European Central Bank warns of drought impact in eurozone

Droughts could reduce economic output in the EU by up to 15 percent. – predicts the European Central Bank (ECB) based on its climate risk analysis. According to Frank Elderson, a member of the ECB’s Supervisory Board, it’s time to start appreciating the importance of pollinators, water resources and other ecosystem services in strictly economic terms.

Profit streams are drying up

The study, conducted by the European Central Bank in cooperation with the University of Oxford’s Resilient Planet Finance Lab, aimed to examine the possible financial and economic impact of an intense but meteorologically plausible drought in Europe. The analysis showed that the greatest risk is to agricultural production in countries in the south of the continent, where losses could be as high as 30 percent. The risk decreases as one moves north, with 12 percent in Finland.

According to the ECB, the sectors most threatened by water shortages, in addition to agriculture, include manufacturing, mining and construction. In addition, reduced water flow in rivers translates into restrictions on electricity production and impediments to inland shipping.

European Central Bank explores relationship between nature and finance

The European Central Bank stresses that any pressure limiting the supply of water resources could trigger a cascade of economic consequences. ECB research shows that the operations of 72 percent of companies in the eurozone are heavily dependent on ecosystem services, with these entities accounting for three-fourths of corporate credit obligations. Destabilizing their operations for climate reasons will have far-reaching consequences for financial institutions.

The financial losses associated with water shortages, poor water quality and flood control appear critical in terms of added value , according to ECB’s Frank Elderson. In a speech at the Naturalis Biodiversity Center in the Netherlands, he cited traditional tulip-growing regions such as Bollenstreek as an example of the risks. Soon, water scarcity could severely limit flower production, leading to huge economic losses. This year’s spring in the Netherlands was the driest in 50 years. Elderson recalled that the drought that hit the Netherlands in 2018 caused losses in the order of €1.9 billion in agriculture and €155 million in water transportation.

NVaR’s new analytics framework

To better determine the relationship between the loss of ecosystem services and the health of the economy, the European Central Bank has developed a new analytical framework called Nature Value at Risk (NVaR). It is based on risk assessments for specific locations, economic sectors and the state of the environment, based on Earth observation data, models and surveys. The calculation also takes into account cross-border financial flows accompanying services and goods.

Translating theory into practice, ECB analysts used NVaR to identify the factor of greatest risk to the European economy, and it turned out to be… surface water scarcity. They calculated that in the event of a drought of the highest severity in a quarter-century, as much as 15 percent of the eurozone’s economic output would be at risk.

In the long term, losses in agriculture, mining, construction and industry due to water shortages will translate into the entire market for goods and services. Food and water will become more expensive, and so will lodging and catering. Thus, the drought will fuel inflation. An analysis of the situation in individual eurozone countries has shown that Cyprus, Spain, Italy, Greece, Portugal and Luxembourg stand to lose the most, while Finland, Latvia and Ireland stand to lose the least.

What does this mean for banks in Europe?

The direct impact of the drought on the performance of individual economic sectors in the eurozone does not yet reflect the full extent of the problem. Companies incurring losses will stop paying their debts, which will translate into an increase in banks’ credit exposure. Thus, in a black scenario, the lack of water could cause instability in the continent’s financial system.

The European Central Bank has subjected the loans made by 2,500 banks in the eurozone to non-financial entities to additional analysis. It found that 34 percent of them related to sectors highly sensitive to water scarcity. In this problematic portofolio, estimated at €1.3 billion, the largest portion was made up of loans to representatives of the manufacturing industry, followed by commercial, construction and energy companies.

In addition to the scarcity of surface water, the ECB also identified the scarcity of groundwater and the shrinking area of floodplains with a retention and flood protection function as factors of high economic and financial risk. Also included in the analysis was the deteriorating quality of surface water and aquatic ecosystems, which reduces the attractiveness of regions for tourism and results in economic losses of 100 billion euros a year.

Drought risk and the reporting system

An independent study published by trade credit insurance company Allianz Trade on May 22 suggests that the biodiversity crisis is beginning to affect the global financial world. In the EU, the United States and Japan, 10-13 percent of economic output comes from sectors that are closely dependent on ecosystem services, such as clean water, fertile soil and climate regulation. According to analysts at Allianz, nature degradation, such as that associated with soil erosion, could cause the global economy to shrink by more than 2 percent.

This alarming data raises a dilemma among economists and politicians. How far should central banks intervene in the market to minimize climate risks for financial institutions? Overseas, President Donald Trump is withdrawing Federal Reserve funds from the NGFS (Network for Greening the Financial System), but in Europe so far there is only talk of drastically reducing ESG reporting obligations that take into account environmental risk. Is this a step in the right direction?

According to Frank Elderson, analysis of the quality of ecosystem services should be standard in the operations of modern banks. Gathering data and collaborating with scientists can help better understand the non-linear relationship between nature and the economy and effectively identify tipping points. In his opinion, it is the environmental information extracted from individual companies that plays an important role in this process, so finding the golden mean for reporting standards is crucial.