It Happened – Central Banks And Water Risks

By Debra Tan, Dharisha Mirando 17 July, 2020

Tan & Mirando run through the six recently released reports for Central Banks and regulators by NGFS

We have been saying for a while now that water risks can trigger systemic shocks. Indeed, CWR exists to push investors and businesses to embed water risks in finance and we are glad that – “IT happened” – we are now at the point where 66 central banks from around the world have finally recognised the various types of water risks and their complex interlinked nature, including water transitional risks which we’ve been harping on about.

The half a dozen reports released by the NGFS in May/June leading to this ‘ta-da’ delivery of one of CWR’s key goals has slipped under the radar. This was not surprising, given the multiple headlines vying for attention in Hong Kong and around the world – so you’ll be forgiven for thinking what’s the big deal?

But it is a big deal and although there is still a long way to go, the first step is always the hardest. Plus it will set the direction for banks around the world for the next 5 years. So we felt it was important to take this moment to acknowledge and explain some key wins and what this means in the long road to embedding water risks…

1. Assess water risks in both categories: 1) climate-related; and 2) environmental-related

Last year, NGFS’ first report categorised water risks into these two areas. Climate-related risks include event-driven water risks such as droughts, floods and storm surges whereas environmental-related risks include water scarcity, pollution and stress and other underlying basin risks.

When assessing physical climate risks related to water, many in the financial industry do NOT include physical impacts of underlying water scarcity, water stress & deforestation

This separate classification of water risks has led to a misunderstanding of what is being assessed. When many in the financial industry say they have assessed physical climate risks related to water – these do NOT include physical impacts of underlying water scarcity, water stress and deforestation. Typically, only acute shocks from typhoons/hurricanes and wildfires and chronic events such as floods and droughts are assessed under climate risks. Insurers have even commented to us that they have never looked at the entire basin when they consider water risks!

Good news – NGFS has stepped up focus on environmental risks

The good news is that the NGFS has stepped up focus on environmental risks in their recent “Guide for Supervisors: integrating climate-related and environmental risks into prudential supervision”. The NGFS is now calling for the need for focus both on climate risks and environmental degradation, whereas they had previously focused on climate related risks.

We worry that categorising the risks separately will lead to water risks being routinely underestimated…

BUT we still worry that categorising them separately will lead to water risks to be routinely under-estimated as many forget how interlinked they are and then only focus on climate risks or environmental risks. For example, floods & droughts impact underlying basin risks; and mismanagement of the basin will also raise the risks of floods and droughts.

…they need to be considered holistically

Therefore, water risks need to be considered holistically or there’s a danger of risks ‘falling between the cracks’. Here, although the new NGFS guide has recognised the connection and overlap between the two categories, it admits that more needs to be done to identify financial risks from environmental degradation.

A good start is to close the gaps in research on basin risks. We had to work with the Chinese Academy of Science to derive the climate impacts on snowfall, rain and river flow for the 10 major rivers in Asia for the entire river basin as these are hard to come by; such analyses need to be carried out and made public for other important rivers. Moreover, consistent methods for assessing such risks globally are lacking.

The good news is that multiple task forces on definitions and standards have been set up – from the Science Based Targets Water Hub to the Valuing Water Finance Task Force and the CDSB Water Technical Working Group. We are involved in these and while a good start, there is a long way to go. And now …the hard work begins.

2. Water transition risks related to government regulatory action are finally recognised

This entire category of water transition risks caused by regulatory action or inaction to adapt are ignored. They are now finally recognised by the NGFS – for the first time, transition risks include those from “government action aimed at regulating the supply of available water through extraction restrictions or pricing” – water transition risk.

Water transition risks are especially important in Asia…

You could have easily missed this as it was tucked away on page 12 and not mentioned in the executive summary when explaining the different risks. But it is important and we want to draw attention to it as water transition risks are especially important in Asia where limited water resources and rising stress will create more regulations that tie economic performance to water management.

…in China, such regulatory actions are already disrupting business operations

Such waternomic regulations could include industrial water allocation, equipment upgrades, factory shutdowns, tighter wastewater discharge permits, tiered water pricing to optimising industrial sectors to the water availability of the basin. In China, such regulatory actions are already disrupting business operations, but in the longer term could benefit those same operations.

Regulatory inaction regarding adaption and managing water risks will also bring about different water transition risks: with less short-term downside but increased probability of binary risk of no water scenarios in the longer term.

What governments are/are not doing matters. Investors have started to highlight such risks, as have Chinese banks – ICBC already started stress testing against the impact of China’s environmental regulations in 2017.

If you are not willing to suffer the carbon transition risks to 1.5ºC then you should be assessing & investing in adaption for water transition risks of 4ºC

Here it is also important to remember that carbon and water transition risks are linked. If governments/banks/corporates are not willing to suffer the carbon transition risks to 1.5ºC then they should be assessing and investing in adaption for water transition risks of 4ºC. The recognition of the NGFS of water transition risks will likely see a re-alignment of no-sense strategies which currently pervade these stakeholders.

3. No bank is immune – credit will be affected, geo-locational analysis is a must

Our current financial system is not set up to deal with impacts of climate change; it did not have to. However, with the rise of water risks and their significant impacts, each loan/asset will need to be geo-tagged and analysed by basin.

This will be a costly and mammoth task, but one that has to be done to ensure financial resilience. Banks are becoming increasingly blind every year we are not mapping water risk exposure, as these risks only accelerate and increase. The cost of inaction on this front is unthinkable and recognised in NGFS’ “Climate change and monetary policy: initial takeaways”.

Climate change could lead to the repricing of assets on banks’ balance sheets & weaken monetary policy effectiveness

In this report, the NGFS states that climate change could lead to the repricing of assets on banks’ balance sheets, thus reducing a bank’s ability to provide credit to the economy. Worse still, a central bank’s ability to use interest rates to pump and prime an economy hit by climate disasters could be limited if rates are already low due to other previous and ongoing climate induced economic setbacks.

Central bankers have now also recognised that each economy will be affected differently by climate change, but none will be exempt from impact. The report also asks if central banks’ prevalent analytical toolkits adequately reflect climate change and encourages central banks to expand their analyses as climate change is already having impacts. That said, despite multiple tools and modelling methods, consensus on assessment has yet to be achieved and more work needs to be done.

Yet, the NGFS is still obsessing over “green” & “brown” classifications…

…which does not help assess physical risks

Yet, the NGFS is still obsessing over “green” and “brown” classifications in its “Status report on financial institutions’ experiences: from working with green, non-green and brown financial assets and a potential risk differential”. While important, this does not help assess physical risks, only potential carbon transition risks. The banking sector must concurrently assess both physical and regulatory risks as focussing only on the latter will leave the sector horribly exposed.

DNB already assessed its water stress exposure in 2018/19

It should be noted here that a few central banks have started to map various types of risks. For example, De Nederlandsche Bank (DNB) started exploring the impact of physical and transitional climate-related risks on the Dutch financial sector in 2017 and then progressed to assessing its water stress exposure in 2018/2019.

For the latter, DNB commissioned Four Twenty Seven to map 2,000 of the largest Dutch businesses (900,000 facilities) against water stress, which showed that the sector’s equity portfolios have a combined exposure of EUR83bn to facilities located in extremely water-stressed regions. Four Twenty Seven has since been acquired by Moody’s pointing to increasing demand for this type of geo-locational analysis in the future. Indeed, we are seeing this with our own work with corporates and investors (more 2020 trends here).

Clearly, this type of geo-locational analysis is possible today (we’ve been doing it since 2016). Why aren’t all banks and asset managers carrying out this analysis? Or have they done it but aren’t willing to share the results as they don’t look good?

High water risk exposure could have implications on CAR ratios

High water risk exposure could have implications on CAR ratios – if banks such as HSBC are being asked to suspend their dividends to ensure financial stability during COVID, what will they be asked to do for climate change as the financial impacts could be 150x worse?

4. Lack of insurance coverage will leave banks exposed

Risks of floods and droughts and other climate and water risks are being ‘passed through’ by lenders to insurers; but insurers have started to stop writing policies due to the increasing frequency of these events in vulnerable regions.

Insurers have started to stop writing policies – this leaves banks exposed with uninsured assets & mortgages

This leaves banks exposed with uninsured assets and mortgages. This has already happened in the US and Europe – 9,000 households in flood-prone areas in England and Wales were excluded from a flood insurance subsidy agreement and insurers are pulling out of wildfire-prone regions in California.

The NGFS has recognised the increasing likelihood of no-coverage risk. Specifically, it points to the potential reduction in insurance coverage due to withdrawal or increased premiums due to the physical risks, as a risk for the rest of the financial system.

So far, lenders have prioritised their focus on carbon transition risks, from governments implementing policies such as carbon caps and taxes to reduce carbon emissions. The TCFD has also been focussed on these risks and physical risks stemming from extreme weather. Therefore, banks have focused their disclosure on these risks.

However, risks are more pronounced today than a few decades ago and let’s not forget that climate impacts are already baked into the system. Therefore, there is rising urgency for banks and companies to get on top of these risks before they are blindsided.

PG&E focused on carbon risks heavily but failed to assess its exposure to rising water risks

The bankruptcy of Pacific Gas & Electric Corp (PG&E) is an example of this. It was focused on carbon risks heavily investing in both renewables and energy efficiency, and played an active role in California’s landmark carbon market but failed to assess its exposure to the rising water stress of the region plus droughts increasing the likelihoods of fire.

In short, basin water risks and regulations also increase the likelihood of no-coverage risks – it will not just be flood cover but also insurance cover for business interruption that could be lost. Again, banks will end up with the exposure to operations.

Now what? Less green & brown; more water risk assessments …

Perhaps we need a new definition for water risks so that they don’t fall between the cracks across any category. They should include event driven floods, droughts and storm surges, underlying basin risks, water transition risks (regulatory and technology) as well as tail risks represented by sea level rise (see chart here). Assess the whole lot so you won’t be blindsided.

Going forward, expect to see the NGFS steer the focus to risk assessments of all types of water risks in different scenarios

So going forward, expect to see the NGFS steer the focus away from obsessing over what’s “green & brown” to risk assessments of all types of water risks in different scenarios – NGFS has already started as they’ve developed various climate scenarios with different chronic and acute physical risks as well as transition risks in “NGFS Climate Scenarios for central banks and supervisors”.

However, HOW we assess these various types of water risks remains undecided. What is clear is that the different types of water risks require different valuation methodologies. Various parties (including CWR) are helping to build consensus on this and we look forward to ERA guidance which will be issued by NGFS Workstream 1, which is chaired by Dr Ma Jun.

It is also worth remembering that while more granular research is still needed at the basin level, current standards/policies don’t need to change for regulators to take action. Climate risks and environmental risks are drivers of existing risk categorises, such as credit risks, markets risks, operational risks, liquidity risks and underwriting risks.

A credit evolution is inevitable & it will happen sooner than you think

A credit evolution is inevitable and it will happen sooner than you think. The path is clear; there is a lot of work ahead. It’s time for banks to roll up their sleeves and assess the sobering impacts of water risks. Sooner or later, they will have to do this – their regulators would demand it as not doing anything could trigger financial collapse.

So don’t wait – banks, start assessing your water risks now. Who knows, a comprehensive assessment of water risks may even result in fast tracking the allocation of capital away from not just the oil & gas industries but less obvious culprits like the fashion industry. Every bit counts to help us avoid 3ºC-4ºC.

Further Reading

• Thirsty And Underwater: Rising Risks In Greater Bay Area – How will water & climate risks, including rising sea levels & droughts, threaten the already water-stressed Greater Bay Area (GBA)? CWR’s Tan & Mirando explain in their latest CLSA report and highlight companies’ failure in climate risk disclosures
• No-Sense Climate Strategies: From DSD To HSBC – Hong Kong’s shortsighted & unrealistic climate plans will leave key assets & infrastructure exposed that mean the government, companies, investors and the public are even more exposed. China Water Risk’s Dharisha Mirando & Debra Tan expand
• Are Asia’s Savings Exposed To Water & Climate Risks? – Asian asset owners have portfolios skewed towards domestic markets that will bear the brunt of climate change. Find out about these risks and what to do as our Dharisha Mirando shares key takeaways from the new report China Water Risk co-authored with Manulife Asset Management & the Asia Investor Group on Climate Change
• 3°C Transition Risks: It’s H2O, Not Just CO2 – 3°C is happening. This means we need to invest so we are ready for longer droughts, more intense & frequent floods, more damaging typhoons, as well as changing monsoon patterns and river flows. China Water Risk’s Dharisha Mirando & Debra Tan warns.
• Banking On Granularity To Reduce Climate Blindspots – Climate & water risks are locational but most financial institutions are flying blind, not having mapped their assets. Until they do, they & our savings are exposed. CWR’s Dharisha Mirando expands
• Banking in the Age of Water Risk – Are water risks and their potential impacts factored in by banks? Or is ‘water exposure’ just the water used in their office buildings & branches? Tan says prudence dictates we must start to waterproof portfolios

More on Latest

• COVID-19 Heightens Water Problems Around The World – Is water access and quality only a problem of developing countries? Global water gurus Asit Biswas and Cecilia Tortajada rebut this as COVID-19 & the lack of political leadership reveal vulnerabilities worldwide
• The Coronavirus Climate Profiteers & The Climate Heroes – Which companies and industries are exploiting COVID-19 and which are doubling down on green efforts? Mighty Earth’s CEO Glenn Hurowitz calls them out and calls for a new, better system to be built
• Fashion Frolicking In Oil – Fashion is practically frolicking in oil as CWR’s Dawn McGregor points out. 2.5% of global oil produced is used by the fashion industry. See why this is and how fashion accounts for 35% of ocean microplastic
• Regulators Have A Role To Play In Tackling The Global Water Crisis – Climate change creates systemic risks to financial systems. With USD316bn of losses from disasters in 2018-19, Ceres’ Robin Miller on urgent actions regulators can take to ensure stability and investors that have made a start on water risks
• Pathway For Hong Kong To Net Zero By 2050 – Hong Kong needs a new plan to decarbonise by 2050 as it only has targets for 2030. ADMCF’s CEO Lisa Genasci shares key findings from a report that shows us how to achieve net-zero and monetised HKD460bn in benefits