Embedding Water‑related Risks in Financial Stability Frameworks

3. Why water-related risks should be a core concern for central banks

Abstract

As the global landscape evolves, financial authorities are increasingly called upon to assess how climate change and ecosystem degradation, notably disruption of the hydrological cycle, may influence both price stability and financial stability.

Stress-testing and scenario analyses by central banks reveal substantial exposure, especially in agriculture, real estate, and utilities, with the potential for systemic shocks. Yet, current assessment frameworks face considerable data and modelling challenges. This chapter discusses early stages approaches to understanding water-related risks and the urgent need for expanding supervisory attention.

3.1. Water-related shocks to the economy and the financial system

3.1.1. Water in the mandates of financial authorities

While mandates vary, most central banks share a common core objective: maintaining price stability. This typically involves setting monetary policy to control inflation and ensure stable economic conditions that are conducive to sustainable growth. By adjusting interest rates and managing money supply, central banks aim to prevent excessive inflation, which can erode purchasing power, as well as deflation, which can stifle economic activity (Bertsch et al., 2025[1]; ECB, 2025[2]).

Central banks also play an important role in safeguarding financial stability, working to address identified systemic risks and strengthen the capability of financial systems to withstand shocks. Systemic risks are vulnerabilities within the financial system that, if triggered, can lead to widespread disruptions in the functioning of financial markets or institutions, with potentially severe consequences for the real economy. These risks often arise from interconnectedness, common exposures, or structural imbalances, and may be amplified by external shocks, such as economic crises, climate events, or nature degradation. The supervisory role of central banks in safeguarding financial stability can overlap or be shared with other regulatory authorities, such as those overseeing banking, insurance, and securities markets.

Discussion regarding the role of central banks in addressing risks associated with climate change has intensified lately, notably since Mark Carney’s pivotal speech on the tragedy of the horizons as the former Governor of the Bank of England (Carney, 2015[3]). This speech highlighted how climate change poses a systemic financial risk that markets, businesses, and policymakers fail to address adequately, as the most severe impacts extend beyond typical economic and financial planning horizons (Bank of England, 2015[4]; Dikau and Volz, 2021[5]).

Over the last decade, there has been growing acknowledgement that climate and nature risks may directly impact traditional responsibilities of central banks, including managing economic fluctuations and achieving price stability within financial planning horizons (Villeroy de Galhau, 2023[6]; NGFS, 2018[7]). For example, severe drought in Argentina cost 3% of GDP and floods in Pakistan in 2022 cost 2.2% of GDP (Dikau and Volz, 2021[5]; Heath, 2023[8]; Villeroy de Galhau, 2023[6]; World Bank, 2022[9]). At sufficient scale, it is acknowledged that these risks could have an impact on the functioning of a financial system as a whole. There is now broad consensus that central banks, and the regulatory authorities with which they share responsibilities for financial stability, cannot ignore the risks posed by climate change. This has led to the launch of initiatives such as the Sustainable Banking Network (SBN) and the Central Banks and Supervisors Network for Greening the Financial System (NGFS) (Dikau and Volz, 2021[5]; NGFS, 2018[7]).However, the extent to which financial authorities currently address climate change and nature risks depends on their respective mandates and leadership. This can range from mitigating risks to exploring sustainable finance options.

Water-related risks are at the heart of climate and nature risks. The impacts of climate change are most felt through the hydrological cycle. Over 90% of natural disasters are weather and water-related, including drought and aridification, wildfires, pollution and floods (UNISDR, 2015[10]). Water is also a significant component of nature, as this precious resource directly or indirectly supports most ecosystem services. The water-related impact of climate change and nature degradation are also mutually reinforcing. For example, declining groundwater levels and soil degradation can intensify the effects of droughts, severely disrupting agricultural production. Similarly, deforestation and urban expansion can exacerbate flood risks, while rising temperatures contribute to water stress in already vulnerable ecosystems.

3.1.2. Water-related risks affect the financial sector through multiple channels

Given the global scale and pervasiveness of water-related risks, their impacts inevitably extend into the financial system. Events such as floods, droughts, and water stress affect productive assets, disrupt supply chains, or alter commodity prices, financial institutions become exposed through the companies, sectors, and geographies they finance. Far from being insulated, the financial sector serves as a key transmission channel through which these risks can amplify and spread across the broader economy.

The financial sector is exposed to water-related risks through numerous channels. Sources of risks include both physical risks, which stem from the degradation of nature and the loss of ecosystem services, and transition risks, which arise from a misalignment of economic actors with actions aimed at protecting, restoring, or reducing negative impacts on nature (NGFS, 2022[11]; NGFS, 2023[12]; NGFS, 2024[13]). Water-related risks arise through both direct and indirect channels. These include physical risks, such as hydrological volatility, declining water quality, groundwater depletion, and the ageing or failure of water infrastructure -each of which can impair asset performance or increase operational costs. They also include transition risks, which may arise from tightening water regulations, pricing reforms, litigation over access or pollution, or shifting investor and consumer expectations around water stewardship. In particular, water-related risks are often locally concentrated yet globally significant, featuring non-linear feedback loops, limited substitutability, and complex regulatory or geopolitical dimensions, including in transboundary river basins (Global Commission on the Economics of Water, 2024[14]).

Water-related events, particularly when they are sustained overtime such as repeated widescale flooding or a prolonged drought, can trigger adverse macroeconomic shocks that widely impact on the operations or decision-making of financial institutions or non-financial corporates. These shocks may reduce agricultural or industrial output, increase input costs, shift asset values, or impair government revenues, thereby affecting credit quality, collateral valuations, liquidity conditions, and insurance liabilities. In turn, these dynamics can be reflected on financial balance sheets through rising default rates, declining asset prices, reduced lending activity, or increased provisioning. Impacts can generate externalities that propagate through the economy via macro-financial feedback loops.

Recent stress tests illustrate these material transmission channels. A stress test in Morrocco, flagged that over one-third of bank loan portfolios are exposed to physical climate risks from drought, principally in agriculture, food processing, tourism, and vulnerable households (IBRD and World Bank, 2024[15]). In Brazil, a stress test analysed sensitivity of the credit portfolio to physical climate risks, specifically extreme drought with scenarios for 2020, 2030 and 2050. In the current scenario, 16% of system loans are exposed to drought risk, with the southeastern part of the country being the most affected. The exposure increases to 19% in 2030 and 20% in 2050, particularly in the southern region (Central Bank of Brazil, 2022[16]). The Dutch Central Bank (DNB) stress test provides an illustration of potential losses that banks could face under a major flood scenario through exposure to real estate and infrastructure. The study found significant impacts for scenarios of extremely severe flooding in the densely populated western regions of the Netherlands, which would have sizeable capital impacts on Dutch banks, with the potential to affect financial stability in a material way. This is described in further detail in Box 3.1 (Coloia and Jansen, 2021[17]).

Several recent central bank stress tests highlight how water-related events can trigger systemic financial risks through multiple channels. In Brazil, prolonged drought scenarios were found to impair productivity in key sectors, leading to asset repricing and potential portfolio devaluation in affected loan books. In Morocco, over one-third of bank lending is concentrated in drought-sensitive sectors, raising concerns about credit quality under worsening water stress. Meanwhile, the Dutch Central Bank’s flood stress test illustrates how increasing flood risks may lead to insurance withdrawal and real estate repricing in high-risk areas. These cases underscore how localised water events can scale into system-wide financial instability through credible, sector-specific transmission channels.

More recently, discussion has progressed from just climate to a broader exploration of environmental degradation as a source of macro-financial risks (NGFS, 2023[12]; Ranger et al., 2023[18]). Notably, the NGFS stated that “nature-related risks, including those associated with biodiversity loss, could have significant macroeconomic implications, and that failure to account for, mitigate, and adapt to these implications is a source of risks for individual financial institutions as well as for financial stability“ (NGFS, 2022[11]).

There is growing recognition that worsening environmental degradation, combined with increasing pressure for major policy shifts, is raising the likelihood of rare but severe shocks to the economy and financial system. These system-wide "fat-tail" macro-financial risks refer to extreme, low-probability occurrences that have a higher likelihood of materialising than predicted by a normal distribution. In standard financial models, risks are often assumed to follow a bell-shaped curve, which significantly underestimates the frequency and severity of rare events. In contrast, fat tail distributions recognise that extreme events, such as catastrophic floods, multi-year droughts, or sudden regulatory shocks, may occur more often and with more severe consequences than traditional models suggest. These events are particularly relevant for financial supervision because they can trigger abrupt, nonlinear losses, strain system-wide resilience, and fall outside the scope of backward-looking risk assessments (NGFS, 2023[12]).

Nature-related risks assessment approaches are critical for understanding water-related risks, as they take a broader approach to exploring risks drivers, encompassing climate change, but also land use and water use change, pollution, overexploitation of resources, and invasive species (NGFS, 2023[12]).

Building on frameworks for assessing nature-related risks, Figure 3.1 provides an illustration of how physical and transition risks can have various economic impact on business operations, such as, disruption of activities and value chains, or price volatility of raw materials (NGFS, 2023[12]; OECD, 2023[19]). These impacts are then transmitted to the financial system in the form of credit, market, liquidity, business and underwriting risks in the following ways:

• Credit risk arises as water shortages, pollution, and climate-related events reduce the ability of borrowers—particularly those in agriculture, mining, and water-intensive industries—to generate income and therefore to repay outstanding loans.

• Market risk is influenced by water-related supply shocks, shifts in investors’ preferences and regulatory changes.

• Liquidity risk emerges when water-related events disrupt financial flows, increase cash withdrawals, or force banks to sell assets at depressed values to meet obligations.

• Operational or business risks and reputational risks have become increasingly relevant as environmental litigation, consumer preferences, and regulatory scrutiny grow.

• Underwriting risk is the risk that an insurer or underwriter faces of incurring financial loss because the actual claims and costs exceed the premiums collected.

Figure 3.1. Transmission channels of water-related risks

Source: adapted from (Davies and Martini, 2023[20]).

The impacts of water-related risks, and broader environmental degradation, can lead to both microeconomic impacts (such as capital destruction, for example irreparable damage to machinery or buildings caused by a major flood) and macroeconomic impacts (including disruptions to trade and capital flows, value chains, and broader socioeconomic conditions). For example, risks could materialise through disruption of infrastructure and supply chains, which can increase credit and liquidity risks for financial institutions with concentrated exposures in the affected regions or sectors. Financial risks can have knock-on effects as the behaviour of one institution in response to water-related risks or other environmental risks can affect the behaviour of others. This could impact a country’s overall financial system, through widescale losses on loans and investments, increased default risk, and reduced access to funding (NGFS, 2023[21]).

In summary, this points to the need for dynamic assessments of water-related risks to financial institutions and to financial system, particularly to assess the feedback loops between the real economy and the financial sector in response to shocks. In order to achieve this, financial institutions and financial authorities must strengthen their capacity to identify, assess and manage water-related financial risks. The following sections explore how central banks are starting to prioritise these risks and develop frameworks to assess their financial implications.

Box 3.1. Evidence from a stress test for the Netherlands

The Dutch Central Bank (DNB) explored conditions under which floods become a financial stability concern, associated with climate-driven slow shifts to weather patterns, which in turn increase the probability of extreme weather events. The study first established a set of 6 flood scenarios that differ in terms of flood types and severity. In the second step, property damages and broader macro financial implications were estimated. In a third step, DNB used stress test modules to explore the implications for credit risk, market risk, and profitability. The overall implications are computed for a sample of ten Dutch banks using a top-down stress test model.

The stress test found that, across scenarios in unprotected zones of the country where there is relatively little real estate and economic activity, the additional erosion of bank capital is much smaller than commonly reported for bank stress tests – a decline of the CET1-ratio of between 110 and 132 basis points. However, capital depletion increases quickly for flood stress in protected parts of the country. A flood with an extreme level of inundation in the populated areas of the western half of the Netherlands would put severe stress on the soundness of the banking system. In that most extreme case, this would mean a decline of the CET1-ratio within one year of well over 700 basis points. This level of depletion is not common in stress tests for Dutch banks Figure 3.2.

The results of the stress test indicate that the banking sector is sufficiently capitalised to withstand floods in unprotected areas where there is relatively little real estate. However, capital depletions would increase quickly if more severe floods were to hit the densely populated western part of the Netherlands. The impact of a major flood event on banks would depend on a range of factors, such as the effectiveness of flood defences, the ability of banks to continue operating during and after a flood, and the availability of insurance and government support. These findings have possible implications for various policy areas, including macroprudential policy. A Key conclusion of this paper is that, if climate change were to continue unabated, flood events could eventually pose systemic risks. By taking a proactive approach to managing flood risk, banks and policymakers can help ensure that the financial system remains resilient and can continue to support the needs of individuals and businesses in the face of climate change. Scenario analyses of this kind also reveal critical data or risk assessment gaps, helping firms and regulators identify vulnerable portfolios​ and enhance overall resilience.

Figure 3.2. Capital depletion in six flood scenarios over one-year horizon (CET1-ratio)

Note: vertical axis shows the depletion of banks' CET1 capital in basis points. Common Equity Tier 1 (CET1) is a component of Tier 1 capital that comprises mostly common stock held by a bank or other financial institution.

Source: (Coloia and Jansen, 2021[17]) Flood Risk and Financial Stability: Evidence from a Stress Test for the Netherlands.

3.2. Supervisors are beginning to integrate water into financial stability frameworks

Financial authorities increasingly recognise the materiality of climate and nature-related risks and that risks linked to water are amongst the most pressing. Indeed, the value of water-related economic risks is estimated to be equivalent to 7 to 9% of Global Gross Domestic Product (GDP), highest amongst other ecosystem services (Ranger et al., 2023[18]).

In most jurisdictions, prudential regulation is one of the key tools available to central banks and supervisors to manage financial risks, including those arising from environmental degradation and climate change. While central banks are often responsible for financial stability, their supervisory roles frequently overlap or are shared with other regulatory authorities, such as those overseeing banking, insurance, and securities markets. In some jurisdictions, however, these functions are managed by separate, independent agencies. Although this report does not cover the role of other regulatory authorities, it is important to acknowledge that overlapping or shared mandates can facilitate risk detection and inter-agency coordination yet may also give rise to fragmentation or accountability gaps in the absence of clearly defined roles or mandates on climate and nature.

While still in relatively early stages, there is increasing action on integrating climate risks into macroprudential measures, notably through climate stress testing, which involves subjecting banks to a range of hypothetical climate scenarios to assess their ability to absorb potential losses. Jurisdictions such as the European Central Bank (ECB), the Bank of England (BoE), and the Dutch Central Bank (DNB) have developed sector-specific stress testing tools, established internal climate teams, and embedded climate scenarios into supervisory practice. In contrast, the integration of nature-related risks, particularly water-related risks, remains nascent. Only a few central banks and supervisors have begun piloting or co-developing scenario tools to assess nature degradation. The resulting implementation gap reflects the recent prioritisation of this broader lens, the early stage of tool development, limited analytical capacity, data constraints, and the evolving nature of regulatory mandates. Progress on climate stress testing and the few first examples of nature scenario analysis, with respect to water, are discussed in Sections 3.2.1 and 3.2.2.

This means assessments of water-related risks to financial and price stability are at best partial, primarily taking the narrow focus of risks driven by climate change and overlooking water-related risk driven by overexploitation of resources, land or water use change, pollution or invasive species.

The evolving prudential landscape presents an opportunity for central banks and financial supervisors to more explicitly integrate water-related risks into existing risk assessment frameworks. This would entail recognising water-related risks as material to financial stability, embedding them into macroprudential risks management tools, supervisory expectations, and ensuring that financial institutions develop the capacity to manage and disclose their exposure to water-related vulnerabilities. Already authorities are integrating such risks into macro and micro prudential policy through a variety of measures (Dikau and Volz, 2021[5]).

The following sections examine how central banks and financial supervisors are beginning to incorporate water into their macroprudential frameworks, including through scenario analysis, risk mapping, and stress testing initiatives. While progress is at an early stage, water is becoming an integral part of broader efforts to assess physical and transition risks in the financial system.

3.2.1. Stress tests are starting to include water-related risks - but gaps remain

In advanced economies, the Basel framework, developed by the Basel Committee on Banking Supervision (BCBS) under the oversight of the Bank for International Settlements (BIS), provides a globally recognised standard for strengthening the resilience of both individual banks and the broader financial system. Revised in the aftermath of the 2008 financial crisis, Basel III sets out minimum regulatory requirements to enhance banks’ ability to absorb shocks, improve risk governance, and increase market transparency (BIS, 2021[22]).

In addition to supervising individual banks through micro prudential oversight (which refers to the supervision and regulation of individual financial institutions to ensure their solvency, sound risk management, and resilience to shocks), prudential frameworks also incorporate macroprudential tools aimed at safeguarding the stability of the financial system as a whole. These tools target broader risks, such as rapid credit expansion, asset bubbles, or high interconnectedness between institutions, that could lead to systemic crises. Although Basel III does not establish a standalone macroprudential regime, it includes features that allow national authorities to exercise macroprudential judgment within a global framework. This includes the use of system-wide stress tests that simulate shocks affecting multiple institutions simultaneously (IMF-FSB-BIS, 2016[23]).

Climate stress testing has emerged as a critical tool to assess the financial system's vulnerability to climate-related risks. Climate stress tests are forward-looking exercises that assess banks and insurers’ resilience under hypothetical climate scenarios. By simulating extreme but plausible water-related events, supervisors can assess how shocks such as prolonged drought or major floods would affect portfolios and capital buffers. This process enables institutions to develop targeted risk management strategies and implement mitigation efforts (UNEP-FI, 2024[24]).

Climate stress tests typically consider two broad types of climate-related risks: transition risks and physical risks. Transition risk scenarios explore the financial impact of policy and market changes as the world shifts toward a low-carbon economy, for instance, a sharp increase in carbon prices or technological breakthroughs that disrupt fossil-fuel industries. These scenarios affect carbon-intensive sectors via higher costs and stranded assets, potentially causing credit losses as firms adapt to stricter climate policies. In contrast, physical risk scenarios simulate the impacts of acute climate events (e.g. extreme floods, droughts, heatwaves) or chronic changes (e.g. rising sea levels, long-term water stress) on the economy (UNEP-FI, 2024[24]). Physical scenarios capture direct damage from climate related events to assets and infrastructure, productivity losses, such as reduced crop yields or construction activity during droughts and supply chain disruptions​ (ECB, 2022[25]).

Many central banks have started assessing water-related risks through climate scenarios

A growing number of central banks and supervisors have begun incorporating drought and flood scenarios into their climate stress-testing frameworks. Table 3.1 presents selected examples of climate stress test exercises that explicitly include water-related risks and presents the scenarios used, sectors affected, and key impacts identified. For example, in 2021, the Bank of England undertook a stress test focused on flood risks, considering the potential impact on property values and mortgage availability. The analysis revealed challenges for homeowners in hardest-hit flood areas to refinance their mortgages due to property devaluation and potential insurability. Under the stress scenario, up to 7% of UK households could face severe flooding, with significant implications for insurance affordability and financial vulnerability in affected regions (Bank of England, 2022[26]). Similarly, the French Prudential Supervision and Resolution Authority (Autorité de Contrôle Prudentiel et de Résolution “ACPR”) and the Central Bank of France (Banque de France) conducted a climate stress test for the insurance sector that included a spatially detailed flood scenario, assessing the exposure of insurers to flood-prone regions across France and highlighting potential vulnerabilities in underwriting and asset portfolios (ACPR, 2024[27]).

Table 3.1. Review of water-related climate stress tests implemented by financial authorities

Institution and year	Water-related scenario	Key affected sectors	Impact findings
Bank of England (2021)	Climate Biennial Exploratory Scenario (CBES)​ “Hot House World” 2050 (no-policy scenario with frequent floods & storms)	General insurers; UK mortgages in flood-prone areas.	Physical risks become concentrated: ~10% of UK postcodes (most flood-prone) account for a large share of banks’ credit impairments under the 2050 no-action scenario​. Mortgage impairments concentrated in hardest-hit flood postcodes; up to 7% of UK households in the scenario could face severe flooding and insurance affordability issues. General insurers see flood and windstorm claims push average annual losses ~50% higher for UK portfolios (∼70% for international portfolios) by 2050​.
French Prudential Supervision and Resolution Authority (Autorité de Contrôle Prudentiel et de Résolution “ACPR”) (2024)	Short term scenario developed on a sequence of extreme weather events. Consecutive drought events followed by heavy flooding + strengthened markets conviction that transition policies have become unavoidable Long term scenarios explore orderly and disorderly NGFS transition pathways with increased frequency and severity of extreme weather events, including floods, coastal flooding, and droughts.	Insurance sector French insurance groups (15 groups representing 90% of sector's balance sheet)	The combined impact of physical and transition shocks significantly weakened insurers’ solvency positions. Under a static balance sheet assumption (i.e. no management action), the Solvency Capital Requirement (SCR) coverage ratio dropped from 230% in 2022 to 170% in 2027. The most substantial hit came in 2025, when financial shocks cause a 28% drop in own funds relative to a no-climate-change baseline. That year, climate-related claims, including those linked to a dam failure, triggered a 48-point fall in the SCR ratio. By 2050, total claims rise by 105% under the disorderly scenario, with weather-related claims increasing 42% relative to the baseline. Over half the rise in claims stems from physical risks, with limited insurer adaptation observed.
Central Bank of the Netherlands (DNB) (De Nederlandsche Bank “DNB”) (2021)	Extreme Coastal Flood (Dike breach flooding Western NL; 1-in-200 year event)	Residential & Commercial real estate; Household mortgages; Business assets in flood zone	Found banks could withstand floods in sparsely populated areas, but capital depletion rises sharply if major dike-protected regions flood, threatening financial stability​. Dutch banks are resilient to minor floods, but a severe inundation of the densely populated Randstad would cause significant capital depletion. In the most extreme case (5m inundation), system-wide CET1 ratios drop by ~712 bps (≈7.1 percentage points) within a year. Even a smaller 1m flood in unprotected areas would erode capital by ~110 bps​ Such outsized losses highlight flood events as a potential financial stability risk if protective infrastructure fails.​ Highlighted importance of flood defences and insurance in containing losses.
European Central Bank (2022)	Drought & heatwave (acute) – 1-year extreme event in Europe; Flood – 1-in-100 year flood affecting European regions. (Also 30-year transition scenarios via NGFS.)	Drought: Agriculture, construction, manufacturing (via supply chains); Flood: Real estate (mortgaged properties), corporate assets in flood zones.	Drought scenario: sectoral output and productivity fall (e.g. crop yields, labour hours) leading to higher loan losses in affected areas. Flood scenario assumes property value shocks in flooded areas, driving up loan-to-value and loss-given-default on mortgages and corporate real estate loans​. Severe property damage undermines real estate collateral values, hitting mortgage and corporate loan portfolios, especially at banks with concentrated exposure in hardest-hit locations. ∼€70 billion total credit & market losses across 41 major EU banks from combined one-off drought/heat and flood shocks​
Spanish Macroprudential Authority Financial Stability Council  (La Autoridad Macroprudencial Consejo de Estabilidad Financiera  “AMCESFI”), (2023)	Severe drought and heatwave impacting the Spanish economy (based on ECB/ESRB short-term scenario); plus assessment of coastal flood risk to mortgage portfolios.	Drought: Economy-wide (labour productivity shock); agriculture; energy; Flood: Housing market (coastal mortgages).	Estimated that extreme drought/heat could significantly reduce labour productivity across multiple sectors, eroding banks’ capital ratios. Initial analysis of flood exposure found portions of banks’ mortgage books concentrated in high-risk flood zones, indicating potential credit risk from property value declines in a severe flood event​
UNEP–FI (2022–2024)​	Pilot Drought Stress Testing Tool Multi-country drought scenarios (acute one-year droughts of varying severities in Brazil, China, Mexico, US).	Water-intensive industries: water utilities, agriculture, power generation (hydro); downstream sectors (food & beverage).	Extreme droughts could increase loan default losses ten-fold in the most-exposed portfolios​. Even moderate droughts caused widespread credit rating downgrades for borrowers. The worst-hit sectors were water supply and agriculture, and in hydro-dependent regions, power producers​. Indirectly, water-dependent manufacturing (e.g. food & drink) also saw significant stress​. The worst-hit sectors are those directly reliant on water – e.g. water supply companies, crop farming, and hydro-dependent power generation​, with significant knock-on impacts observed for water-intensive processing industries like food and beverages
Central Bank of Brazil (Banco Central do Brasil “BCB”) (2022)	Extreme Drought (2030/2050 climate scenario, nationwide water scarcity)	Agriculture (especially smallholder farms); Hydroelectric power generation; Water-intensive industries	~16% of current bank loans are in municipalities with medium/high drought risk and in water-intensive activities (rising to 19% in 2030–2050 scenarios)​ Loan exposures are especially concentrated in individual farming and the energy sector​ Drought-related drops in output and income could impact up to 15% of banking system interest income in high-risk areas​, underscoring material profitability risks even though banks meet capital requirements in the test.
Central Bank of Brazil (Banco Central do Brasil “BCB”) (2022)	Extreme Rainfall & Flooding (Intense precipitation scenario 2030/2050)	Real estate (property damage to buildings); Infrastructure & logistics (roads, ports); Secured lending in affected areas	Under current conditions, no loans fall in “high risk” zones for extreme rainfall. By 2030, however, ~15.5% of banks’ credit portfolios would be exposed to high flood risk, rising to ~33% by 2050​
IMF (2022) – Mexico FSAP Climate Risk Analysis	Severe Hurricane & Flood (Category 5 hurricane striking coast, acute flood shock)	Coastal tourism & real estate; Retail/SMEs in affected region; Infrastructure (utilities, transport)	The FSAP’s macroprudential stress showed that an extreme hurricane/flood event could have material economic and credit impacts but not a banking meltdown. GDP could drop by over 1% relative to baseline in the disaster year​
Colombia (World Bank & Superintendency of Finance, 2021)	Nationally tailored precipitation and temperature scenarios to assess transition and physical climate risks (through 2100), including shifts in drought frequency.	Commercial banking sector (credit exposures across sectors); water-intensive and agriculture-related industries.	Stress tests found that capital adequacy ratio (CAR) of Colombian banks would decline by 0.3 to 1.1 percentage points across three long-term climate transition scenarios. Physical risks, particularly precipitation shifts and sector-specific water vulnerabilities, were found to increase credit risk over time, with localised exposure in agriculture, water utilities, and real estate sectors (World Bank, 2021).

Source: (Bank of England, 2022[26]; Coloia and Jansen, 2021[17]; ECB, 2022[25]; AMCESFI, 2023[28]; RMS, GIZ and NCFA, 2017[29]; World Bank, 2021[30]; Climate Bonds, 2024[31]; IMF, 2022[32]).

These studies notably illustrate how droughts can impair productivity, profitability, and loan performance (e.g. Spain, ECB, Colombia, UNEP-FI pilots), while floods can damage collateral, spike insurance losses, and trigger credit deterioration (e.g. Netherlands, UK, Spain). Sectors such as agriculture, utilities, real estate, energy, and banking are on the front lines of these water-related shocks (Bank of England, 2022[26]; Coloia and Jansen, 2021[17]; ECB, 2022[25]; AMCESFI, 2023[28]; RMS, GIZ and NCFA, 2017[29]; World Bank, 2021[30]; Climate Bonds, 2024[31]; IMF, 2022[32]). In addition, this analysis underscores that the magnitude of losses can be substantial. The Bank of England projected a 50–70% increase in annual flood-related insurance losses by 2050 under a high physical risk scenario, while the Dutch central bank found that a severe coastal flood could reduce bank capital ratios by up to 7.1 percentage points. UNEP FI’s multi-country drought stress test revealed that loan default losses could increase tenfold in the most exposed portfolios (Bank of England, 2022[26]; RMS, GIZ and NCFA, 2017[29]).

By quantifying these risks, climate stress tests help supervisors and financial institutions identify the most vulnerable portfolios and sectors, supporting better-informed supervisory priorities and forward-looking risk management.

There are important limitations to climate scenarios for assessing water-related risks

Climate scenarios (such as those used in climate stress tests or climate models highlighted above) focus on physical hazards driven by climate change (e.g. droughts, floods) and transition pathways driven by greenhouse gas emissions. Central banks often use scenarios developed by NGFS or tailor national scenarios to their economies.

The NGFS provides a standardised set of global climate scenarios for supervisory use, covering various combinations of policy ambition and physical climate outcomes. There are seven key scenarios, Net Zero 2050, Below 2°C, Divergent Net Zero, Delayed Transition, Nationally Determined Contributions (NDCs), and Current Policies, which correspond to four distinct transition narratives: orderly, disorderly, too little too late, and 'hot house world (NGFS, 2023[33]). These scenarios are valuable for their consistency, comprehensiveness, and alignment with international climate goals. By using common reference scenarios, regulators can compare results across institutions and jurisdictions. For example, the European Central Bank’s 2022 climate stress test drew on NGFS scenarios for long-term transition pathways, alongside short-term physical risk shocks (a one-year severe drought/heatwave and a one-year severe flood) to probe banks’ vulnerabilities​ (ECB, 2022[25]).

However, there are several limitations to these climate-related scenario frameworks. NGFS scenarios rely on global or regional averages, such as temperature increases or sea-level rise, whereas water-related risks are highly localised. Water-related risks are highly site-specific, depending on river basin conditions, land use patterns, and ecosystem health. In addition, current frameworks do not adequately account for the complex interplay between physical and transition risks, such as how a water shortage may simultaneously affect production capacity, regulatory costs, and reputational risks across value chains (UNEP-FI, 2024[24]).

Taking a different approach, some countries have developed their own internal scenarios, which can be useful especially when seeking to develop tailored analysis for water-related challenges in the country, as they provide greater granularity of scenario analysis outputs. For example, a stress test in Colombia used data from the Colombian Institute of Hydrology, Meteorology, and Environmental Studies (IDEAM) to model changes in precipitation through to 2100 and assess physical risk impacts on the Colombian banking system. Under severe flood scenarios, the assessments showed declines in capital adequacy that could moreover coincide with other shocks. Across three scenarios, they found an average decline in the capital adequacy ratio (CAR) for Colombian banks of between 0.3 and 1.1 percentage points. Capital Adequacy Ratio (CAR) is a key financial metric used to measure a bank’s financial strength and stability. It is defined as the ratio of a bank’s capital (such as equity and disclosed reserves) to its risk-weighted assets. While the average decline for Colombian banks is potentially moderate depending on the baseline level of capital and the regulatory thresholds in place, these declines are significant enough to warrant supervisory attention. A fourth scenario, investigating a severe flood coinciding with a recession, found an average decline in the CAR of 3.2 percentage points. This points to the importance of considering risks that are persistent or compounded with other vulnerabilities (World Bank, 2021[30]).

Some of the drawbacks are that this can reduce the ability to perform cross-border assessments, and possibly limit the financial industry’s ability to address climate risks on a global scale (UNEP-FI, 2024[24]).

Broadly speaking, climate scenarios are limited in their ability to capture water-specific risks. These scenarios typically focus on climate driven events (for instance, increased drought frequency), and emphasise carbon emissions, temperatures, and broad macroeconomic impacts. However, they often overlook localised or non-climate water issues. Events such water pollution, degradation of watershed ecosystems, or highly localised water scarcity are not explicitly modelled and typically fall outside the scope of these scenarios. Moreover, floods and droughts are local manifestations of shifts in the hydrological cycle, which are only partially driven by climate change. In addition, land use change and mismanagement of water resources matter as well in driving such risks.

As a result, current climate stress tests will underestimate water-related financial risks that stem from ecological dependencies or regional water mismanagement. In addition, this can underestimate long-run economic instability by ignoring nature and water feedback. For example, the loss of ecosystem services (like wetlands filtering water or forests regulating runoff) could amplify flood and drought damages in ways not reflected in generic climate models.

These gaps highlight the need to refine scenarios or supplement them with more granular analyses to fully capture financial risks from water-related risks. The NGFS itself acknowledges that climate risk is only a subset of broader environmental and nature-related risks (NGFS, 2022[34])..

Central banks and financial institutions must expand their risk assessments beyond traditional climate stress tests. To fully account for water-related risks, they now need to implement nature stress tests that encompass a broader spectrum of natural capital dependencies and impacts and take account of the specificities of water-related risks.

3.2.2. Water plays a central role in nature-related financial risk assessments

Central banks and supervisors are increasingly broadening their focus from climate-related risks to nature-related financial risks. This shift gained momentum after the adoption of the Kunming–Montreal Global Biodiversity Framework at COP15 in late 2022, commits countries to halt biodiversity loss by 2030 and explicitly calls for aligning financial flows with biodiversity goals (CBD, 2022[35]) (NGFS, 2023[12]). As NGFS Chair Sabine Mauderer noted, “The NGFS started its journey with a focus on climate risks. Yet… biodiversity is under threat worldwide, making it essential for central banks, supervisors and regulators to understand nature-related risks to the financial system”​ (NGFS, 2024[36]). In response, several central banks have begun assessing how ecosystem degradation, including for freshwater ecosystems, could pose systemic risks​ (OECD, 2023[19]). This marks a significant broadening of prudential risk assessments beyond carbon emissions and climate change alone.

Nature risks can be more localised and multifaceted. Nature-inclusive scenario analysis extends the scope of traditional climate risk models by incorporating a broader set of ecological disruptions, including land and water-use change, pollution, overextraction of resources and invasive species. However, this makes nature scenario analysis inherently complex, requiring significant new work by many institutions to develop frameworks and methodologies to assess these risks.

Emerging frameworks for assessing nature-related risks

Multiple institutions have developed frameworks to integrate nature-related (including water-related) risks into financial analysis.

The OECD, in partnership with the Hungarian National Bank (Magyar Nemzeti Bank “MNB”), developed a methodological supervisory framework for assessing biodiversity (and nature) related financial risks (OECD, 2023[19]). This framework aimed at helping central banks and financial supervisors assess biodiversity-related financial risks, impacts and dependencies in the financial sector, including transmission channels for physical and transition risks. The framework provided a step-by-step approach for supervisors to identify, prioritise, and assess nature-related outlined in Box 3.2.

Box 3.2. The OECD Supervisory Framework for assessing nature-related risks

The OECD Supervisory Framework for assessing nature-related risks is a principles-based risk assessment framework to help financial authorities consider the relevant elements of nature-related financial risks and to develop policies and actions while taking into consideration their jurisdictional context. This framework, like the NGFS Conceptual Framework on Assessing Nature-related risks, takes a three-step approach, as set out below.

Step 1: Risk identification and prioritisation

As a first phase, financial authorities should identify nature-related risks that are potentially material from a macroprudential or macroeconomic risks perspective. The OECD framework details a risk identification process consisting of (i) impacts and dependencies assessment; (ii) economic sector identification; and (iii) ecosystem identification. Potential risks are identified and ranked based on their potential impact and likelihood.

Step 2: Economic risk assessment

In the second phase, central banks and supervisors assess the potential economic effects and risks that can stem from these exposures. Importantly, risks may cascade through value chains, between sectors, to other parts of the economy or across borders. On a macro level, water-related risks can impact gross domestic product (GDP) and inflation, by affecting prices, productivity, investment, socio-economic changes, fiscal balance, and trade and capital flows. This assessment should take into account differing abilities to adapt to shocks, either through geographical substitution between ecosystem services or technological substitution trough capital. To support the conceptualisation of economic impacts stemming from physical and transition risks, the OECD framework invites financial authorities to explore how economic risk originates, their economic impacts, and possible channels of propagation to other parts of the economic system. The purpose is to provide clarity on which type of risks could be considered by financial authorities to design relevant scenarios for their own assessment of financial materiality.

Step 3: Financial risks assessment

In the final phase, the financial risk assessment, financial authorities are invited to explore financial risks stemming from the exposure to sources of physical and transition risks, notably through financed activities. Different financial risk channels can be explored, including credit, market, liquidity and underwriting risks. Potential impacts on financial stability and individual financial institutions are assessed.

Source: (OECD, 2023[19]).

The OECD Supervisory Framework aligns with the NGFS’s conceptual framework to guide central banks on assessing nature-related risks​, which established a common taxonomy, emphasising the “twin crises” of climate change and nature loss (NGFS, 2023[12]). Both frameworks explore nature-related risks by looking at systemic transmission channels.

The NGFS Conceptual Framework for Nature-related Risks outlines how the degradation of nature, including ecosystems, can lead to financial risks through physical and transition channels, impacting macroeconomic and financial stability. It emphasises how changes in ecosystem services affect economic sectors, which then transmit risk to financial institutions via traditional channels like credit, market, and operational risk. Figure 3.3 provides an overview of the relevant transmission channels of nature-related risks from the NGFS framework (NGFS, 2023[12]; NGFS, 2024[13]).

Further, the framework highlights how nature-related financial risks, including those stemming from water, present new risks for the financial system, and amplify those stemming from climate-related risks. The effect on individual financial institutions has the potential to spread through contagion within the financial system or create feedback loops to the real economy. This process may amplify shocks, so that they propagate across financial institutions and pose risks to financial stability. Nature related financial risks are endogenous, which means that the impacts that economic and financial actors have on nature affect the financial risks these actors need to manage (NGFS, 2024[13]).

Figure 3.3. Transmission channels of nature-related risks

Source: (NGFS, 2024[13]).

With respect to nature scenarios, researchers at the University of Oxford jointly with the NGFS, developed the “Green Scorpion” analysis, so named to reflect the “sting in the tail” of hidden nature-related risks (Ranger et al., 2023[18]). This study created a preliminary set of nature scenarios to quantify macroeconomic impacts of ecosystem service decline. It focused on five critical ecosystem services (including groundwater supply, surface water, and water quality as well as pollination and air quality)​. The Green Scorpion framework also introduced a “Nature-Related Value at Risk” approach and transmission channels, whereby ecosystem shocks (such as droughts or aquifer depletion) cascade through supply chains and financial markets​. This work has been foundational in highlighting water-related risks as a macro-critical component of nature-related financial risk. The findings clearly demonstrate that water-related risks dominate amongst other nature-related risks: declines in water availability or quality could put an estimated 7 to 9% of Global GDP at risk (5% expected loss), plus an additional 2% of Global GDP due to water quality issues (Ranger et al., 2023[18]). This is further described in Box 3.3.

Both the Green Scorpion Shock-Based Approach and the NGFS Conceptual Framework offer valuable methodologies for assessing water-related financial risks, each with distinct strengths and limitations. The Green Scorpion approach models immediate, acute water-related disruptions, providing financial institutions with insights into potential short-term shocks. However, its primary focus on physical risks and short-term events may overlook longer-term trends and transition risks associated with water resource management.

Conversely, the OECD and NGFS framework offers a structured perspective, integrating water-related risks into broader environmental and climate risk assessments. This comprehensive approach aligns with global regulatory efforts, facilitating standardised reporting and compliance. Nonetheless, its emphasis on long-term trends and potential complexity in integration may limit its ability to take account of sudden water crises.

However, these approaches can be complementary. A hybrid approach that combines the immediate, shock-based insights of the Green Scorpion methodology with the structured, long-term planning of the NGFS and OECD framework could provide a more robust assessment of water-related financial risks. This integration would enable financial institutions and regulators to address both acute disruptions and chronic water-related challenges, enhancing overall financial resilience. A summary of how the OECD Supervisory framework and the NGFS Conceptual Framework for Nature-Related Financial Risks differ from the Green Scorpion approach in their scope, methodology, and integration of water-related risks is described in Table 3.2.

Box 3.3. The Green Scorpion

The Green Scorpion report, published by NGFS examines foundational methodologies for analysing nature-related financial risks, with a strong emphasis on their macro-critical importance to financial systems. It provides a novel approach for understanding the complex, multi-sectoral and potentially cascading risks arising from environmental degradation.

A distinctive feature of the Green Scorpion is its hazard-based methodology: it uses historical analogues, which are past ecological disruptions with economic consequences, to explore how sudden environmental shocks can propagate through economies and financial systems. This shock-oriented perspective differs from the systemic, scenario-based frameworks proposed by the NGFS Conceptual Framework and the OECD Supervisory Framework, which tend to focus on gradual transitions, long-term dependencies, and systemic transmission channels, though these methodologies can be complementary.

By analysing over 60 historical events where ecological stress led to economic or financial instability, the report identifies recurring transmission pathways and uses them to inform a preliminary risk screening framework. In the context of this paper, five critical environmental and ecological dimensions were assessed:

• Pollination services: assessing the economic impact of pollinator decline on food production and broader ecosystem services.

• Groundwater availability: evaluating risks from falling groundwater reserves, especially for agriculture, industry, and urban water supply.

• Surface water depletion: analysing the economic effects of lower river and lake levels on energy generation and water-intensive sectors.

• Air quality decline: exploring macroeconomic consequences such as reduced labour productivity, higher healthcare costs, and industrial disruption.

• Water pollution: investigating how degraded water quality can cause supply chain disruptions and reduce freshwater availability for industrial and human consumption.

The analytical process is structured around three key components:

1. Identifying hazards, whether physical or transition-related, and developing scenarios around these shocks.

2. Assessing exposure, determining how different agents, such as households, firms, financial institutions, or government, are exposed to the identified hazard.

3. Evaluating vulnerability, by understanding how sensitive these agents are to the shock, and their capacity to adapt or recover, through measures of sensitivity and adaptive capacity.

Figure 3.4. Schematic of process to generate narrative scenarios

Source: Adapted from (Ranger et al., 2023[18]) (NGFS, 2023[21]).

The report’s findings clearly demonstrate the prominence of water-related risks. Declines in water availability or quality could place an estimated 7–9% of global GDP at risk (with ~5% expected losses), with particularly large impacts on water-intensive industries such as manufacturing. Agriculture is also highly vulnerable, with 14–18% of global agricultural output estimated to be at risk from water scarcity alone. This rises further, to an additional 12% of output at risk, if pollinators collapse, illustrating the compounding effects of ecosystem degradation. These early estimates reinforce the conclusion that water scarcity is not just an environmental concern, but a systemic economic threat.

Source: (Ranger et al., 2023[18]) (NGFS, 2023[21]).

Table 3.2. Comparison of the Green Scorpion Shock-Based Approach and the NGFS Conceptual Framework for Nature-Related Risks for water

	OECD and NGFS Conceptual Framework	Green Scorpion Shock-Based Approach
Focus	Provides a broad, integrated framework for assessing both physical and transition risks related to nature, considering longer-term systemic risks.	Examines the macro-criticality of nature for finance, focusing on physical nature-related risks and sudden ecosystem shocks.
Methodology	Uses a risk transmission approach, mapping how physical and transition risks linked to nature degradation propagate through the economy and financial system.	Uses a shock-based approach, modeling sudden disruptions in nature (e.g., water shortages, pollinator loss) and assessing their immediate economic and financial impacts.
Scenario Development	Builds integrated nature-climate transition scenarios, similar to existing climate stress testing methodologies, to provide a structured approach for financial supervisors.	Develops physical risk scenarios based on historical environmental and ecological crises, emphasising non-linear and cascading risks.
Sectoral Focus	Takes a cross-sectoral approach, mapping nature dependencies across economic sectors and their financial exposure.	Focuses on high-exposure sectors (e.g., agriculture, forestry, and manufacturing) and their vulnerability to nature shocks, though the methodology is applicable to all sectors.
Integration of Water-related risks	Incorporates water-related risks through groundwater depletion, water quality deterioration, and long-term water availability. Case studies, such as the Colorado River example, illustrate how water stress translates into financial risks.	Directly examines water-related risks, such as groundwater and surface water depletion, water pollution, and supply chain disruptions due to water shortages.
Regulatory & Supervisory Relevance	Regulatory-aligned framework developed for central banks and supervisors, enabling integration into financial stability assessments and prudential regulation.	A research-driven approach that supports financial institutions with identifying critical nature-related risk drivers but lacks standardised regulatory alignment.
Time Horizon of Risk Assessment	Takes a long-term perspective, incorporating both slow-moving and abrupt nature-related financial risks.	Primarily short-term, focusing on immediate economic shocks and acute financial disruption.
Strengths for water-related risk assessments	Structured, principle-based risk assessment, which provides a comprehensive framework for integrating water-related risks into long-term financial planning. Recognises systemic interdependencies, emphasises the interconnectedness of water-related risks with broader environmental and climate factors. Aligns with global regulatory efforts, supporting initiatives like the taskforce on nature-related financial disclosures (TNFD), facilitating standardised reporting and regulatory compliance.	Direct assessment of water-related risks, focusing on immediate economic impacts of water-related disruptions, such as groundwater depletion and water pollution. Models non-linear, sudden shocks, capturing acute water crises, including drought-induced agricultural failures or industrial shutdowns due to contamination. Utilises historical case studies, employing past economic events to validate risk pathways, aiding financial institutions in understanding real-world financial consequences. Enables compounding and cascading shocks analysis in scenario design (through transmission channels framework and building blocks database).
Limitations for water-related risk assessments	Limited granularity on water-related risks, as while comprehensive, it may not differentiate between specific water-related issues such as surface water versus groundwater-related risks. Focus on long-term trends, and may not adequately capture sudden, non-linear water crises like regional water shortages or industrial disruptions due to pollution. Complex integration process, incorporating detailed water-related risk assessments into the broader framework can be resource-intensive for institutions.	Focus on physical risks, primarily addressing immediate physical disruptions, with less emphasis on transition risks such as regulatory changes affecting water-intensive industries. Short-term perspective, but concentrating on immediate shocks, which may not fully account for long-term water scarcity trends. Lack of standardised framework, where the absence of a uniform approach may pose challenges for consistent application across financial institutions.

Source: Authors analysis from (Ranger et al., 2023[18]; NGFS, 2024[13]; OECD, 2023[19]).

Findings from country-specific studies of nature-related risks

A number of country-specific studies of nature-related risks have also been carried out. Both the OECD and Oxford frameworks have been implemented through country specific studies. These are described in Box 3.4. A common finding across these studies is that water-related risks are often among the most significant drivers of nature-related financial impact.

Box 3.4. Findings from assessments of nature related financial risks

Application of OECD Supervisory Framework for Assessing Nature-related risks in Hungary

The OECD collaborated with the Hungarian Central Bank to develop a Supervisory Framework for Assessing Nature-related risks (see Box 3.2) The project took a two-phase process: research and development (mapping tools, metrics, and frameworks), followed by implementation (applying the framework and capacity building).

Key findings from its implementation were that Hungary faces significant physical risks linked to water resources, with sectors like agriculture and manufacturing experiencing up to a 53% output reduction under severe drought scenarios. Shocks of different severity could lead to a decline in the domestic GDP from 4-7%, and tan increase in the proportion of non-performing loans by 1-3%. Financial risks include rising non-performing loans and market risks tied to sovereign debt quality, potentially increasing debt-to-GDP ratios by 2.8%. Over 50% of Hungary’s high-risk financial instruments are concentrated in five banks, thereby increasing systemic and contagion risk.

The report highlights that the Hungarian banking sector is exposed to nature-related physical risks, particularly from industries that heavily depend on surface water and groundwater, with exposures of EUR 24.4 billion (43%) and EUR 23.3 billion (41%) of corporate lending, respectively. The report found that water use ranks as the second most significant impact after greenhouse gas emissions, based on combined direct and indirect materiality ratings. In Hungary’s banking sector, the agriculture, forestry, and fishing industries, along with the manufacturing sector, are especially reliant on surface and groundwater resources. In scenarios involving severe drought, they estimate that the financial shock is primarily concentrated within the manufacturing and agriculture, forestry and fishing sectors, with sectoral output under the most severe conditions projected to decline by EUR 10.6 billion and EUR 5.9 billion, respectively.

Assessing nature-related financial risks in the UK

In the UK, the Green Finance Institute (with Oxford and others) assessed the materiality of nature-related risks to the UK economy and financial sector, building on the methodology developed in the Green Scorpion report (see Box 3.3). The analysis, conducted in 2024, combined domestic and global nature-degradation scenarios to evaluate impacts on UK GDP and banks. Strikingly, the analysis found that continued deterioration of natural ecosystems (soil, water, biodiversity) “could lead to an estimated 12% reduction in UK GDP” in coming decades​ – a loss larger than the 2008 financial crisis or the COVID-19 shock.

The most affected sectors are those heavily reliant on ecosystem services: agriculture (dependent on water, soil fertility, pollination), but also manufacturing and certain services​. For example, UK agriculture faces rising risks from water shortages, soil degradation and pollution, which threaten food production. The UK energy sector is dependent on surface water for cooling power plants, so increased water stress could constrain electricity generation and drive-up energy costs.

This study also introduced a nature-related value-at-risk metric for financial portfolios. Initial results indicate that between 8% and 53% of the loan portfolios of the seven largest UK banks are exposed to nature-related transition risks (e.g. stricter water use or land-use regulations).

These findings reveal that UK banks have substantial credit exposure to sectors that are vulnerable to water scarcity and other nature risks. Overall, the GFI study confirmed that nature-related risks (especially those linked to water and land) could be as material as climate risks for a developed economy, yet are not fully priced into financial decision-making.

Source: (OECD, 2023[19]) (Boffo et al., 2024[37]) (Green Finance Institute, 2024[38]).

Table 3.3 below summarises selected nature-related scenario analyses by various institutions, highlighting the nature scenario used, which water-linked sectors are impacted, and the main findings. A number of important takeaways can already be drawn from these country studies.

Firstly, it is clear that water-related risks are of macro critical importance. Sustainable water supply is foundational for the global economy, if that foundation erodes, losses mount quickly. For example, the ECB finds a high share of non-financial corporates are highly dependent on at least one ecosystem service (72% of corporates, covering three quarters of bank lending). Clusters of high dependency on surface water can be observed in France, the Netherlands, northern Italy and western Germany (Boldrini et al., 2023[39]). This dependency means financial systems are heavily exposed to water scarcity or degradation in underlying economies. In the EU example, the ECB found in most cases, surface and ground water, together with mass stabilisation and erosion, represent the major potential sources of physical risk for banks (Boldrini et al., 2023[39]).

In addition, there are important sectoral vulnerabilities. Water-intensive sectors consistently emerge as vulnerable “hotspots” in nature scenario analyses. Agriculture is repeatedly flagged; drought and groundwater depletion can devastate crop yields and livestock, threatening food production and agricultural loan performance. Manufacturing and heavy industry also rely on water for processes and cooling. If water becomes scarce or polluted, factories may face higher costs or operational disruptions. Power utilities require water for cooling thermal plants; in the UK, for example, any constraint in water supply can impede electricity generation and drive up energy prices​ (Green Finance Institute, 2024[38]). Mining operations, as seen in the Chile case, depend on water for mineral processing; a lack of water can directly curtail output. These direct impacts then trickle through supply chains. For example, reduced mining outputs raise metal prices, affecting manufacturers and eventually consumers. In financial terms, banks and investors with concentrated exposures to these water-sensitive sectors could see rising defaults or market losses when water-related risks materialise (OECD, 2023[19]).

Further, these studies highlight important geographical and cross-border effects. Water-related risks often manifest themselves locally (at the scale of a river basin or a region), but their financial impacts can spread system wide. The Green Finance Institute study highlighted that over half of the UK’s nature-related financial risks originate overseas​ (Green Finance Institute, 2024[38]). For instance, droughts or ecosystem collapse in global commodity-producing regions can disrupt supply chains and raise costs in the UK. Drought in one country might reduce its agricultural exports, leading food importers to face price spikes and higher inflation (and potential loan stress for food processors). This underscores that financial institutions must consider cross-border water-related risk transmission. A domestic bank’s portfolio could be hit by water shortages on the other side of the world, if its clients rely on globally traded resources (grains, cotton, metals, etc.).

Lastly, many studies note the potential for cascading effects that amplify water-related shocks. For example, a water supply crisis can not only directly hurt farms and power plants but also compel governments to impose export bans or water rationing, which in turn create secondary shocks (as noted by OECD and IMF analyses). The NGFS/Oxford report calls water-related nature loss a potential “risk multiplier” on climate change​ (Ranger et al., 2023[18]). Indeed, water stress can exacerbate climate physical risks – e.g. a drought combined with ecosystem degradation can lead to more severe wildfires, crop failures, or power blackouts – thereby compounding financial losses. These interconnected risks highlight why water is often described as the “lifeblood” of the economy: when the flow is disrupted, the damage spreads widely.

Overall, emerging analyses reveal that financial stability can be undermined by water scarcity and ecosystem collapse just as by extreme weather or carbon shocks. Nature-related scenario results demonstrate significant numbers, for instance, estimating that 12% of GDP is at risk under scenario of ecosystem collapse (Green Finance Institute, 2024[38]) (FSB, 2024[40]). Such figures underscore that water and biodiversity risks are not distant, immaterial concerns: they bear real, quantifiable relevance for banks, insurers, and economies at large.

Table 3.3. Nature-related scenario analyses

Institution	Nature scenario used	Water-related sectors affected	Key impact findings
OECD (2023) – Supervisory framework for assessing biodiversity-related risks (Chile case study)	Localised water stress scenario (severe water scarcity in mining regions)	Mining (copper extraction); Agriculture (irrigated farming); Energy (hydropower and mining operations’ power supply); Aquaculture & communities (downstream water users)	Overuse of water in Chile’s arid mining regions threatens mining output (mining = ~15% of GDP​ and causes conflicts with agriculture and aquatic ecosystems. Scenario analysis shows water scarcity can raise costs, reduce output and tax revenue, and fuel inflation. Financial risks materialise as higher credit risk (firms’ solvency under declining water availability), market risk (commodity price volatility for copper/lithium) and liquidity risk (supply shocks in tradable commodities)​. This underscores that water scarcity can trigger both firm-level defaults and broader market disruptions.
NGFS (2024) Conceptual framework for assessing nature-related risks (Colorado river case study)	Drought scenario (escalating frequency of droughts in the Colorado River Basin, which are projected to reduce the river's flow by 19%-31% by 2050 under worst-case climate scenarios)	Agriculture (particularly irrigation and livestock farming, which are heavily dependent on consistent water supplies). Hydroelectric Power (dams along the river rely on adequate water levels to generate electricity). Urban Water Supply (Cities across seven U.S. states and two Mexican states depend on the Colorado River for municipal water needs.)	The anticipated decline in water availability poses significant economic risks to sectors reliant on the Colorado River. For instance, reduced water flows can diminish agricultural yields and hydroelectric power production, leading to financial losses.
Oxford/NGFS (2023) – “Green Scorpion”​	Global ecosystem service decline scenario (physical risk shocks to groundwater, surface water, water quality, pollination, etc.)	Manufacturing (water-intensive industries); Agriculture (irrigation, crop yields)	Water-related risks emerge as dominant, constituting ~7–9% of global GDP at risk (≈5% expected loss). ~14–18% of agricultural output is at risk from water scarcity, plus ~12% at risk from pollinator loss, indicating large macro-financial exposures to water and ecosystem degradation.
OECD (2024) – Hungary Pilot	Water stress scenario (severe drought)	Agriculture and manufacturing	Hungary faces significant physical risks linked to water resources, with sectors like agriculture and manufacturing experiencing up to a 53% output reduction under severe drought scenarios. Financial risks include rising non-performing loans and market risks tied to sovereign debt quality, potentially increasing debt-to-GDP ratios by 2.8%. Over 50% of Hungary’s high-risk financial instruments are concentrated in five banks, increasing systemic risk. The report highlights that the Hungarian banking sector is exposed to nature-related physical risks, particularly from industries that heavily depend on surface water and groundwater, with exposures of EUR 24.4 billion (43%) and EUR 23.3 billion (41%) of corporate lending, respectively.
Green Finance Institute (UK) 2024	Nature degradation scenario impacting UK (domestic ecosystem decline + global supply-chain pressures)	Agriculture (crop and livestock farming); Water-intensive Industry (manufacturing); Utilities/Power (cooling water); (Indirectly, broad economy)	Agriculture, manufacturing, and services are hardest hit (e.g. crop yield losses from soil/water degradation). An estimated 8–53% of the top 7 UK banks’ loan portfolios are exposed to nature-related transition risks (e.g. stricter water use or pollution limits)​ indicating significant bank vulnerability if nature-related policies tighten.
ECB/ESRB (2023)	Combined climate–biodiversity scenarios for Europe (e.g. “business-as-usual” nature degradation vs. Paris-aligned climate & nature protection)	Multi-sector – especially firms with high water dependency (e.g. agriculture, manufacturing) under drought conditions; also energy utilities	~72% of euro-area corporates are highly dependent on ecosystem services (water, etc.), accounting for ~75% of banks’ corporate loans​. Under a BAU biodiversity loss path, euro-area banks’ credit losses could be almost 3× higher than under a climate-only Paris-aligned scenario​. High dependence on surface water provision coupled with climate-induced drought risk amplifies default risks for borrowers​.

Source: (Ranger et al., 2023[18]) (FSB, 2024[40]) (Ceglar et al., 2023[41]) (GFI, 2024[42]) (OECD, 2023[19]) (Boffo et al., 2024[37]).

3.2.3. Supervisors face major data and modelling hurdles in assessing water-related risks

Data challenges and limitations are significant

Central banks and financial supervisors consistently face a range of data limitations that constrain the accuracy, granularity, and comparability of stress test results. These constraints have been highlighted across recent climate stress testing exercises by the European Central Bank, Bank of England, De Nederlandsche Bank, Banco Central do Brasil, the Spanish Macroprudential Authority Financial Stability Council (La Autoridad Macroprudencial Consejo de Estabilidad Financiera “AMCESFI”), and international pilots supported by the World Bank and UNEP FI, as well as by recent work on assessing nature related risks (Ranger et al., 2023[18]) (NGFS, 2023[12]).

One of the primary challenges that constrain the accuracy, granularity, and comparability of stress test results is data limitations. One of the most frequently cited challenges is the lack of geospatially disaggregated data on financial exposure. Many institutions are unable to access precise location data for underlying assets or collateral, such as the exact siting of residential properties, commercial infrastructure, or agricultural holdings. This impairs efforts to assess exposure to highly localised water-related hazards such as riverine flooding, coastal inundation, or sub-basin droughts (ECB, 2022[25]; Coloia and Jansen, 2021[17]).

A second recurring issue is the limited availability of environmental risk information at the counterparty level. The severe lack of data availability and quality in low and middle-income countries creates a critical blind spot in understanding and managing water risks, ultimately allowing water risks to be transmitted and amplified across global value chains, impacting countries far beyond their domestic water challenges. In particular, many borrowers, especially small and medium-sized enterprises and companies operating in emerging markets, do not disclose data on water use, local environmental dependencies, or exposure to nature-related regulation. This forces financial institutions to rely on sectoral proxies or conservative assumptions, reducing the precision of risk estimates and increasing uncertainty in model outcomes (ECB, 2022[25]) (RMS, GIZ and NCFA, 2017[29]).

Detailed, high-resolution data on water exposure (e.g. firm-level water usage, local flood defence quality, granular floodplain maps) are often lacking, forcing banks to rely on proxies and simplifying assumptions. This makes it difficult to capture geographic granularity, since water-related risk is highly localised (a city’s flood vulnerability or a river basin’s drought stress can vary over small areas). Most stress tests aggregate impacts at sector or country level, potentially masking pockets of acute risk: for example, a few flood-prone districts accounting for a disproportionate share of mortgage losses​ (Bank of England, 2022[26]).

Historical data limitations further complicate the modelling of water-related risks. Long-term records on extreme hydrological events, such as droughts or floods, are often inconsistent across regions or maintained using divergent standards. This makes it difficult to calibrate the frequency, severity, and probability of future water-related shocks, particularly in jurisdictions where climate-related hazard monitoring infrastructure is limited (Bank of England, 2022[26]; IMF, 2022[32]).

Several stress tests also identified difficulties in linking water-related environmental data with financial exposures. For example, assessing how a drought in a specific agricultural zone might impact the creditworthiness of downstream manufacturing firms, or how floodplain expansion might influence insurers’ underwriting losses, requires complex data integration. In many cases, this type of systems-based modelling remains underdeveloped. (AMCESFI, 2023[28]) (RMS, GIZ and NCFA, 2017[29]).

In addition, many stress tests apply water-related risks at a relatively aggregated level due to a lack of granularity in sectoral or sub-sectoral data. This constrains efforts to differentiate between, for example, irrigated and rain-fed agriculture or between hydropower and thermal energy generation in water-sensitive regions. Without this granularity, transition risk exposures and physical vulnerabilities can be masked or underestimated (World Bank, 2021[30]) (AMCESFI, 2023[28])

There are also technical challenges in modelling compound or cascading events, such as a sequence of drought followed by flood, or the interaction of prolonged rainfall with weakened infrastructure. Most current stress testing frameworks assess single hazard events in isolation, which may understate the systemic risk potential of water-related disruptions that occur in close succession or interact across sectors. Acute drought or flood shocks are typically assessed over one year, whereas cascading effects (like multi-year agricultural downturns, or successive disasters eroding insurers’ capital) and compound events (e.g. droughts coinciding with heatwaves and wildfires) are not fully explored. Indeed, in many cases flood risks and drought or water scarcity risks may be overlapping and compounding (Barendrecht et al., 2024[43]). Capturing second-round effects and interconnections (for instance, how a water crisis could trigger energy outages, supply chain disruptions, or social unrest) remains an analytical challenge (UNEP-FI, 2024[24]).

Finally, differences in methodologies and data sources across jurisdictions continue to pose challenges for comparability. While scenario-based tools such as those developed by the NGFS provide a useful starting point, they do not yet account for regional disparities in water-related risk exposure or data quality, nor do they fully incorporate ecosystem degradation or water pollution impacts. This reduces the ability of cross-border institutions and supervisors to perform harmonised risk assessments.

Furthermore, current scenarios usually exclude broader nature degradation that interacts with water-related risk, such as deforestation (affecting flood patterns) or wetland loss (reducing natural buffers), which means ecosystem service losses are not reflected in financial impact estimates. In addition, these scenarios do not capture shifts in the hydrological cycle that affect precipitation patterns and total water storage. Addressing these gaps will require enhanced data collection, more sophisticated modelling (potentially combining climate, hydrological, and economic models) and development of integrated climate–nature scenarios. As central banks and international bodies (NGFS, OECD, IMF) work to refine these tools, strengthening stress tests will be crucial to ensure that financial systems are prepared for the water-related dimensions of the climate crisis. Importantly, while data gaps are a key concern, this should not stop central banks from starting their nature related analysis.

Nature-related risks scenarios are in their infancy

It is important to note that nature-related scenario analysis is still in its infancy, with significant methodological challenges to overcome. However, as the MNB’s project emphasises, doing nothing until perfect information is available is not an option: failing to account for nature risks leads to mispricing and misallocation of capital, increasing the likelihood of abrupt losses in the future. In addition, ignoring nature risks can lead to risks of contagion if risks materialise – that is where nature-related financial risks within individual financial institutions could spread throughout financial systems and/or create feedback loops to the real economy (MNB, 2023[44]). Thus, regulators and researchers are proceeding with the best-available methods, while acknowledging these limitations. Each pilot provides lessons that will refine future models (for example, improving how to link drought scenarios to specific company financials, or how to aggregate firm-level impacts into system-wide stress).

Unlike climate stress-testing (which has a relatively mature toolkit, agreed scenarios, and abundant climate data), incorporating water and biodiversity into financial models presents a different set of complexities such as:

• Data gaps and granularity: assessing nature risks requires highly granular environmental data: for example, which specific watersheds a company’s operations depend on, or the state of local ecosystems. Such data are not routinely collected in financial reporting. Many exercises relied on mappings like the ENCORE (Exploring Natural Capital Opportunities, Risks and Exposure) database (linking industries to ecosystem services) or satellite-derived indicators. While useful, these introduce uncertainty as it considers generalised impacts and dependencies of sector without geographic specificities. There is also a lack of historical precedent for many ecosystem-finance linkages (there are no recent analogues of a global pollinator collapse, for instance), making model calibration difficult. Banks have noted the need for better mapping of their clients’ geographic dependencies (e.g. which river basin supplies a factory) and for improved IT systems to handle geospatial biodiversity data​ (UNEP FI, 2023[45]).

• Scenario standardisation: climate scenarios (e.g. IPCC Representative Concentration Pathways or NGFS climate pathways) provide a common reference for temperature and policy trajectories. No equivalent set of widely accepted nature scenarios exists as of yet. Each study has taken a bespoke approach, to model pollinator loss, deforestation, water stress, or other events, which makes results hard to compare. The NGFS’s work is moving toward developing standardised nature-climate scenarios, but for now this is a patchwork. Financial institutions and regulators are calling for harmonised scenario sets and guidance, so that nature-related stress tests can be conducted more consistently (similar to how climate stress tests use a handful of reference scenarios). While the diversity of ecosystems makes full standardisation of nature scenarios impractical, greater convergence in guidance, methodologies and data would significantly improve comparability and supervisory relevance.

• Partial coverage of risks: by necessity, current analyses tend to focus on a subset of nature risks. For example, the Green Scorpion pilot looked at 5 ecosystem services out of many; the World Bank scenario modelled three services. This means the results are likely underestimating total risk (as acknowledged, they are a “lower bound”) (Ranger et al., 2023[18]). There are many interlinked aspects (e.g. genetic biodiversity, coastal wetland protection, pollination, soil fertility, water flow regulation) and isolating one or two can miss the synergistic effects of multiple natural systems degrading at once. Over time, models will need to incorporate more of these elements together.

• Uncertain transmission channels: converting an ecological shock into economic and financial outcomes requires several modelling steps, each with uncertainty. For instance, if a drought hits, one must estimate how much crop yields would fall, how that affects food prices, how that in turn affects farmers’ incomes and their loan defaults, and so on. Each link in the chain can vary. Many pilot studies made simplifying assumptions to approximate worst-case risk. These give a sense of magnitude but are not precise forecasts. Additionally, current models often omit second-round effects (like financial contagion or market sentiment shifts). The ECB’s biodiversity stress test, for example, did not fully capture investment portfolio re-pricing or feedback loops within the financial system. As a result, today’s estimates of nature-related losses may underplay systemic aspects (or conversely, some may overestimate certain direct effects for caution) (FSB, 2024[40]).

• Early policy and market response: another challenge in assessing nature-related financial risks is the uncertainty around future policy action. Scenario analyses often rely on assumptions about regulatory responses. For nature risks, a wide spectrum of potential policy trajectories exists, from stringent conservation measures (which could increase transition risks for sectors that rely on unsustainable land or water use) to limited or delayed action (which could exacerbate physical ecosystem collapse). The timing, scope, and severity of such responses remain highly uncertain, making the design of forward-looking transition scenarios particularly complex. For instance, if governments introduce higher water pricing or accelerate the enforcement of nature protection regulations, sectors such as agriculture, utilities, real estate, and manufacturing could face higher operational and compliance costs.

Nature-related financial risk assessment today is roughly where climate risk was perhaps a decade ago.; It is recognised as important, but there is still much work to do to develop robust tools. The complexity of ecosystems and scarcity of standardised data make this a challenging task.

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