Water is the leading nature-related financial risk, with a potential 7-9% of global GDP at stake. Yet water risk is not fully priced into financial markets, exposing the financial sector to systemic risks. This contributes to the misalignment of capital flows while also driving climate change, nature loss and social inequality, a new report warns.

‘Navigating Troubled Waters’ is published by CDP, a not-for-profit charity that runs the global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts. According to the report, at the current rate of consumption there will be a 40% global shortfall in freshwater supply by 2030. Yet only 1% of European financial institutions have set water security targets, despite water’s critical role in industrial processes.

The report underlines the duty of directors of financial institutions to give careful consideration to water as part of their strategic planning and risk management, and to disclose their material risks.

Aside from the physical and transition risks of economic prosperity and social wellbeing, the mismanagement of water exposes financial institutions to litigation risk, reputational damage and loss of social licence, the report warns.

Company directors are urged to think of sustainability holistically or risk missing vital, urgent issues that threaten their company’s short and long-term success.

Water is fundamental to life on this planet and vital to the global economy. The economic value of water is vast, with direct and indirect benefits equivalent to approximately $58trn in 2021. Yet the current global water system is being degraded. 

In 2023, 235 out of 350 financial institutions (67%) globally were not assessing their portfolio exposure to water risks. Yet the financial costs are already taking place today. Four infrastructure projects alone account for over US$13.5bn in stranded assets, according to the report. 

The Network for Greening the Financial System, a network of 138 central banks and supervisors, is concerned that water risks are not sufficiently reflected in market prices or climate models. Financial institutions are likely underestimating the actual financial risks and increasing nature-related financial risks through the economic activities the sector finances and insures, the report says.

“The World Bank has suggested that in some regions water-related impacts on agriculture, health and incomes could cut up to 6% of GDP by 2050. This welcome report from CDP highlights clear steps that can be taken. We must work together to protect, manage and restore the global water system; it is central to a well-functioning global economy and a fundamental part of living in harmony with nature,” Michael Marks, Head of Investment Stewardship and Responsible Investment Integration, Legal and General Investment Management, says in the report.

Immediate action

Human-induced climate change is causing more frequent and intense heat waves, droughts and floods, which combined with the over-abstraction and misuse of water is driving water insecurity. 

CDP warns company directors to have a clear focus on water issues now. Boards must take steps to guide businesses to look “beyond carbon and navigate the troubled waters ahead, holding management accountable”.

“While climate risks are increasingly understood by financial institutions, nature-related financial risks are less so. This report highlights just how vital the water cycle is to the entire global economy and why it is so important that insurers understand their own exposures to water-related risks – particularly as climate change drives drought, flooding and pollution risks,” Rebecca Lea, Investment and Climate Manager at the Association of British Insurers says in the report.

The report urges directors to adopt a systems approach that involves understanding how climate change and water are interrelated, and align internal governance to embed consideration of water into strategy and business decision-making. 

They should also assess risks and opportunities by identifying and evaluating businesses’ impacts, dependencies, risks and opportunities on water. 

Reuben Walse, Head of Financial Services, ICAEW, says: “The report underscores the importance of water-related risks for banks and insurers, highlighting the need for a deeper understanding of the implications for bank lending and insurance underwriting. The sector as the primary mechanism for allocating capital and pooling risk also has an important role to play in setting the right societal incentives for change to help address the challenges that water insecurity might bring.”

Directors can also use their influence to support sustainable water usage and management, as well as document and disclose water risks. “Transparency drives accountability, supports trust and helps to mitigate risk,” the report says.

“Financial institutions should recognise that merely following existing policies and regulations may not eliminate their exposure to water-related financial risks or avoid harming water resources,” the research warns.

Digital transition

One alarming example of the necessity of water to the digital transformation highlighted in the report looks at the manufacture of semiconductors – the microchips that power the modern economy – which is water-intensive, with production geographically concentrated. 

The financial risks of water scarcity were underlined in 2021 when Taiwan, which produces more than 90% of the world’s most advanced chips, suffered its worst drought in more than 50 years. Water was prioritised to the semiconductor industry, increasing production costs and affecting other industries domestically by reducing their access to water. 

The knock-on impacts were global. It caused supply shortages in the automotive sector, materially reducing vehicle production over 2021-2022 with an estimated global sales shortfall of US$210bn in 2021 alone.

With artificial intelligence (AI) critical to the transitioning global economy, water sustainability should be prioritised. The large-language models use very dense chips that are more water-intensive to make, and consume a lot of energy to process complex computations.

The International Energy Agency expects electricity consumption from data centres, AI and the cryptocurrency sector to potentially double over the next two years. Data centres’ water use is expected to nearly double over the decade to 2030. 

Richard Spencer, Head of Sustainability, ICAEW says: “Water is the basis of life on Earth and of our economic prosperity. Taking steps to avert the significant risks of water scarcity is at the core of tackling the interrelated climate and nature crises. This report is a valuable and welcome call to action for directors and boards in the finance sector.”

ICAEW will be hosting sessions on nature-related topics at its annual October conference.