental challenges in the world today. As drought events increase both in regularity and severity, large numbers of people and companies are at risk. According to the World Bank, water shortages could lead to the economies of the Middle East, Central Asia and Africa, suffering significant reductions in GDP by the middle of the century. East Asia alone could lose up to 7% of GDP.
Improving how drought-related risks are measured is vital to making financial decision-making more prudent and economies more resilient. At the moment, the few banks that use environmental stress testing use different methodologies and analytical approaches. This in turn leads to inconsistencies in reporting. The existing gaps in the environmental risk management capacity of financial institutions are increasingly being addressed by international initiatives and forums such as the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD) and the G20 Green Finance Study Group (GFSG).
The Drought Stress Testing Tool helps to reduce this deficit by providing a consistent framework for scenario analysis in alignment with the anticipated guidance from the TCFD. It examines five drought scenarios in Brazil, China, Mexico and the US to show the impact of drought - geographically and over time - on companies' creditworthiness in 19 different industry sectors. UBS joined eight other financial institutions in piloting the stress tests on sample corporate lending portfolios. The key findings were:
- Extreme droughts could increase loan default losses 10-fold for portfolios most exposed to the effects of drought.
- Medium-severity droughts would lead to most companies in the analyzed portfolios seeing their credit ratings downgraded.
- Water supply, agriculture and power generation were the sectors most affected.
- Significant impacts are also found in water-dependent sectors such as food and beverage production.
- Sectors highly sensitive to general economic strength are also affected by widespread economic impacts of drought.
Liselotte Arni, Head Environmental and Social Risk at UBS, said: "While climate change is a global phenomenon, its impacts will vary across geographies. This project explored unchartered territory by modeling the impact of drought scenarios on lending portfolios. It has helped us better understand the data requirements in quantifying drought-related risk and the challenges that will need to be addressed to further develop climate-related risk quantification methodologies."
Further information and links
This project was financed by the German Federal Ministry for Economic Cooperation and Development (BMZ) and developed by the Natural Capital Financial Alliance (NCFA) and the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH.
A summary of the results of the pilot project can be found in the report “Drought Stress Testing – Making Financial Institutions more Resilient to Environmental Risks”.
