Conclusions and Recommendations from October 2024 Event - Water Resilience for Economic Resilience in the Context of Climate Change
by Josefina Maestu (Univ. of Alcalá, WR4ER initiative) & Carles Manera (Univ. of the Balearic Islands, Board Member of the Bank of Spain)
These conclusions and recommendations have been drawn from the presentations and discussions during the seminar on Water Resilience for Economic Resilience that took place on 4 October 2024 at the Botín Foundation in Madrid, Spain. This seminar was organised by the University of Alcalá, the Botín Foundation and the international WR4ER Initiative with the collaboration of the Bank of Spain.
What is water resilience and what policies are we developing?
Resilience describes the ability of a system to withstand shocks without collapsing, and the ability to recover, reorganize and transform in anticipation of future stressors (IPCC, 2022). For the OECD, resilience is the ability to anticipate, resist and avoid shocks and to respond to and be prepared for those with high uncertainty and low confidence, building flexibility to adapt to future impacts, including unforeseen ones (OECD, 2014).
For this reason, water resilience requires the ability to resist, recover, adapt and transform, even in situations of extreme uncertainty. In Spain, infrastructures have been built to withstand situations of water stress, but they are not very flexible and with climate change many reservoirs will be empty. The flexibility that the system has is because in the concession regime, the allocations are contingent on the availability of water and allow for a reduction in supply (allocations) when there are situations of drought. We have drought and flood plans and instruments for monitoring them (Pérez Blanco, 2024).
But water stress situations are going to occur more and more. Not only will there be more five-year droughts, but the impact of droughts will be greater and greater because they occur in a context of decreasing water availability with climate change. In addition, rising temperatures will lead to an increase in evapotranspiration, which means higher crop demands than in the past, compromising watershed resources. Being able to recover and adapt to these situations will have economic impacts such as those seen in California and Australia, where there has been a loss of woody crops. Above all, it will require a reallocation of scarce resources and bring to a territorial scale nature-based solutions that facilitate, for example, infiltration into aquifers. This is what is currently being done in Northern Italy, where forests have been planted with channels between the trees, so that the roots contribute to the infiltration of water into the surface aquifer. But the effectiveness of such solutions depends very much on the context (Pérez Blanco, 2024).
The social consequences of these phenomena affect those who are least resilient. There are many supplies in small municipalities where there is a real social problem because there are no alternative supplies when a drought occurs. Not to mention the problem of quality. All this represents a huge challenge for planners. The biggest challenge is in irrigation, where 80% of the water is used for agriculture and livestock, 5% for industry, and 15% for domestic use (including tourism). Some measures that the government has put in place are in the Hydrological Plans of the third cycle and include investments in purification, flood risk management and more efficiency in water use. A key aspect is the digitalisation of the water cycle to address water risk. Artificial Intelligence, digitisation and remote sensing represent a very important leap forward as they allow for very accurate monitoring of rainfall and consumption. In China, they are already predicting very accurately where it is going to rain, which makes it possible to adapt crops. In Spain, a water management observatory is going to be created and there is already a national irrigation roundtable. International alliances such as IDRA are being led to raise awareness of desertification, mobilise financial resources and promote innovation (de la Rocha 2024; Pascual, 2024).
Spain is among the countries with the highest level of water stress, but this, together with droughts, is only one part of the risks associated with water. Clearly, we find ourselves in a frequent situation of climatic emergency such as the prolonged droughts in Catalonia or Andalusia and the violent floods on the Mediterranean coasts and the DANAS. But we should not forget the issue of inadequate water quality, which presents a very important risk as well, and is indirectly linked to catastrophic events associated with the reduction of dilution volumes in rivers and reservoirs due to climate change. But this is something that can be foreseen and managed (Trémolet, 2024; Baliña, 2024). Half of Spain's aquifers are polluted, largely due to the infiltration of surplus fertiliser and agricultural leachates, which introduce excess nutrient pollutants into the water supply. In addition, it is important to consider the risks associated with the deterioration of ecosystems which, if they lose their integrity, cannot provide the ecosystem services they provide when in good condition. These services include water purification or water retention capacity. For example, well-preserved wetlands retain water, act as a carbon store and host high biodiversity (Trémolet, 2024).
In responding to climate change, we have focused on mitigation and efforts on adaptation remain more limited. There are asymmetries in the responses, as some companies are making more effort than others. In addition, there are experiences that help to raise awareness, such as changes in cultivation practices or regenerative agriculture. However, it is necessary to take these experiences to the field scale and combine policies such as reducing supply and managing demand. It is also important that water has a price that allows its opportunity cost to be recognised (Baliña, 2024).
Analysis of economic and financial impacts
According to Manuel de la Rocha (2024), water management is the great challenge of this country, and it is therefore very important to know the impact of water management on the economic and financial system, how droughts affect the credit rating of companies, sovereign debt, the liquidity and profitability of investment portfolios and possible defaults. The financial effects are already here. Insurance claims in the agricultural sector in 2023 were 1.2 billion Euros, surpassing the record of 2022. There are effects in many economic areas and what lies behind this is a debate about what kind of economy we want.
Both developed and developing economies are exposed to water risks. These risks can generate large economic costs across sectors. For example, the 2021 floods caused $82 billion in economic losses worldwide, of which only $20 billion was insured. These impacts can be transmitted to the financial system. Banks may also be exposed to credit risks if drought-vulnerable sectors, such as farmers, account for a large share of their portfolio. If this occurs on a large scale, water-related risks may have implications for financial stability, which is relevant for Central Banks that have to maintain stability (Trémolet, 2024).
Economic impacts
Analyzing the macroeconomic impacts of climate change effects on water requires being able to model uncertainty. For this it is necessary to establish economic indicators beyond GDP and use projections according to agreed scenarios such as those of the NGFS: Phase IV, which already predict more disorderly future climate scenarios. Water is one of the most cross-cutting risk factors for the economy (Cubero, 2024).
The water and heat stress associated with droughts reduces agricultural yields, increases agricultural prices and also reduces the availability of hydropower. The indirect impact of a drought is a negative supply shock on GDP, increasing prices and reducing production and income in the economy. They also have direct impacts such as the inestimable loss of human lives or physical damage to property of households, businesses or public infrastructure. A shock to the SPEI (Standardized Precipitation Evapotranspiration Index) has significant and long-lasting consequences on agricultural activity. The rest of the economy is also negatively affected, while prices tend to increase. If more detailed sectoral impacts are to be analyzed, they can be obtained through I-O analysis (Cubero, 2024).
Financial impacts
Both physical and transitional climate risks have a significant impact on financial stability and bank solvency. Physical risks, such as natural disasters, directly affect banks' assets and loan portfolios, while transitional risks, arising from regulatory and technological changes, also have an impact, albeit from a business and structural cost perspective (Lombardo, 2024).
Banking
Managing the financial implications of the physical risks arising from climate change requires the collection and publication of relevant information, the management of these risks and their monitoring, considering the capital requirements that are necessary to address these risks. However, supervisors have a limited role because they do not have the tools to combat these problems. It is governments, banking agents and investors who can act. It is clear in any case that measures have to be taken in the most planned way possible so that financial actors can incorporate these measures into their decision-making (Estrada, 2024).
In 2023, the OECD published a working paper: "Watered Down? Investigating the financial materiality of water-related risks in the financial system" which explored whether climate and natural water-related risks are perceived as financially material by actors in the financial system. This work highlighted that water-related risks are increasingly important and may have significant implications for financial stability. But it agrees that these risks are not widely captured in current approaches to financial risk assessment (Trémolet, 2024).
There are risks such as those arising from aridity that are being studied. These risks are a consequence of rising temperatures and chronically reduced rainfall in certain regions. An ongoing study at the Bank of Spain merges data from the Central Risk Information System with geolocated arid areas. Since the late 1970s, average aridity has increased in Spain, although unevenly across regions. Aridity negatively affects the volume of credit, but it usually takes a long period of time for its full impact to be observed. Credit declines overall (-20 bps for every 1% increase in aridity), so the agricultural and real estate sectors are particularly affected, unlike tourism which has proved relatively immune so far (Estrada, 2024).
In the case of environmental deterioration as a physical risk, it is also having a significant impact on the value of real estate in the Mar Menor area, for example. Since 2015, the return on investment in housing in this area has been 43% lower than in other nearby areas. This loss in value, of more than four billion euros, is more than ten times greater than the benefits associated with switching from rain-fed to irrigated crops (Estrada, 2024).
Securities market
The assessment of equity market risks from climate change shows how the assessment of decarbonisation risks to financial assets is much more advanced than the physical risks associated with water. But there are important methodological lessons. Five asset classes have been considered in the CNMV analysis: 1) Equities; 2) Corporate bonds; 3) Sovereign debt; 4) Investment funds; 5) Cash. A comprehensive framework for measuring transition risk in investment portfolios has been developed which should also be applied to physical risks such as those related to water stress. It concludes that expected changes in investor preferences, technological changes and changes in public policies may lead to stranded assets, deterioration in credit quality, reduced company valuations and higher financing costs, resulting in losses on financial instruments issued especially by companies most vulnerable to transition. Analyses of decarbonisation show how sustainable funds are less exposed to transition risk and perform better than the fund sector (Crisóstomo, 2024).
Insurance
In the insurance sector, there is a wide range of policies taken out to cover extraordinary risks. The insurance compensation consortium surcharge for this type of risk is universal and depends only on the type of risk and the sum insured. It covers property and persons affected by any extraordinary event listed in the regulation. Since 2019, insurers are obliged to share information on all sums insured of all policies by postcode, which gives a much better overview of the exposure and thus the risk. This type of information makes it possible to assess how loss ratios are changing over time. One can compare, for example, the average flood loss ratios between the time periods 1996-2009 and 2010-2023 (Villamayor, 2024).
In the case of the agricultural sector there are 366,701 policies contracted, with an insured production value of 16,748.24 million euros and an insured surface area of 5.96 million hectares. The number of agricultural claims has been 178,763 and compensation payments 1,241.21 million euros. In the future, it is being taken into account that risk situations with recurrent and high loss rates need to be characterised. All of this is in order to analyse which aspects of the cover need to be improved and to review the adaptability of the tariffs to the characteristics of the insured risk and its exposure to perils. This would be the case, for example, of the cultivation of crops in climatologically unsuitable areas or of cultivation and management practices that increase the risk. It is also proposed to review those coverages for which experience has shown them to be ineffective or those for which the evolution of crops makes them unviable (Villamayor, 2024).
Role of the financial sector to reduce or eliminate investments in activities that exacerbate water-related risks and support those that enhance resilience
It is essential to raise awareness of water challenges among financial sector actors and to better understand how financial actors can make different decisions than usual and invest more in building resilience in water use (Trémolet, 2024).
Further progress needs to be made in understanding how economic activities depend on water, how they impact water resources, and how this affects financial institutions and other sectors. This is also fundamental for proper risk management. Therefore, data availability and measurement methodologies are central. In this sense, tools such as stress tests or heatmaps for drought, fire, coastal and river flood risk are useful to advance in the quantification of these risks. In fact, these are tools that authorities and institutions are already using and which will continue to evolve in the future. It is also expected that, based on observed best practices and advances in methodologies and data availability, regulatory frameworks and supervisory practices will also continue to evolve in order to adapt to the differential and specific characteristics of this type of risk (Castro, 2024).
WWF has estimated that 60% of global GDP depends on water. On an international scale, being positive on water-related risks requires between six and eight billion dollars per year by 2030. This is what would be needed for a positive transition for nature according to the organisation. It involves investments in agriculture, in the agri-food value chain, in the circular economy and above all in transforming the production model. In the banking sector, as in the case of BBVA, customers are accompanied on how to reduce their water footprint. To do so, it is necessary to calculate, reduce, compensate and communicate to the affected sectors (Frias, 2024).
This is an area in which there has been quite a lot of progress recently, with the analysis that has been done at the macro level by the NGFS and also with the development of risk disclosure systems, first on a voluntary basis with CDP or CERES (who were the first to define these systems) and now with European regulation such as with the Corporate Sustainability Reporting Directive - CSRD (Corporate Sustainability Reporting Directive) or the CSDDDD (Corporate Sustainability Due Diligence Directive). It is necessary to be ambitious in the implementation of these standards, and to improve risk analysis at a micro and localised level (Trémolet, 2024).
Agrarian insurance (Agroseguro) covers economic losses or increased costs caused by extraordinary situations of water shortage for rainfed crops or livestock. In inertial systems the calculated premium is 13% and 14% of the insured value for 100% coverage. In the case of irrigation in the Las Bárdenas region, which is a non-inertial system, the premium ranges between 0.4% and 1.8% of the insured value. It is clear that rainfall is an insurable risk, and allows for derivatives. However, hydrological drought is the result of meteorological drought, but also of watershed and resource management. Moreover, the economic impact of a drought depends on product prices, markets, past water management, water allocation and anticipation. Only in very specific situations do the conditions exist to ensure the risk of irrigation water shortages. This means that drought risks do not fit easily into the agricultural and weather catastrophe insurance system in Spain, at least for irrigated farmers (Garrido, 2024).
Rating agencies are beginning to recognise the importance of integrating climate risks into their assessments. The inclusion of environmental, social and governance (ESG) factors in risk assessment not only improves the resilience of financial institutions, but can also result in more favourable credit ratings. This signals a shift towards greater consideration of sustainability in credit risk assessment. There are some difficulties in obtaining quality data and in their financial interpretation. The forward-looking nature of these risks also complicates their integration into current management frameworks, which typically have a three-year horizon, while climate risks require a 10–20-year approach (Lombardo, 2024).
Transparency in the disclosure of ESG risks, including water management, is critical for financial institutions to obtain more favourable credit ratings. This highlights the need for financial institutions to be proactive in communicating their water resource management practices and their impact on sustainability. It is very important to note that unsustainable natural resource management, such as the type of water governance, can significantly increase credit risk. This implies that rating agencies should pay attention to companies' water management practices and their ability to adapt to environmental risks, as failure to adapt can lead to increased transition risk and affect bank creditworthiness (Lombardo, 2024).
Further regulatory development is needed. Progress is already being made in incorporating ESG aspects into prudential regulation with the adoption of the Corporate Sustainability Reporting Directive (CSRD), which extends reporting requirements to equate sustainability with financial reporting. The EBA and the Basel Committee are working on integrating climate risks into their regulatory frameworks (Lombardo, 2024).
Recommendations
The following recommendations are a summary of those presented by the OECD Water Team Lead and include other recommendations from speakers during the seminar.
While we cannot avoid extreme weather events or the decrease in available water due to reduced precipitation, we can manage our exposure and vulnerability to them. To do so, it is essential to distinguish which problems we attribute to climate change and which are the responsibility of our own actions. This reflection leads us to the need for a productive transformation that makes both cities sustainable and resilient, through green infrastructures and nature-based solutions, and the rural world, through agricultural practices that have a lower impact on resources and the environment.
Pricing policies for water services in a way that recovers the costs of these services are essential to improve water resilience and support a more resilient economy that ensures viable productive activities. However, one cannot be reductionist as prices do not currently incorporate all ecosystem services or issues of uncertainty or environmental externalities that need to be taken into account in decision-making.
The water sector must work on reducing risk, adopting regional and local measures to reduce vulnerability to natural disasters, accompanied by better planning and tariff reforms (including for farmers). Investments in innovation, changing cropping patterns such as regenerative agriculture, nature-based solutions, greater control of quantities consumed, controlled deficit irrigation, etc. are also needed. Resilience gained in this way must be a fundamental pillar of investment decisions to avoid creating future liabilities and assets that have no prospect of use.
Collaboration between environmental and financial stakeholders is needed to improve the collective understanding of how water-related risks translate into macroeconomic impacts and financial risk, and to develop the tools and data needed to assess financial materiality and environmental impacts.
Dialogue between the water sector and the financial community can improve information on the type of policies that can mitigate water-related risks and help prioritise public and private sector actions and investments in ways that improve economic resilience.
The financial sector can design new financial products to incentivise better practices, reallocate its assets according to risks, etc. Central banks can define a global supervisory framework to facilitate understanding of water-related risks.
Extreme weather disasters, such as floods and droughts, have a significant impact on the financial stability of banks, increasing their exposure to systemic risk. This suggests that rating agencies should consider not only individual risks, but also how these events may alter the economic environment in which financial institutions operate.
There are recent developments and initiatives to understand financial risks related to nature (in particular NGFS, the Network for the Greening of the Financial System) and to strengthen assessments of risks related to water and freshwater ecosystems. There is a need to actively engage to ensure that water-related risks, which are so important in countries such as Spain, are adequately considered.
A number of central banks are moving forward, such as the European Central Bank, or the Dutch Central Bank, which has analysed the financial impact of floods. The OECD has also worked with the Central Bank of Hungary on the application of the general framework of the NGFS to flood and drought risks. This is work that could be developed for Spain.
Central banks can enhance economic resilience in relation to water through monetary policy, prudential policy, supervisory guidance, collaboration with other institutions and through their participation in networks such as the Network on greening the Financial system (NGFS).
Sectoral and value chain analyses (agriculture, energy production, mining, textile industry) by banks can serve to highlight how different activities are impacting water and how they depend on water to guide their lending policies.
Further work and exchange of experience on the implementation of the Corporate Sustainability Reporting Directive (CSRD) is needed.
The development of the OECD Guidance on assessing water-related risks to financial systems can help policy makers, central banks and financial supervisors to assess and manage risks in different scenarios.
References
Baliña, Sara (Director of the National Foresight and Strategy Office, Government of Spain). Oral presentation at the Seminar on Water Resilience for Economic Resilience on 4 October 2024. Fundación Botín: Madrid.
Castro, Christian (Director of Public Affairs at Caixabank). Powerpoint presented at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
Crisóstomo, Ricardo (Senior Economist, Comisión Nacional del Mercado de Valores). Powerpoint presented at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
Cubero, Julian (Lead Economist of the Economics of Climate Change Cluster at BBVA Research). Powerpoint presented at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
de la Rocha, Manuel (Secretary of State of the Office of Economic Affairs and G-20 of the Presidency of the Government, Government of Spain). Oral presentation at the Seminar on Water Resilience for Economic Resilience on 4 October 2024. Fundación Botín: Madrid.
Estrada, Angel (Director General for Financial Stability, Regulation and Resolution of the Bank of Spain). Powerpoint presented at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
Frías, Avelina (Natural Capital Manager - Global Sustainability, BBVA). Powerpoint presented at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
Garrido, Alberto (Director of the Water Observatory of the Botín Foundation). Professor of Agricultural Economics and Vice Chancellor of the Polytechnic University of Madrid, Powerpoint presented at the Seminar on Water Resilience for Economic Resilience on 4 October 2024. Fundación Botín: Madrid.
Gómez, Carlos Mario (Professor of Fundamentals of Economic Analysis, University of Alcalá). Oral presentation at the Seminar on Water Resilience for Economic Resilience on 4 October 2024. Fundación Botín: Madrid.
IPCC. 2022. Climate Change 2022: Impacts, Adaptation, and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [H.-O. Pörtner, D.C. Roberts, M. Tignor, E.S. Poloczanska, K. Mintenbeck, A. Alegría, M. Craig, S. Langsdorf, S. Löschke, V. Möller, A. Okem, B. Rama (eds.)]. Cambridge & New York, NY: Cambridge University Press.
Lombardo, Francisco (Axesor Vice President - Risk rating). Oral presentation at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
OECD. 2014. Recommendation of the Council on the Governance of Critical Risks. https://legalinstruments.oecd.org/en/instruments/OECD-LEGAL-0405
Pascual, Dolores (Director General for Water, Ministry for Ecological Transition and the Demographic Challenge, Government of Spain). Oral presentation at the Seminar on Water Resilience for Economic Resilience on 4 October 2024. Fundación Botín: Madrid.
Pérez Blanco, Dionisio (Professor of Fundamentals of Economic Analysis, Unit of Excellence in Sustainable Economic Management, University of Salamanca). Powerpoint presented at the Seminar on Water Resilience for Economic Resilience on 4 October 2024. Fundación Botín: Madrid.
Trémolet, Sophie (Lead of the Water Team, OECD). Oral presentation at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.
Villamayor, Celedonio (Director of Operations, Directorate General for Insurance and Pension Funding). Powerpoint presented at the Water Resilience for Economic Resilience Seminar on 4 October 2024. Fundación Botín: Madrid.