Embedding Water‑related Risks in Financial Stability Frameworks

Report

6 October 2025

2. Water is at the heart of economic and financial systems

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Abstract

Water is a critical resource for human life and well-being, and the functioning of most economic activities. Yet, its availability, quality, and spatial distribution are increasingly under pressure due to climate change, pollution, overuse, and ecosystem degradation. These risks pose significant challenges to economic productivity and financial resilience, particularly in key sectors such as agriculture, energy, infrastructure, and industry.

While water-related risks have traditionally been viewed as localised environmental concerns, their systemic economic and financial implications are becoming more evident, requiring a shift in how they are assessed and managed and at which geographical scales. This chapter discusses the various dimensions of water-related risks and their interlinkages with the economy and financial system.

2.1. Our economies rely on a stable hydrological cycle

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2.1.1. Blue and green water drive the hydrological cycle

While water is the most abundant liquid on Earth, only a small share of it is freshwater, which is irregularly distributed over different continents. Seasonal climatic variation, climate change and intensive exploitation of freshwater resources cause variations in volumes over time, which can have drastic impacts at local or regional scales (UNESCO, 2022[1]).

The water cycle is profoundly interconnected with society, the environment and the economy. Ecosystems and societies depend on freshwater stocks in groundwater and soil moisture, in rivers and lakes, wetlands and glaciers. Flows, which determine where and when water is available, are affected by human activity (e.g. ecosystem degradation, land-use change, irrigation and industry) from different regions that change the state of water (e.g. from frozen to liquid to vapour).

Within the water cycle, blue water is referred to as the freshwater in streams, rivers, aquifers and surface water storage that provides drinking water and supports around 30% of the world’s food, besides sustaining all freshwater aquatic biodiversity. Blue water is the basis for all aquatic ecosystems, including wetlands, and is available to humans as an extractable resource. Green water consists of terrestrial precipitation, evaporation and soil moisture. Atmospheric green water flows of water vapour extend far beyond traditional watershed boundaries (Global Commission on the Economics of Water, 2024[2]; Wang-Erlandsson et al., 2022[3]).

Green water supports all terrestrial ecosystems and rainfed agriculture. On global and annual scales, approximately 60% of the precipitation that falls on land becomes available as green water and 40% as blue water, meaning green water constitutes the majority of freshwater on land (Global Commission on the Economics of Water, 2024[4]). Green water’s role has long been overlooked. Green water, especially soil moisture, plays a critical role in the biosphere’s resilience, in securing terrestrial carbon sinks and in regulating atmospheric circulation (Wang-Erlandsson et al., 2022[3]). In terms of human water requirements, green water mainly relates to rainfed agriculture and is defined as the soil moisture available for productive moisture flow from agricultural land (Global Commission on the Economics of Water, 2024[4]).

Figure 2.1. The hydrological cycle
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2.1.2. Freshwater plays a central role in ecosystem services

Freshwaters, including lakes, rivers, wetlands, including floodplains, have played a major role in the history of humankind, providing essential goods and services that support our survival and well-being (Vari et al., 2022[6]). These benefits arise from the ecological functions of freshwater ecosystems, which regulate water cycles, sustain biodiversity, and support food production. Freshwater systems, like all ecosystems, are not static. Rather, they are dynamic complexes of plants, animal, and micro-organism communities interacting with their non-living environment as a functional unit (IPBES, 2019[7]).

Freshwater ecosystems provide a wide range of essential services, including water supply, water quality regulation, flood control, and climate regulation (Vari et al., 2022[6]). They support biodiversity by offering habitat for fish, amphibians, and birds, including spawning and migration grounds. Additionally, they provide cultural benefits such as recreation, tourism, and spiritual value. Provisioning services include fertile soils for agriculture, construction materials like reed, and food sources such as fish and molluscs (Vari et al., 2022[6]). Given their ecological and economic importance, freshwater ecosystems have the highest estimated per-hectare value of ecosystem services among inland ecosystems, despite covering only a small fraction of the Earth's surface (Costanza et al., 1997[8]; Costanza et al., 2014[9]).

To support global, regional and national efforts to assess and manage risks to ecosystems, the IUCN Global Ecosystem Typology provides a hierarchical classification system of ecosystems, from broad classifications at the realm level to detailed functional groups1, facilitating conservation and management strategies (IUCN, 2020[10]). Following this classification, freshwater is defined as one of the five global realms, alongside terrestrial, subterranean, marine, and the atmosphere. The freshwater realm includes all permanent and temporary freshwater bodies as well as saline water bodies that are not directly connected to the oceans. The interfaces between these core realms are recognised as transitional realms, accommodating ecosystems, such as mangroves, that depend on unique conditions and fluxes between contrasting environments. A typology of these different realms can be found in Table 2.1.

Realm	Biome	Ecosystem functional group	Disruption examples
Freshwater	Rivers and streams	Permanent upland streams	River fragmentation River ecological quality
		Permanent lowland rivers
		Freeze-thaw rivers and stream
		Seasonal upland streams
		Seasonal lowland rivers
		Episodic arid rivers
		Large lowland rivers
	Lakes	Large permanent freshwater lakes	Surface water affected by eutrophication, “Dead zones” (including in lakes and coastal and marine areas) (Jenny et al., 2020[11])
		Small permanent freshwater lakes
		Seasonal freshwater lakes
		Freeze-thaw freshwater lakes
		Ephemeral freshwater lakes
		Permanent salt and soda lakes
		Ephemeral salt lakes
		Artesian springs and oases
		Geothermal pools and wetlands
		Subglacial lakes
	Artificial wetlands	Large reservoirs	Reduction in wetlands
		Constructed lacustrine wetlands
		Rice paddies
		Freshwater aquafarms
		Canals, ditches and drains
Subterranean-Freshwater	Subterranean freshwaters	Underground streams and pools	Groundwater aquifer depletion and impact on groundwater dependent ecosystems
	Subterranean freshwaters	Groundwater ecosystems
	Anthropogenic subterranean freshwater	Water pipes and subterranean canals
	Anthropogenic subterranean freshwater	Flooded mines and other voids
Freshwater-Marine	Semi-confined transitional waters	Deepwater coastal inlets	Surface water affected by eutrophication, “Dead zones” (including in lakes and coastal and marine areas) (Jenny et al., 2020[11])
		Permanently open riverine estuaries and bays
		Intermittently closed and open lakes and lagoons
Marine-Freshwater Terrestrial	Brackish tidal	Coastal river deltas	Pollution
		Intertidal forests and shrublands
		Coastal saltmarshes and reedbeds
Terrestrial-Freshwater	Palustrine wetlands	Tropical flooded forests and peat forests	Reduction in wetlands and peatlands More than 85% of wetlands have been lost since 1700 (UNEP, 2021[12]) (UNEP, 2021[12])
		Subtropical/temperate forested wetlands
		Permanent marshes
		Seasonal floodplain marshes
		Episodic arid floodplains
		Boreal, temperate and montane peat bogs
		Boreal and temperate fens

Note: Realm: one of five major components of the biosphere that differ fundamentally in ecosystem organisation and function: terrestrial, freshwater, marine, subterranean, atmospheric; Biome: a component of a realm united by one or a few common major ecological drivers that regulate major ecological functions; Ecosystem functional group: a group of related ecosystems within a biome that share common ecological drivers promoting convergence of biotic traits that characterise the group.

Source: adapted from (Keith et al., 2020[13]) (IUCN, 2020[10]) and authors.

The OECD Council Recommendation on Water defines water-related ecosystems to include wetlands, rivers, aquifers, lakes and interrelated components of the surrounding landscape (mountains and forests), as well as coastal ecosystems (such as mudflats and estuaries) (OECD, 2016[14]).

The importance of green water is increasingly being emphasised (Global Commission on the Economics of Water, 2023[5]). Indeed, as green water consists of terrestrial precipitation, evaporation and soil moisture, it is relevant across all terrestrial, freshwater and marine realms, as they act as watersheds and water sinks within the global hydrological cycle. For example, green water refers to moisture in soils generally, including in arable land and urban environments, which is beyond the current definitions of freshwater ecosystems in the IUCN Global Ecosystem Typology. This highlights that there are strong interdependencies across ecosystems, but also the critical role of the hydrological cycle across ecosystems.

Nevertheless, these classifications and definitions underscore the critical role of blue and green freshwater, and freshwater ecosystems in sustaining life, supporting economies, and maintaining ecological balance. Given their high economic value and fundamental role in the global hydrological cycle, protecting and managing these ecosystems is essential.

Policies and management strategies must account for their strong interdependencies with other realms, terrestrial, marine, and atmospheric, to mitigate water-related risks, ensure long-term water security, and enhance climate resilience. In particular, the focus should be broadened from blue water to also include green water which is a fundamental part of the hydrological cycle and of water security. However, currently many non-market values of water, primarily associated with ecosystem services (provisioning, supporting and cultural), are not typically included in economic decision-making (Manero et al., 2022[15]). In practice, its economic value depends largely on its use, the level of its excludability and rivalry and different assumptions about how to govern it (Global Commission on the Economics of Water, 2023[5]).

2.1.3. Water plays a critical role in our global economies

Water is embedded in most production activities and services, with large volumes of freshwater consumed throughout global supply chains. This includes water used for growing crops, manufacturing materials, and processing final goods. Water demand is increasing across the globe, driven by use patterns in developed economies and growing population and economic activity in developing and emerging economies. This increasing demand creates competition for existing resources whilst also contributing to increased pollution and depletion of local freshwater sources.

The System of Environmental-Economic Accounting for Water (SEEA-Water) offers a useful systematic framework for the organisation of water information to enable the study of the interactions between the economy and the environment, providing a clear overview of how the economy both depends and impacts on water (United Nations, 2012[16]).

This illustrates how the economy uses water, as outlined in Figure 2.2 by either removing it or by using it where it is located (in situ uses). The economy physically removes water from the environment for activities involving production and consumption through abstraction from the inland water bodies or uses the precipitation for example through rain-fed agriculture. Water can also be used without being physically removed from the environment. For example, when water is used for recreational, transport purposes or fishing, this relies on the physical presence of water and often on the quality of the water. In addition, discharging treated or untreated wastewater or polluting water through other means can be considered a use of water.

Water may also return into the environment, either into the inland water system or directly into the sea. Return flows from irrigation and discharges from industrial and urban wastewater have a negative impact on the environment in terms of water quality, as the quality of discharged water is typically lower than that of abstracted water. Although returns to the water resource system alter the quality of the receiving body, they represent an input into the water system, as returned water then becomes available for other uses (United Nations, 2012[16]).

Figure 2.2. Main flows within the inland water resource system and the economy
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2.1.4. Water underpins trade of goods and services

Water plays a fundamental role in connecting economies across regions, serving as both a physical and virtual medium for the trade of goods and services. Historically, rivers and other waterways have served as critical enablers for moving goods and people across continents and providing resources to support local development. This includes rivers such as the Nile, the Yangtze, the Mississippi, and the Rhine that have shaped the development of civilizations, cities, and markets. Even today, major rivers and canals remain essential for transporting bulk commodities and fostering economic interdependence between regions.

Inland waterways are particularly vital for the movement of heavy and voluminous goods, including agricultural products, minerals, coal, and petroleum. For example, the Mississippi River system in the United States carries hundreds of millions of tons of grain, soybeans, and other commodities each year from the Midwest to international markets. In Europe, the Rhine and Danube rivers connect landlocked countries to seaports, supporting both regional and international trade.

When disrupted, these can have important impacts on trade. In 2023, drought-induced low water levels in the Panama Canal led to delays and increased shipping costs. In 2018, low water levels on the Rhine, which carries over 300 million metric tons of goods annually, led to a 27% decrease in transport volume. This disruption caused companies in Germany to face shortages of raw materials, forcing some to shut down operations. Even minor drops in water levels can have outsized impacts; for example, on the Mississippi River, a one-inch drop can reduce tow capacity by 255 metric tons (SEI, 2023[17]).

Beyond physical conveyance, water is deeply embedded in the production of goods and services that are traded internationally. The concept of “virtual water trade” refers to the hidden flow of water used in the production of commodities that are then exported and imported between countries.

This means that when a country imports wheat, rice, or other agricultural products, it is also importing the water used to produce those goods in the exporting country (Scanlon et al., 2023[18]). For example, Figure 2.3 illustrates global virtual water flows linked to food trade, which is in the order of 300 cubic kilometres (km³) per year (Scanlon et al., 2023[18]), with the largest virtual exports coming from the United States, India and Pakistan. While global food security is improved by allowing water-constrained countries to import water-intensive agricultural products rather than producing them domestically, virtual water trade can enhance water inequalities and damage the environment of water-intensive exporting countries if the external costs of water consumption and pollution are not fully considered (Scanlon et al., 2023[18]).

Figure 2.3. Global virtual blue water flows linked to food trade between countries (1996–2005)
Copy link to Figure 2.3. Global virtual blue water flows linked to food trade between countries (1996–2005)

In the context of these high interdependencies, water-related shocks like floods and droughts can lead to wide reaching impacts across the globe. For instance, water scarcity in key food producing countries can impact on international food prices. The severe food price shocks of 2008–10 and 2020–22 were, in part, caused by food supply shocks that arose from reduced water availability first in Australia, East Africa, Russia and Ukraine and then in the United States of America, Brazil, Argentina, East Africa, China over respective periods (Katic and Grafton, 2023[19]).

While food is a clear example, virtual water trade is relevant across products and services, from textiles, computer chips and electronics, to energy production, and construction materials like steel and concrete, each requiring substantial amounts of water throughout their supply chains. The fashion, electronics, and energy industries are among the most water-intensive sectors outside of agriculture, making virtual water trade a critical consideration far beyond just food products.

2.1.5. Human activity increases pressure on freshwater

Water and broader nature underpin all economic activities, providing a fundamental resource for agriculture, industry, energy, and urban development. At the same time, economic activities exert significant pressures on water systems, contributing to depletion, pollution, and ecosystem degradation. The relationship between water and the economy is bidirectional; while economic sectors depend on water, they are also primary drivers of water-related risks, affecting both the quantity and quality of freshwater resources and the resilience of ecosystems.

While water-intensive activities are essential for many aspects of economic development, problems arise when the scale or location of activities pushes water systems beyond their ecological thresholds. Investments that fail to consider local freshwater condition and ecosystem limits can contribute to water scarcity, pollution, and long-term ecosystem degradation -eroding water security and generating future social, economic, and financial liabilities. A more informed understanding of drivers should encourage both policymakers and financial actors to direct capital toward projects and practices that remain within ecological boundaries, thereby reducing the risk of building liabilities and enhancing long-term resilience.

The degradation of freshwater ecosystems results from multiple pressures that stem from human activity. Key drivers of water-related risks and broader nature degradation include land-use and land-cover change, over-abstraction of water resources, climate change, pollution, and the proliferation of invasive species:

Changes in land use in particular are a key driver of “unprecedented” biodiversity and ecosystem change. OECD countries have lost approximately 50 000 kilometres squared (km²) of natural and semi-natural vegetated land since 2 000, equivalent to a territory approximately the size of Switzerland. A key reason for this is the increase of artificial surfaces, developed at the expense of natural and semi-natural vegetated land and cropland (Tesnière, Maes and Haščič, 2024[20]). One third of the world’s wetlands have been lost in the last five decades, and there has been an 83% decline in freshwater species populations with habitat degradation change and loss as a main driver (WWF, 2022[21]). Changes in land use also impact on evapotranspiration, which impact directly on green water, including soil moisture and rainfall on land (Global Commission on the Economics of Water, 2024[2]).
Direct exploitation of freshwater resources has had important consequences for freshwater ecosystems. To date, studies have focused on the depletion of groundwater for agriculture, whereas a growing body of research now take a broader approach to explore the impact of abstraction on freshwater ecosystems. As an example, a study of the Ogallala aquifer, which spans underneath eight states in the US Great Plains, found that over 50 years of abstraction had led numerous streams to run dry and to a collapse in large fish populations (Perkin et al., 2017[22]). It is estimated that by 2050, without better management, between 42% and 79% of regions in which groundwater is extracted will have reached their limits, which means that watersheds would pass ecological tipping points (University of Freiburg, 2019[23]).
Water and climate change are inextricably linked. The impacts of the climate crisis are largely felt through increasing pressure on the hydrological cycle, including unpredictable rainfall patterns, shrinking ice sheets, rising sea levels, floods and droughts. Between 1995 and 2015, 90% of major natural disasters were caused by floods, storms, heatwaves, droughts and other weather-related events (UNISDR, 2015[24]). Climate change also impacts green water flows and atmospheric moisture. It is estimated that every 1°C of additional global warming increases vapour in the air by 7% (IPCC, 2023[25]). At the same time, a tilted hydrological cycle can exacerbate the impacts and contribute to drivers of climate change. For example, drier soil will capture less carbon (IPCC, 2023[25]) and at the same time will be more susceptible to landslides and floods following heavy rainfall (IPCC, 2019[26]).
Pollution is a challenge that plagues high- and low-income economies alike. Whereas poor sanitation services are a major challenge in countries that are developing their infrastructure and public services, pollution linked to chemicals from consumer products and pharmaceuticals is a challenge that developed economies are in the midst of grappling with (UNESCO, 2023[27]). Agriculture also plays an important role in generating diffuse pollution. When excess nutrients, in the form of nitrogen and phosphorus, enter water courses, they cause an overgrowth of plants and algae, resulting in eutrophication in lakes and rivers and vast dead zones in oceans and lakes that harm fish and devastate ecosystems (Bechmann and Stålnacke, 2019[28]).
The introduction of invasive species disrupts ecosystems and leads to ecological degradation. In the case of aquatic ecosystems, water quality can be degraded by negative changes in the diversity and abundance of species, as well as the characteristics of specific species that live within or near aquatic environments. For example, following its introduction in the early 1900s, water hyacinth has become one of the most important invasive alien plant species in China. By 2001, it had become a bio-disaster in Guangdong, Yunnan, Fujian, and Zhejiang. Water hyacinth tends to replace existing aquatic plants and form interlocking mats. These grow and decompose at a faster rate than the surrounding plants, affecting nutrient cycles, and posing threat to agriculture, fisheries, transportation and the environment (Jianqing et al., 2001[29]).

2.1.6. The planetary boundary for freshwater change has been crossed

These pressures do not operate in isolation but interact and amplify each other, accelerating ecosystem decline. Land conversion for agriculture, urban expansion, and infrastructure development disrupt hydrological cycles, while over-abstraction of water alters river flows and groundwater reserves. Climate change exacerbates water-related risks, making extreme events such as floods and droughts more frequent and intense. Pollution from agriculture, industry, and households further compromises water quality, while invasive species disrupt the balance of aquatic ecosystems. These interlinked challenges highlight the need for an integrated approach to managing water-related risks, ensuring that economic activities remain within ecological limits.

Recent analysis of freshwater resources across the globe shows that economic activity has pushed the planet’s freshwater cycle well outside of its pre-industrial stable conditions, and that the planetary boundary for freshwater change was surpassed by the mid-twentieth century (Porkka et al., 2024[30]; Richardson et al., 2023[31]). Drivers of change include notably dam construction, large-scale irrigation and global warming, which have altered the freshwater resources and put at risk their capacity to regulate vital ecological and climatic processes (Porkka et al., 2024[30]).

A better understanding of the role of green water is essential to understanding how freshwater change has crossed the planetary boundary. “Everywhere, from the boreal forests to the tropics, from farmland to forests, soil moisture is changing. Exceptionally wet and dry soils are increasingly the order of the day” (Wang-Erlandsson et al., 2022[3]). Green water feedbacks in the Earth system can either stabilise or amplify feedbacks. These refer to processes where changes in green water (e.g. soil moisture) influence other components of the Earth system, such as vegetation growth, evaporation, and rainfall patterns. These in turn can further alter soil moisture, either reinforcing (amplifying) or counteracting (stabilising) the original change. Green water-related amplifying feedbacks are increasing more than stabilising, suggesting that green water-related changes in the Earth system are amplifying challenges rather than stabilising, as seen in Figure 2.4.

An integrated approach to water-related risk management must consider both impacts and dependencies, ensuring that economic activities remain within planetary boundaries while also safeguarding financial stability. Recognising the interdependence between freshwater ecosystems, economic sectors, and financial markets is essential for developing policies and financial strategies that are resilient to emerging water-related risks and aligned with sustainable water management.

Figure 2.4. Green water-related feedbacks
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Source: adapted from (Wang-Erlandsson et al., 2022[3])

2.2. Water-related risks are diverse, dynamic and depend on multiple variables

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Common understanding of what constitutes a water-related risk often varies. Some focus on specific risks, such as water stress, while others would include a broader list of water-related hazards and trends. This lack of consistency is evident not only across disciplines, such as climate science, finance and economics (’Reisinger et al., 2020[32]; United Nations, 2016[33]). The following sections seek to clarify what can be construed as water-related risks, with view of supporting their identification, assessment and management.

2.2.1. Risks emerge from hazards, exposure, and vulnerability

Risk is not determined by a single factor

To conceptualise risks, key bodies such as the IPCC and the United Nations office for Disaster Risks Reduction (UNDRR) define three necessary components: hazard, exposure and vulnerability. Hazard refers to the potential occurrence of physical events or trends that may cause damage and loss. Exposure indicates the presence of assets, services, resources and infrastructure that could be adversely affected. Vulnerability is the propensity or predisposition to be adversely affected (’Reisinger et al., 2020[32]).

Further, risk is described by the IPCC as “the potential for adverse consequences for human or ecological systems, recognising the diversity of values and objectives associated with such systems”. “Relevant adverse consequences include those on lives, livelihoods, health and wellbeing, economic, social and cultural assets and investments, infrastructure, services (including ecosystem services), ecosystems and species” (’Reisinger et al., 2020[32]).

In the context of this report, economic and financial risks linked to water and freshwater ecosystems are explored. The NGFS provide a useful definition of nature-related risks that can be applied for water. They define physical and transition risks, as risks respectively “stemming from the degradation of nature and loss of ecosystem services” or “stemming from a misalignment of economic actors with actions aimed at protecting, restoring, and/or reducing negative impacts on nature” (NGFS, 2023[34]).

In terms of physical risks, the OECD Council Recommendation on Water refers to water-related risks, in terms of their potential likelihood and impact, including water shortage (e.g. droughts), water excess (e.g. floods), water pollution, and the risks of undermining the resilience of water-related ecosystems (e.g. wetlands, rivers, aquifers, lakes and interrelated components of the surrounding landscape) (OECD, 2016[35]). These water-related risks are the direct consequences of hazards on water availability, quality, or distribution, (too little, too much, or too polluted water), or on the resilience of freshwater ecosystems, as determined by exposure and vulnerability.

Sources of water-related transition risks are linked to the misalignment of economic activities with actions aimed at supporting water security including water policies and regulation, market sentiment, technology or others trends relating to the protection, restoration, or reduction of negative impacts on water resources and freshwater ecosystems. Actors exposed to transition risks are likely to be those that have the most impact on water and freshwater ecosystems, for example in terms of pollution or water use, and who consequently will be most impacted by actions aimed at supporting water security.

Physical and transition risks can have both microeconomic impacts, through damage to assets, disruption and relocation of activities, and macroeconomic impacts, through impacts on trade and capital flows, value chains, or socioeconomic changes. These impacts can then transmit to the financial system and adversely affect individual financial institutions in the form of traditional financial risk categories, or even financial systems as a whole if amplified by feedback loops within the financial sector (see Figure 3.1 in Chapter 3) (NGFS, 2024[36]).

Systemic risks are those arising from the breakdown of the entire system, rather than the failure of individual parts. These are characterised by modest tipping points combining indirectly to produce large failures with cascading of interactions of physical and transition risks (contagion), as one loss triggers a chain of others, and with systems unable to recover equilibrium after a shock (TNFD, 2022[37]).

Figure 2.5. TNFD definition of nature-related risks
Copy link to Figure 2.5. TNFD definition of nature-related risks

Assessments of sources of risks must be dynamic, with trade-offs between global and local dimensions

Hazards, exposure and vulnerability are each dynamic and subject to uncertainty. The IPCC highlights that “hazards, exposure and vulnerability may each be subject to uncertainty in terms of magnitude and likelihood of occurrence, and each may change over time and space due to socio-economic changes and human decision-making” (’Reisinger et al., 2020[32]). This means the assessment of risks cannot be done as a static exercise but rather requires the development and use of scenarios.

The essential first step to any scenario-based risk assessment is to generate narratives. Narratives are storylines that describe how the world could evolve in the future, considering likely socio-political, macro-financial and environmental trends. For the purposes of assessing nature-related risks, an essential component in narrative creation is to identify specific physical and/or transition risks that can become sources of economic or financial risks (depending on the exposure and vulnerability to hazards). Once the sources of risks are identified, it is then possible to study their micro- and macroeconomic impacts, and transmission channels to the financial system (see section 3.2.2 for further discussion on frameworks for assessing nature-related risks) (OECD, 2023[38]).

Identifying sources of physical and transition risks is particularly critical for building scenario-based assessments of water-related risks. Nature scenarios require consideration of how locally specific ecosystems, sectors and firms interact to understand how distinct policies and processes may drive changes at the smallest level and through very precise transmission channels. However, local socio-economic and environmental changes must be aggregated to maintain tractability for scenario development. This is especially important if the purpose is to assess macro-financially relevant impacts while providing a common language for central banks and financial supervisors internationally. Local issues are likely to have multiple indirect, complex and compounding features which can then have cascading effects along global value chains, across other sectors and economies, and through which they can become macro-financially and globally relevant (NGFS, 2023[39]).

Overcoming the local-global trade-off is not an easy task when attempting to assess both physical and transition risks. When assessing physical risks, scenario development should therefore be able to connect nature loss at the local scale (e.g., degradation and loss of wetlands) to its global drivers (e.g., rising global demand for agricultural commodities, timber, and biofuels, as well as land use change) and global impacts (e.g., disrupted rainfall patterns, reduced carbon sequestration accelerating climate change, biodiversity loss, and increased risk of zoonotic disease outbreaks) (Convention on Wetlands., 2021[40]).

The local-global trade-off for nature-related scenarios requires the use of frameworks that connect global macro and sectoral dynamics to local environmental changes. However, this makes nature scenario analysis inherently complex, requiring significant new work across central banks and academia to develop and then continue to refine and strengthen frameworks and methodologies to assess these risks.

The complexity of nonlinear patterns and interconnectedness in nature

Further compounding this challenge is the complexity of the natural system itself, including nonlinear patterns and interconnectedness between environmental processes (e.g., between climate and nature). These complexities pose additional challenges for scenario development. Ecosystem services, for instance, are not easily represented by a single metric, are largely non-substitutable, and tend to be complementary, increasing the difficulty of modelling their degradation or loss (IMF, 2024[41]).

Moreover, while risks are often considered as direct threats to specific sectors and geographies, evidence suggests that climate risk, especially when interacting with nature risk, are likely to materialise through the non-linear interaction of multiple risk drivers, leading to complex, cascading, and compounding risks (Ranger et al., 2023[42]). Existing risk assessments often focus on dependencies, which are equivalent to exposures, and fail to fully account for these cascading dynamics, resulting in a potentially significant underestimation of the scale and severity of risks. The challenge is heightened by the fact that it is often difficult to measure or predict when and at what scale environmental degradation will occur, due to the tipping-point behaviour of many ecological systems (NGFS, 2023[39]).

Interactions between climate and nature can further amplify systemic risk. For example, deforestation can increase flood risks, and flooding after a drought can raise the likelihood of landslides. Climate change can exacerbate nature-related risks: a normally non-threatening level of water pollution, when combined with drought conditions, can lead to unusable water and widespread ecosystem degradation (UN WATER, 2011[43]; Ma et al., 2020[44]). It has been estimated that degradation of water quality through pollution exacerbates water scarcity in more than 2 000 of the over 10 000 sub-basins worldwide. This represents a tripling of water scarcity due to anticipated future nitrogen pollution globally (Wang et al., 2024[45]).

These examples highlight why risk assessments must explicitly account for the interplay between climate and nature to avoid underestimating the true level of risk. They must also incorporate the possibility of tipping points and cascading effects in scenario development and modelling (Ranger et al., 2023[42]).

The likelihood of reaching tipping points increases when the planet’s safe operating space, as defined by the planetary boundaries’ framework, is crossed. Planetary boundaries are thresholds in Earth system processes beyond which abrupt or irreversible environmental change may occur. Evidence suggests that several of these boundaries, including for water, have already been exceeded due to human pressures (Richardson et al., 2023[31]).

In light of these scientific insights, it becomes even more critical that narratives used in nature-related scenarios strike a balance between capturing locally specific environmental changes and maintaining global relevance. That is: the more global and aggregated the scenario narrative, the less it may capture the local specificities that are essential to understanding the dynamics of nature-related risks, potentially even more so than for climate-related scenarios.

These insights underscore the importance of designing nature-related scenarios that are both scientifically grounded and practically applicable. For water-related risks in particular, scenario narratives must account for the complexity, spatial variability, and ecosystem dependencies of freshwater systems. Water-related risks, whether driven by scarcity, pollution, or ecosystem degradation, are inherently local and basin-specific, shaped by hydrological, ecological, and socio-economic conditions. This often requires more localised scenario construction than is typical for climate scenarios, which tend to operate at broader spatial scales.

In other words, global or aggregated scenario frameworks may fail to capture the critical sub-basin dynamics, tipping points, and feedback loops that make water-related risks so acute, especially where pollution, biodiversity loss, and climate change interact. This presents a methodological challenge for integrating climate and nature scenarios, as water-related risks often operate on different spatial and temporal scales and require tailored modelling approaches. Scenario design must therefore strike a careful balance, anchoring in local hydrological and ecological realities, while still linking them to macroeconomic and financial system dynamics (NGFS-INSPIRE, 2022[46]).

2.2.2. Physical water-related risks arise from too much, too little, or polluted water

In this section, four categories of source of physical risks are described in detail: these relate to too much, too little, polluted waters and disruption of freshwater systems. This follows the framing of water-related risks provided by the OECD Council Recommendation on Water (OECD, 2016[14]). Water-related risks are discussed in the following sections in terms of potential economic risks. However, it should be noted that there are numerous highly critical environmental and social impacts, such as loss of human life and psychological trauma, which are not covered in the scope of this discussion.

Too much - economies are seeing increasing risk from excess of water

Too much water, whether due to extreme precipitation, storm surges, or infrastructure failures, poses significant risks to communities, economies, and ecosystems. Flooding is a rapid-onset hazard that can cause immediate and widespread damage. Floods occur when water exceeds the natural or built capacity to absorb or redirect it, often triggered by intense rainfall, overflowing rivers, coastal storm surges, or dam failures. Climate change exacerbates these risks by increasing the frequency and intensity of extreme weather events, altering rainfall patterns, and accelerating sea-level rise (Seneviratne et al., 2023[47]).

Importantly, changes in green water can either exacerbate or alleviate flood impacts. Green water enables the landscape to absorb and retain excess rainfall, buffering against runoff and downstream flooding. Degraded soils and loss of vegetation reduce this buffering effect, thereby increasing flood risks, whereas healthy soils and restored ecosystems enhance resilience. (Global Commission on the Economics of Water, 2024[2]).

The consequences of excess water can be far-reaching, affecting public health, food security, infrastructure, and economic resilience and financial stability. The economic implications of excess water are substantial. Flood-related economic losses exceed USD 100 billion annually, with costs projected to rise due to urban expansion, inadequate drainage infrastructure, and climate change-driven extreme weather (Bangalore et al., 2017[48]). As the impacts of climate change increase, with view of increasingly severe and frequent incidences of flooding, such as in Central Europe in 2021, that is estimated to have caused economic losses amounting to USD 54 billion (Naik, 2021[49]).

Flooding significantly impacts key economic sectors, including agriculture, energy, water supply, construction, manufacturing, transportation, and real estate. Coastal and riverine flooding threatens urban centres, disrupting transport networks, damaging the built environment, and leading to significant economic losses. For agriculture, excess water can lead to soil erosion, crop loss, and prolonged waterlogging, damaging yields and food production. Power plants, oil refineries, and manufacturing facilities are susceptible to operational disruptions due to inundation. Moreover, extreme precipitation events increase runoff contamination, leading to deteriorating water quality and heightened risks to public health.

The built environment notably in urban centres is particularly at risks from flooding, where this can disrupt transport networks, damage buildings, and lead to significant economic losses. Financial and insurance industries are increasingly exposed. As more properties and businesses suffer repeated flooding, the number of claims rise, increasing the insurance payouts owed. The real estate and mortgage markets are also vulnerable, as properties in flood-prone regions may face declining values and increased default risks.

Businesses and individuals may bear a large share of the costs. Increasing risk of flooding may lead to rising premiums, and the potential withdrawal of coverage in high-risk areas. Moreover, when risks materialise, they are already often uninsured, which means that society overall bears the costs. For instance, flooding in 2021 led to USD 82 billion in economic losses globally, of which only USD 20 billion were insured (SwissRE, 2022[50]).

Too little - risks from a shortfall of water are also on the rise

At least half the global population (4 billion people) already live with water shortages for at least one month of the year (Kuzma, Saccoccia and Chertock, 2023[51]). By 2050, an estimated 52% of the world’s population is projected to live in water-stressed regions (Colin et al., 2018[52]). A study in the United States found that nearly half of its 204 freshwater basins may not be able to meet the monthly water demand by 2071 (Brown, Mahat and Ramirez, 2019[53]).

Water scarcity is a relative concept determined by the availability of usable water in relation to its economic, environmental, and social demands for consumptive use. Demand and supply of water are both crucial elements influencing the availability of usable water. Water scarcity intensifies as demand increases, in addition to (or alternatively), as water supply is affected by decreasing quantity or quality. Acute water stress occurs when the demand for water exceeds the available supply within a short period. It is mostly driven by intensive water use as well as water pollution. Traditional metrics often undercount water stored in soils and vegetation (green water). Green water, soil moisture and vegetation, provides about half of land-based rainfall, fundamental for crop growth and ecosystem health (Global Commission on the Economics of Water, 2024[2]).

Drought differs from other extreme events, droughts have developed slowly, making them hard to detect. Drought is generally defined as a slow on-set disaster, characterised by a lack of precipitation and resulting in water shortages (WMO, 2023[54]). However, as soils get drier, fast-evolving drying events have become increasingly common, especially in the last decade (2011 - 2021). These are driven by changes in temperature and precipitation, coupled with atmosphere-ocean interactions, like El Niño in the equatorial Pacific Ocean, which drive important soil moisture variations (Iglesias, Travis and Balch, 2022[55]).

Because of the complexity of drought there is no single definition that can apply in all circumstances. The World Meteorological Organisation categorises identified different categories of drought. The first is meteorological drought driven by the atmospheric conditions resulting in the absence or reduction of precipitation over a period. This can then lead to agricultural drought identified by precipitation shortages, higher evapotranspiration and soil moisture deficits. Meteorological drought can also lead to hydrological drought, which develops from depleted surface or subsurface water supplies. Socioeconomic drought is the imbalance in supply and demand of water, or the effect of water shortages on the economy (such as crop losses) and society (such as impacts on health) (WMO, 2023[54]). Drought can have devastating and costly impacts on society, the economy and ecosystems.

From an economic perspective, industries with the highest dependence on water, such as agriculture, industry, and energy production, are particularly vulnerable to risks associated with decreasing water availability. Agriculture is the largest consumer of freshwater, with irrigation accounting for around 70% of global water use and over 40% in many OECD countries (FAO, 2024[56]). As well being exposed this also makes it a large contributor to global water stress. This heavy demand is driven by the need to support extensive crop production, particularly in regions with limited rainfall. Inefficient irrigation methods and the cultivation of water-intensive crops exacerbate the strain on water resources.

Industry and energy depend heavily on water (UN Water, 2018[57]) (IEA, 2016[58]). The energy sector alone is responsible for about 10% of global withdrawals, UN Water estimates that the industrial sector also plays a major role in water stress, accounting for approximately 20% of global water consumption (UN Water, 2018[57]). Industries such as manufacturing, mining, and chemical processing use vast amounts of water for a range of activities, including cooling systems, production processes, and cleaning. Water is also essential for cooling in power plants, including those that generate electricity from fossil fuels, nuclear power, and biofuels. The extraction and processing of fossil fuels and biofuels requires considerable water resources (IEA, 2016[58]). Rapid advances and use of artificial intelligence (AI) are also driving increased water usage. AI server cooling consumes significant water, with data centres using cooling towers and air mechanisms to dissipate heat. In addition, data centres rely on electricity which indirectly increase data centre’s water footprints and AI chip and server manufacturing also uses a large amount of water (Li et al., 2025[59]).

Polluted water - there is growing awareness of risks arising from pollution

People, biodiversity, and economic activities rely not only on the availability of freshwater but also on its quality. Water pollution occurs when harmful substances contaminate water bodies, degrading their quality and making them unsuitable for human, agricultural, or industrial use, or impacts on biodiversity and the health of ecosystems. Water pollution is a challenge faced by developed and developing countries alike. In developing economies, untreated wastewater is often cited a key issue. Yet, globally, water is being contaminated by agricultural run-off and emerging contaminants including pharmaceuticals, hormones, industrial chemicals, detergents, cyanotoxins and nanomaterials. In a study of 258 of the world’s rivers, over a quarter of these were found to have concentrations of active pharmaceutical ingredients that exceeded safe limits (Wilkinson et al., 2022[60]). Pollution degrades not only the visible water in rivers and lakes, but also the green water stored in soils and plants. Contaminated soils and reduced vegetation due to land use change erode the landscape’s ability to filter pollutants (Global Commission on the Economics of Water, 2024[2]).

Pollutants can be chemical, biological, or physical, with sources ranging from agricultural runoff and industrial discharges to untreated wastewater and urban stormwater runoff (European Commission, 2022[61]) (see Table 2.2). Water pollution can be either acute or chronic. Acute pollution results from sudden contamination events, such as industrial spills, oil leaks, or untreated sewage discharges, which cause immediate and severe damage to water quality and aquatic ecosystems. In contrast, chronic pollution occurs gradually over time, with contaminants accumulating from ongoing industrial activities, agricultural runoff, or persistent mismanagement of wastewater. Chronic pollution has long-term environmental and health consequences, contributing to ecosystem degradation and waterborne diseases.

Pollutants	Examples	Sources
Chemical pollutants	Pesticides, herbicides, heavy metals, industrial chemicals, excess nutrients (nitrogen, phosphorus), pharmaceuticals	Agriculture, industrial production, mining, waste and landfills, urban wastewater
Physical pollutants	Sediment, thermal pollution, solid waste, microplastics, radioactive metals, turbidity	Construction, deforestation, waste disposal
Biological pollutants	Algal blooms, fungi, biofilm, invasive species, pathogens	Untreated wastewater, agricultural runoff

Source: Authors.

Agriculture is the largest contributor to water pollution worldwide, primarily through the use of fertilisers, pesticides, and intensive irrigation (FAO, 2024[56]; UN Water, 2018[57]). Excess nitrogen and phosphorus from fertilisers wash into rivers and lakes, triggering eutrophication and algal blooms, which deplete oxygen levels and threaten aquatic ecosystems. Agricultural runoff is particularly problematic in regions with intensive farming and heavy rainfall, where pollutants enter watercourses rapidly. Pesticide residues also persist in water bodies, contaminating drinking water and affecting biodiversity. In one notable example, Mar Menor, a coastal lagoon in Spain of great ecological and socio-economic value, has experienced significant environmental degradation in recent years. Agriculture has been identified as a major source of excessive external nutrient input, particularly nitrogen and phosphorus, mainly from non-point source (NPS) pollution. Frequent torrential rainfall events cause intense surface runoff, leading to large inflows of water carrying high pollution loads into the coastal lagoon. As a result, eutrophication has significantly degraded water quality, with severe consequences for the local economy, particularly in the fishery and tourism sectors (Senent-Aparicio et al., 2021[62]; García-Pintado et al., 2007[63]; Jimeno-Sáez et al., 2020[64]).

Industrial activities contribute to water pollution through cooling processes, cleaning, and the discharge of hazardous waste. Key pollutants include heavy metals (lead, mercury, cadmium), organic compounds, and synthetic chemicals used in production. The metals and mining industry is a primary source of metal pollution, while the information technology sector generates wastewater containing toxic substances from semiconductor and circuit board production. Textile manufacturing also has a high pollution footprint, particularly in Asia, due to wastewater discharges from dyeing processes. Unlike general sewage, industrial waste requires specialised treatment, yet many facilities lack sufficient wastewater treatment infrastructure, leading to direct pollution of rivers and groundwater (CERES, 2022[65]). In addition, industrial accidents, including chemical leaks, oil spills, and hazardous waste releases, cause severe water contamination. Chemical spills introduce toxic substances into drinking water supplies and aquatic ecosystems (Laurent et al., 2024[66]). In the United States of America alone, more that USD 1.23 billion has been spent from 2004 to 2023 in cleaning up toxic legacy pollutants from manufacturing in waterways around the Great Lakes, with a significant effect on housing prices in the vicinity (Cassidy, Meeks and Moore, 2023[67]).

Urbanisation is connected to a large share of water pollution. Globally, 80% of wastewater is discharged back into ecosystems untreated, introducing pathogens, organic matter, and heavy metals into water bodies (UN Water, 2018[57]). Urban runoff, rainwater flowing from impervious surfaces such as roads, rooftops, and parking lots, washes pollutants like oil, heavy metals, and debris into storm drains, which often discharge directly into waterways (Lapointe, Rochman and Tufenkji, 2022[68]). Additionally, leachate from landfills introduces hazardous substances such as pharmaceutical residues and industrial chemicals into groundwater. The economic costs of water pollution are high. The World Bank estimates the cost of inadequate sanitation at USD 260 billion every year globally, linked to premature death health care expenses and loss of productivity (World Bank Group, 2019[69]).

There is increasing concern over PFAS (per- and polyfluoroalkyl substances), which are a large group of chemicals consisting of approximately 10 000 different compounds. These are also referred to as ‘forever chemicals’, given their extreme persistence in the environment. PFAS pollution in water can harm human health as well as the environment (Kurwadkar et al., 2022[70]). Early estimates suggest that the cost of treating PFAS will be large, with some estimates as high as USD 1.6 trillion in the United Kingdom and Europe over a 20-year period (Hosea and Salvidge, 2025[71]).

Despite decades of monitoring efforts, a significant water quality data gap still persists at the global level. Key challenges include insufficient data collection, inadequate ambient water quality standards, and resource-intensive monitoring processes that are not accessible in all countries. In-situ water quality assessments often require laboratory analysis, skilled technicians, and well-developed research infrastructure, limiting widespread data availability. Additionally, transboundary water bodies present challenges for data-sharing due to political sensitivities and regulatory discrepancies (UNEP, 2024[72]).

Disruption of freshwater ecosystems

An annual estimate of the economic value of water and freshwater ecosystems is over USD 11.44 trillion (EUR 11 trillion) in Europe (WWF, 2023[73]). Degradation of rivers, lakes, wetlands and aquifers threatens their economic value and their irreplaceable role in sustaining human and planetary health (WWF, 2023[73]). Direct economic benefits, such as water consumption for households, irrigated agriculture and industries, amount to a minimum of nearly USD 1 trillion (EUR 1 trillion) annually in Europe. It is also estimated that the unseen benefits, which include purifying water, enhancing soil health, storing carbon, and protecting communities from extreme floods and droughts, are ten times higher at around USD 10.4 trillion (EUR 10 trillion) annually (WWF, 2023[73]).

Disruption to freshwater ecosystems is increasing. Freshwater biodiversity has fallen by 84% between 1970 and 2021 globally, recording the highest decline across all ecosystems, i.e. when compared to terrestrial and oceanic ecosystems (WWF, 2022[21]). Native migratory freshwater fish species have declined by 81% globally, though some populations (31%) have increased (Deinet et al., 2024[74]). Deteriorating water quality due to pollution is one of the key drivers of ecosystem degradation, amongst others that include hydro(morpho)logical changes, land use change, climate change and invasive species. For example, habitat fragmentation interrupting surface water flows, through dams, weirs and sluices, trigger biodiversity losses (Parasiewicz et al., 2023[75]).

The rapid degradation of freshwater ecosystems is a critical driver of biodiversity loss, with cascading effects on terrestrial and marine ecosystems, human well-being, and economic stability. Given that all life depends on accessible, high-quality water, the continued decline of freshwater biodiversity threatens global food security, climate resilience, and economic sectors reliant on healthy aquatic systems.

The disruption of freshwater ecosystems means the disruption of the delivery of ecosystems services on which our societies and economies rely. These include provisioning services (resources humans directly obtain), regulating services (processes that maintain environmental balance), cultural services (non-material benefits, such as recreation and spiritual value) and supporting services (underlying ecological processes that enable all other services) (Millennium Ecosystem Assessment, 2005[76]).

Table 2.3 provides a non-exhaustive list of ecosystem services provided by different types of freshwater ecosystems.

Ecosystem	Provisioning Services	Regulating Services	Cultural Services	Supporting Services
Freshwater Ecosystems (Rivers and Streams, Lakes, Artificial Wetlands)	Water supply: provide fresh water for drinking, irrigation, and industrial use, transport. Food resources: support fisheries yielding fish, crustaceans, and molluscs. Raw materials: supply materials like reeds for construction and crafts.	Water purification: natural filtration of pollutants, enhancing water quality. Flood regulation: mitigate flooding by absorbing excess rainfall. Climate regulation: influence local climates through evapotranspiration.	Recreation and tourism: opportunities for boating, fishing, and nature observation. Spiritual and aesthetic value: hold cultural significance and natural beauty.	Habitat provision: support diverse flora and fauna. Nutrient cycling: facilitate the circulation of essential nutrients. Soil formation: contribute to the development of fertile soils.
Freshwater-Marine Transitional Ecosystems (Semi-Confined Transitional Waters)	Fishery resources. Nurseries for various marine species. Salt production.	Coastal protection. Buffer against storms and tidal surges. Water quality maintenance. Trap sediments and detoxify pollutants.	Cultural heritage. Sites of historical and archaeological importance. Educational and research opportunities: unique environments for scientific study.	Biodiversity support. High species diversity due to the mix of fresh and saltwater habitats. Primary production support complex food webs through photosynthetic activity.
Marine-Freshwater Transitional Ecosystems (Brackish Tidal Zones)	Aquaculture: suitable for farming species like shrimp and certain fish. Timber and plant products: mangroves and other vegetation provide wood and plant materials.	Erosion control: stabilise shorelines and prevent land loss. Carbon sequestration.	Recreational activities: bird watching, fishing, and ecotourism. Cultural practices: integral to the traditions of coastal communities.	Nursery habitats: crucial breeding grounds for many marine organisms. Detritus processing: breakdown and recycling of organic materials.
Terrestrial-Freshwater Transitional Ecosystems (Palustrine Wetlands)	Freshwater supply: source of water for various uses. Edible plants and animals: harvesting of wild rice, berries, and game.	Flood mitigation: absorb and slowly release floodwaters. Groundwater recharge: facilitate the infiltration of water to aquifers.	Traditional practices for many indigenous peoples. Nature-based tourism for wildlife viewing and recreation.	Species habitat: support a range of terrestrial and aquatic species. Biogeochemical cycling: play a role in the transformation and movement of chemicals in the environment.

Source: adapted from (Millennium Ecosystem Assessment, 2005[77]) (Barbier et al., 2011[78]) (Costanza et al., 1997[8]) (Costanza et al., 2014[9]) (Duke et al., 2014[79]).

1. In particular, wetlands uniquely contribute across all service categories in ways that many other ecosystems do not. Their ability to store and regulate water, purify pollutants, provide carbon sinks, and support diverse species makes them one of the most functionally important ecosystems on Earth (Millennium Ecosystem Assessment, 2005[76]). The Millennium Ecosystem Assessment of ecosystem services provide or derived from wetlands is therefore presented in Table 2.4.

Type of services	Service	Examples
Provisioning	Food	Production of fish, wild game, fruits and grains
	Water supply	Storage and retention of water for domestic industrial or agricultural use
	Fiber and fuel	Production of logs, fuelwood, peat, fodder
	Biochemical	Extraction of medicines and other materials from biota
	Genetic material	Genes for resistance to plant pathogens, ornamental species
Regulating	Climate regulation	Source of and sink for greenhouse gases; influence local and regional temperature, precipitation, and other climatic processes
	Water regulation (hydrological flows)	Groundwater recharge/discharge
	Water purification	Retention, recovery, and removal of excess nutrients and other pollutants
	Erosion regulation	Retention of soils and sediments
	Natural hazard regulation	Flood control, storm protection
	Pollination	Habitat for pollinators
Cultural	Spiritual and inspirational	Source of inspiration; many religions attach spiritual and religious values to aspects of wetland ecosystems
	Recreational	Opportunities for recreational activities
	Aesthetic	Many people find beauty or aesthetic value in aspects of wetland ecosystems
	Educational	Opportunities for formal and informal education and training
Supporting	Soil formation	Sediment retention and accumulation of organic matter
Supporting	Nutrient cycling	Storage, recycling, processing, and acquisition of nutrients

Source: (Millennium Ecosystem Assessment, 2005[76]).

Green water and changes in the hydrological cycle

Considering freshwater ecosystems alone only partially considers green water, which consists of terrestrial precipitation, evaporation and soil moisture, which play a crucial role across all terrestrial, freshwater and marine ecosystems. These systems act as watersheds and water sinks within the global hydrological cycle. Therefore, an ecosystem approach limited to freshwater ecosystems as they are typically defined may fall short of capturing risks linked to green water.

Changes in soil moisture and atmospheric moisture, often referred to as green water, are increasingly recognised as critical, yet still underappreciated, drivers of water-related risks globally. Research commissioned by the Global Commission on the Economics of Water underscores that shifts in these terrestrial moisture stocks play a fundamental role in the stability of the hydrological cycle, food systems, and local as well as regional climate patterns. Declines in soil and atmospheric moisture can disrupt moisture recycling, reduce precipitation, and intensify droughts, leading to cascading risks for agriculture, ecosystem health, and even water supply security for cities (Global Commission on the Economics of Water, 2024[2]).

The destabilisation of soil and atmospheric moisture stocks is linked to land degradation, deforestation, and unsustainable agricultural expansion, which reduce the land’s ability to retain and recycle water. As the report highlights, these changes can push regions past tipping points, triggering more frequent or severe drought and amplifying risks to food production and livelihoods. Furthermore, these dynamics are not isolated: the disruption of moisture flows in one region can have profound effects on rainfall and water availability in distant areas, owing to the interconnected nature of atmospheric water transport.

From an economic risk perspective, failure to account for green water dynamics exposes countries and markets to unforeseen supply chain shocks, yield losses, and cross-sectoral water crises (Global Commission on the Economics of Water, 2024[2]).

Untangling sources of water-related risks

The first three water-related risks - too much, too little, and polluted water - refer to quantifiable water-related pressures that directly impact human systems (e.g., shortages, infrastructure damage, health risks), and that can be viewed directly as hazard and trends. In contrast, disruption to freshwater ecosystems may be triggered by water-related risks and, in turn, amplify them. This can either be acute (triggered by shocks, such as extreme weather events, droughts, floods), and/or chronic, for example linked to gradual changes associated with pollution stemming from pesticide use or climate change. Given the complexity of freshwater ecosystems, their degradation and potential collapse should be assessed through a broader lens that considers interconnected environmental, social, and economic drivers and impacts.

Physical risks such as flooding and drought are highly correlated with climate change and the modelling of water-related risks will not be accurate without considering climate scenarios. NGFS scenarios are originally designed to facilitate climate scenario analysis for central banks and supervisors and are now widely accepted by financial practitioners as useful scenarios. Instead of covering all Shared Socioeconomic Pathways (SSP) scenarios presented in IPCC AR6, all of NGFS scenarios are based on SSP 2 “Middle of the road” with variations on how policy actions may evolve in the future, and classified into “orderly transition”, “disorderly transition” and “Hot house world” (NGFS, 2020[80]). Targeting financial sector audience, water-related physical risks are well covered by projection on capital asset damages, crop yield losses, and labor productivity decline due to flood/cyclones, droughts and heatwaves respectively (NGFS, 2024[81]).

Assessing water-related risks through a nature lens requires looking at the degradation of freshwater ecosystems or the impact of hazards on ecosystem services. However, this is not a simple task as there is no agreed-upon means or easily identifiable metric for aggregating environmental data to assess ecosystem health or ecosystem degradation, meaning that nature-related scenarios will need to build on a large number of metrics and indicators (NGFS, 2023[39]). There is therefore an important role for judgment and expertise in identifying and prioritising disruption of freshwater systems. Notably, integrating soil and atmospheric moisture (green water) into water risk assessment will be essential for anticipating systemic hazards linked to changes in the hydrological cycle, ecosystem services, and food security (Global Commission on the Economics of Water, 2024[2]).

As discussed further in Chapter 4.1, different approaches can be taken to identify and prioritise risks in assessments of nature-related risks. For the purpose of developing narrative scenarios to assess nature-related financial risks, including those pertaining to water, the NGFS suggest using of a framework based on the Environmental Sustainability Gap – Strong Environmental Sustainability index (ESGAP-SESi). This provides an aggregate measure for identifying the distance between the current state and a “healthy” operating state for different ecosystems. As such, it is a tool that can help identify which freshwater ecosystems and their functions are more degraded than others, and thus more likely to collapse. This can help to translate the broad concept of planetary boundaries into observable trends at the national scale (NGFS, 2023[39]).

A second option for identifying physical hazards has been developed by a team of researchers at Oxford University as part of the INCAF2 project. The INCAF-Oxford team has developed an indicator-based approach, which focuses on hazards (i.e., shocks) to natural capital, and their relationships to specific ecosystem services in a particular country or region. This work is based on a long list of potential material hazards (and associated risks) generated by nature loss and degradation of ecosystem services, many of which are linked to water. Hazards were then mapped forwards to economic impacts and backward to ecosystem services, natural assets and drivers of degradation along the impact chain. An indicator approach is used to identify and understand the most important material financial risks to a country, sector, or portfolio (NGFS, 2023[39]).

2.2.3. Transition risks grow as water policy and regulation evolve

Nature transition risks can be defined as the misalignment of economic activities with actions and developments aimed at protecting, restoring and reducing negative impacts on nature (FSB, 2024[82]; NGFS, 2024[36]). Taking a finance lens, transition risks result from a misalignment between an organisation or an investor’s strategy and management, and the changing landscape in which it operates (TNFD, 2022[37]). These can be broadly categorised as risks stemming from developments aimed at halting or reversing the damage to nature, such as government regulations or policy, technological developments, market changes and reputational pressures. Understanding the sources of transition risks is therefore important to understand how the changing landscape may impact economic activities, sectors and the financial system.

Water related transition risks

Taking a water lens, transition risks arise from the misalignment between economic activities with evolving policies and initiatives aimed at managing, protecting and restoring water resources and freshwater ecosystems. Notably, sectors that have the largest impacts on water resources, through consumption or pollution, are likely to be those most exposed to more stringent controls or changing sentiment. Assessments of water impacts can serve as indicators of transition risk exposure. Although, the assessment of water-related transition risks is highly contextual, varying by region, industry, and regulatory environment. A non-exhaustive list of potential transition risks is included in Table 2.5. This in-depth view of transition risks is too granular for macroeconomic modelling exercises but provides useful context on what can be a source of transition risk.

Transition risk	Description
Policies and regulations	Ecosystem protection and restoration: policies to protect or restore freshwater ecosystems, legislation and targets that support nature markets, land-use and urban planning. Stringent regulations: new water use, discharge, pollution control regulation or conservation rules. Permitting and Licensing Issues: delays or rejections for water-related projects due to policy changes or environmental concerns. Reforming harmful subsidies: scaling back or eliminating harmful subsidies. Economic instruments: water allocation and rights, water pricing and tariffs, environmental taxes and charges, tradeable permits.
Market dynamics	Changing demand due to greater consciousness of water impacts.
Technological shifts	Transition toward more water efficient technologies, water treatments, reuse or desalination.
Reputational risks	Negative public perception or loss of trust due to water mismanagement. Opposition to water-intensive industries or perceived environmental harm. Lawsuits related to water contamination, overuse, or environmental damage.

Source: Authors.

With respect to policies and regulations, for nature, the Kunming-Montreal Global Biodiversity Framework (the Global Biodiversity Framework) is widely seen to be a driver of transition towards nature protection and restoration. Therefore, is also seen as a key driver of nature-related transition risks for financial and economic activities. Particularly, target three, sets out that countries should ensure and enable that by 2030 at least 30% of terrestrial and inland water areas, and of marine and coastal areas are effectively conserved and managed. This notably refers to areas of particular importance for biodiversity and ecosystem functions and services (CBD, 2022[83]). A number of other international environmental agreements create legal commitments for governments on freshwater ecosystems, such as the Ramsar Convention on Wetlands that imposes legal commitments on governments to restore and protect wetlands, which could alter water and land-use regulations in specific regions (Ramsar Convention Secretariat, 1971[84]).

Water management regulations could also be a source of transition risks. Implementation of stringent water use policies, including caps on extraction and higher tariffs, could affect sectors that are heavily reliant on water. Enforcement of regulations limiting pollutants, such as nitrates and phosphorus, create the obligation to invest in cleaner technologies and processes. Similarly, reduction or elimination of subsidies that encourage excessive water use can alter economic incentives, affecting profitability.

To give a few illustrations, one of the key regulatory developments influencing water-related transition risks in Europe is the EU Water Framework Directive3 and related directives, which require member states to achieve good qualitative and quantitative status for all water bodies. This translates into tightening regulatory controls on water abstraction, discharge permits, and pollution thresholds. Under the new Urban Wastewater Treatment Directive, pharmaceuticals and cosmetics industries, whose products create the most micropollutants in treated wastewater, are required to pay at least 80% of the cost for their removal, which could impact on the profitability or operations of these companies (European Commission, 2024[85]). In addition, Water Disclosure in EU regulation can lead to reputation risks as firms must disclose on water use and pollution. Disclosure regulation is discussed further in Chapter 5.3.2.

Market dynamics can also be impacted by shifts in consumer preferences. Growing public awareness of water sustainability can drive demand towards products and services with lower water footprints, impacting the market share for certain businesses.

As industries adopt water-saving technologies to comply with new regulations or to enhance sustainability, there may be significant capital expenditures and changes in competitive dynamics. The development of desalination or water recycling methods can mitigate risks but require substantial investment and operational changes.

Mismanagement of water resources can lead to negative publicity, affecting brand reputation and customer loyalty. Companies may face lawsuits or fines related to water contamination or overuse, leading to financial and reputational damage. The legal challenges to Tesla in 2021 are an illustrative example, which had the potential to delay or even stop Tesla’s USD 5.7 billion Brandenburg manufacturing project, with implications for the project’s investors and lenders. The Nabu and Gruene Liga groups sued Brandenburg's environment office, citing a failure to take into account the impact of climate change when approving a 30-year permit to pump more groundwater for Tesla's factory (Bloomberg, 2022[86]).

Physical and transition risk interplay, where climate-induced alterations in water availability can exacerbate transition risks. For instance, water scarcity may prompt stricter regulations or necessitate costly infrastructure investments. For instance, in response to water shortages, South Africa’s National Water Act4 mandates licensing for water abstraction, impacting water-intensive industries such as mining and agribusiness. Central banks should integrate climate models with economic scenarios to capture these complex interactions.

Interactions between climate-related transition and water-related risks

Climate-related transition risks are typically defined as risks arising from the adjustment to a low-carbon and more sustainable economy, including changes in policy, regulation, technology, market expectations, and societal preferences. These risks are often considered primarily in the context of carbon and energy transitions (TCFD, 2017[87]).

However, the low-carbon transition is inseparable from changes in how water resources are regulated, allocated, and valued. Climate-centric transitions will therefore affect water. The intersection of climate and water transition risks is particularly pronounced as many mitigation and adaptation strategies, such as renewable energy, green hydrogen, or resilient infrastructure, have significant implications for water demand and water stress.

Policies or incentives introduced as part of climate action can unintentionally create new pressures on water resources (Juhola et al., 2016[88]). For example, expanding water-intensive industries (such as hydrogen production or batteries) to support decarbonisation goals may intensify competition for finite water supplies, crowding out existing users and leading to potential regulatory intervention (Helerea, Calin and Musuroi, 2023[89]).

These risks can be compound. A policy intended to accelerate the climate transition can increase water scarcity or pollution if water externalities are not accounted for. Therefore, risks may materialise as both transition and physical risks, with knock-on effects for companies, investors, and lenders.

Conversely, climate transition risks may also have positive consequences for water security, for example growing consumer awareness of climate-driven water scarcity can drive demand for products with a lower water footprint. Carbon pricing and related climate policies can lead to higher operational costs for water-intensive industries, through increased energy costs embedded in water treatment and supply, which could lead to new investment in water-efficient technologies or water reuse. Some examples are illustrated in Table 2.6.

Climate transition risk	Description	Example of positive or negative impacts on water
Policy & Legal Risks	New carbon regulations, emissions targets, adaptation laws	Climate-driven water allocation limits, stricter abstraction permits.
Technology Risks	Shift to low-carbon tech and innovations	Adoption of water-intensive green hydrogen or cooling tech.
Market Risks	Changing consumer preferences, carbon pricing	Demand shifts to low-water products. Cost increases that are passed on through water tariffs.
Reputational Risks	Stakeholder expectations on climate action	Water stewardship scrutiny as part of broader sustainability reputation.

Source: Authors.

For financial institutions, it is important to recognise that climate transition scenarios may not adequately capture the full range of water-related transitions necessitated by climate change, particularly where shifts in water policy, pricing, or allocation create "shocks" or abrupt changes for specific sectors or geographies. Incorporating water-related risk alongside decarbonisation pathways and using narratives or scenarios that anticipate water policy developments and scarcity shocks, is important for robust risk modelling and strategic decision making.

There is no one single target for water

Scenarios that combine nature and climate are still in early stages. This is challenging because of the difficulty of integrating the local dimensions of nature risks.

To understand climate-related financial risks, international frameworks can provide a set of global goals and targets and standardised indicators around which transition risks are identified. However, unlike for climate, for water there is no global convention nor single global target, akin to the 1.5°C global temperature change. Unlike climate transition risks, which often have global indicators (e.g., carbon pricing, net-zero commitments), water-related risks tend to be localised and highly sector-specific. Similarly, while climate transition risks may affect global markets in relatively predictable ways, freshwater transition risks are shaped by regional policies and local or regional ecological conditions (except for the disturbance of the global hydrological cycle). This lack of a uniform metric makes it challenging for financial institutions to quantify and compare freshwater-related transition risks across jurisdictions.

As stated by the Financial Stability Board, nature transition risks may become particularly relevant as the global policy agenda on biodiversity loss progresses (FSB, 2024[82]). Attempts at defining nature transition risks, such as the United Nations Principles of Responsible Investment (UNPRI)’s Inevitable Policy Response Climate and nature scenario, identify new nature transition trends including nature markets, land protection and land restoration as risks drivers, alongside well-established climate transition risks such as emission pricing (UNPRI, 2023[90]).

The Kunming-Montreal Global Biodiversity Framework has been a significant diver of nature-related commitments, including for water. It underscores the critical role of freshwater ecosystems in global biodiversity conservation and sets forth ambitious targets to protect and restore inland water systems, recognising their importance for both ecological health and human well-being. But the way that targets are implemented will depend on the context and natural characteristics (CBD, 2022[83]).

There are a variety of policies and socioeconomic evolutions that could be implemented to reverse nature loss and protect freshwater ecosystems. It is therefore important to focus on specific items and translate them into potential ‘shocks’ for specific countries and sectors. The outcomes of such narratives could then be used as inputs to economic models and tools aimed at assessing nature-related risks. This could include, for example:

Economic shocks from water policy changes (e.g., tariff increases, protected area expansion, pollution and water quality standards).
Sector-specific credit risks (e.g., higher loan default risks in water-intensive industries).
Capital reallocation trends (e.g., shifting investment from water-exposed industries to water resilient ones).

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Notes

Copy link to Notes

← 1. Realm: one of five major components of the biosphere that differ fundamentally in ecosystem organisation and function: terrestrial, freshwater, marine, subterranean, atmospheric; Biome: a component of a realm united by one or a few common major ecological drivers that regulate major ecological functions; Ecosystem functional group: a group of related ecosystems within a biome that share common ecological drivers promoting convergence of biotic traits that characterise the group.

← 2. Integrating Nature-Climate Scenarios & Analytics for Financial Decision-Making (INCAF) is a project that contributes foundational networks, researcher upskilling, and robust, standardised methods and tools needed to integrate biodiversity and nature into financial decision‑making.

← 3. More information on EU Water Framework Directive:

https://environment.ec.europa.eu/topics/water/water-framework-directive_en

← 4. More information on South Africa’s National Water Act: https://www.gov.za/documents/national-water-act

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