Environmental Stress Testing

The objective of the pilot project on Environmental Stress Testing was to develop and test an innovative analytical framework and open-source tool that allow banks to assess the potential impact of drought events on the performance of their corporate loan portfolio. Typically, financial institutions lack respective instruments and capacities. The drought stress testing tool enables banks to assess, if a client may be at risk from drought and how drought can affect a sector or region. A clearer understanding of the risk associated with droughts can help build stronger resilience by:

  • re-allocating core capital to less vulnerable sectors and regions,
  • increasing the funding costs for water-sensitive, resource-intensive sectors, and
  • enhance the dialogue between financial institutions and their clients with respect to resource-efficient and drought resilient business models and technologies.

Consequently, this translates into more sustainable economies and financial systems as well as healthier ecosystems, which are better equipped to absorb shocks such as droughts.

In order to equip finance professionals with such a tool, a consortium led by global risk modelling experts from Risk Management Solutions (RMS) designed, developed and implemented the drought stress testing tool and underlying framework based on the catastrophe modelling framework that the insurance industry has used for 25 years. The developed framework and tool look at five drought scenarios in four countries – Brazil, China, Mexico and the U.S. – to model the impact on 19 different industry sectors, the companies in those sectors and the likelihood that they will default on their loans.

The project was implemented in partnership with nine banks from across the globe, which tested the tool on a sample of their corporate loan portfolio as showcased in the project report. The partner banks, which represent more than USD 10 trillion in assets under management, comprise:

  • Banorte (Mexico)
  • Caixa Econômica Federal (Brazil)
  • Citibanamex (Mexico)
  • Citigroup (U.S.)
  • Industrial and Commercial Bank of China (ICBC) (China)
  • Itaú Unibanco (Brazil)
  • Santander (Brazil)
  • Trust Funds for Rural Development (FIRA) (Mexico)
  • UBS (Switzerland/U.S.)

Key findings from the report include:

  • Extreme droughts could increase loan default losses ten-fold for specific portfolios that are most exposed to the effects of drought;
  • Even when exposed to less extreme drought scenarios, most companies in the analysed portfolios see their credit ratings downgraded;
  • The most affected sectors are water supply, agriculture and, in countries with high reliance upon hydroelectric energy, power generation;
  • Significant impacts are also found in water-dependent sectors such as food and beverage production;
  • Sectors that are less water-dependent but highly sensitive to general macroeconomic conditions, such as petroleum refining, are also affected by widespread economic impacts of drought.

Voices

Eric Usher, Head of UN Environment – Finance: “Making the move to a sustainable finance system will require the development of innovative tools such as this. This is the first time drought risk has been assessed in this way, and the involvement of nine forward-thinking banks from around the world proves how serious global financial institutions are becoming about considering the risk from extreme environmental events such as drought.”

Courtney Lowrance, Global Head of Environmental and Social Risk Management, Citi: “The development of the tool is timely, as it will inform how ‎institutions can conduct scenario analysis on climate change risks in alignment with the expected guidance from the Taskforce on Climate-Related Financial Disclosures.”

Linda Murasawa, Sustainability Head, Santander Brazil: “This tool will have immediate impact in terms of awareness raising and bringing the issue of environmental stress testing closer to mainstream risk management.”

Resources

An introduction to the tool

The methodology behind the tool

Events

Press

Partners

Implemented by:

            

Developed in cooperation with:

    

       

    

Supported by
EMDF | Emerging Markets Dialogue on Finance