The CCLI’s Biodiversity and Africa Lawyer, Victoria Puxley, talks to Annabel Nelson, Strategic Advisor to the CDP, about what water risk means for financial institutions and directors’ duties. This follows the release of a CDP water briefing for directors authored by Annabel and linked at the bottom of this Insights.

Victoria: What prompted you to write this Briefing?

Annabel: I’m increasingly worried that many financial institutions are overly focused on carbon emissions when it comes to climate action. Financiers generally aren’t environmental scientists, so they’ve followed the IPCC recommendations and regulations that emphasise reducing carbon emissions to net zero by 2050. As a result, most climate risk management focuses on carbon emissions and the risks of high-carbon assets, with little attention to water-related risks beyond sea levels and flooding.

However, the real impacts of global warming are playing out through the water cycle—changing rainfall patterns and freshwater shortages. Our economy relies heavily on freshwater for everything from agriculture to technology, but we’re depleting these resources faster than they can be replenished. If we continue at this rate, we’ll face a 40% global shortfall in freshwater supply by 2030. This is an immediate problem – a systemic risk in fact – that isn’t captured in carbon reporting.

Financial institutions need to factor in these water-related risks because they directly affect financial returns. That’s why I wrote this Briefing—to broaden the focus beyond carbon and help boards understand the ‘What,’ ‘Why,’ and ‘How’ of water-related financial risks that are often overlooked, including the potential legal risks for boards and provide practical steps to help them address these challenges.

Victoria: The Briefing states that water risk exposes the financial system to systemic risks. Can you explain why and what that means in practice?

Annabel: In our highly interconnected global economy, every product and service we use has a water footprint, which reflects how much freshwater is consumed throughout its entire supply chain. Although water use is local , its economic impact can ripple globally through the supply chains it supports. When water availability drops, it can severely affect all the businesses that depend on it.

Take the 2021 drought in Taiwan as an example. Taiwan, which produces over 90% of the world’s most advanced microchips, experienced its worst drought in 50 years. Since microchip production is very water-intensive, this drought caused a global shortage of chips. The automotive industry, which heavily relies on these chips, saw a significant reduction in vehicle production, leading to a worldwide sales shortfall estimated at USD 210 billion in 2021. This also drove up prices in the second-hand car market and impacted the adoption of new electric vehicles (EVs) and the expansion of EV charging infrastructure.

The economic value of freshwater varies depending on location, availability, quality, and how it could be used elsewhere. The problem is that the price of water often doesn’t reflect its true value, which has encouraged unsustainable water use in supply chains. Currently, about 50% of the water footprint in high-income economies comes from areas experiencing high water stress, making it unsustainable.  This water risk doesn’t just affect the regions where goods are produced; it also impacts the businesses relying on those goods and the financial institutions backing them.

Victoria: What are the financial costs of water risks to financial institutions and how do they show up in portfolios? 

Annabel: Water risks can lead to significant financial losses for financial institutions by affecting the insurance risk or the performance of investment loans in water-dependent industries. When water becomes scarce or is mismanaged, it can disrupt production, increase costs, and reduce profitability for companies reliant on it. This, in turn, can lower the value of stocks, bonds, and other assets in a portfolio; increase loan defaults or insurance claims.

Global Water Intelligence estimates that 69% of the insurable impact of climate change over the next decade—around USD 1.375 trillion—will be due to water issues. But the actual economic impact could be much higher since many drought-related losses aren’t fully covered by insurance. To give you an idea of the magnitude of this, in 2023 only 38% of the USD 280 billion in natural catastrophe losses were insured.

Financial institutions need to consider water risks during due diligence, as these risks can accumulate across portfolios, especially given how interconnected water use is in supply chains. It’s concerning that 67% of financial institutions globally admitted they’re not assessing water risks in their portfolios, according to CDP.

I’d also add, how financial institutions handle water risks reflects their overall strategy, risk management, and governance. This influences customer trust, talent attraction, and how capital providers assess their risk, all of which can affect an institution’s ability to deliver long-term financial performance. 

Victoria: The Briefing states that financial institutions do not have the luxury of prioritising carbon emissions reductions before taking action on freshwater. How should boards navigate evolving expectations around water? 

Annabel: There’s growing concern among the scientific community that we’re approaching an ecosystem tipping point beyond which we face cascading and compounding, irreversible, environmental change, with devastating social and economic consequences. This means that carrying on with business-as-usual financing activity without actively managing both firms’ exposures and contribution to water-related risks will increase risk at both an asset and portfolio level. 

The quip that TCFD was the taskforce on carbon-related financial disclosure, is no joke. Though climate change and the water cycle are two of the natural planetary systems which regulate our environment, global warming is changing rainfall patterns. This is generating climate-related financial risks which in many jurisdictions financial institutions have a regulatory requirement to manage. 

Many parts of the world already face acute water stress. Supply chains exacerbate the problem and at the current rate of consumption the prospect of a 40% global shortfall in water supply by 2030 means this is a foreseeable, material, systemic financial risk. CCLI’s work on directors’ duties is clear that directors have a duty to act with care and loyalty, considering risks to nature as foreseeable and material risks. This responsibility is integral to their governance of strategic planning, risk management and disclosure.

Victoria: Do you think existing policies and regulations go far enough to help financial institutions eliminate their exposure to water-related financial risks?

Annabel: It’s pretty clear that there’s a major gap in policy here. Even though 196 countries signed the Paris Climate Agreement back in 2015, their actions and policies are still steering the planet toward a 2.7°C increase by the end of the century. The core issue is that our global economy is demanding the resources of 1.7 Earths to sustain itself and manage its waste, and things are only getting worse.

What’s frustrating is that, despite the Network for Greening the Financial System pointing out that water is the biggest nature-related financial risk—potentially putting 7-9% of global GDP at risk—and sounding the alarm about how these nature risks aren’t being factored into financial markets, nothing has changed. They’ve warned that these risks aren’t being considered in the scenarios used by financial institutions, central banks, and supervisors. This oversight is leaving the financial system vulnerable to major risks and causing a mismatch between how capital is allocated and what society actually needs. Yet, somehow, this still hasn’t been addressed in regulations.

We’re seeing an increase in environmental litigation stepping in to fill the gap in policy and regulation and drive behavioural change. It feels somewhat counter-intuitive to say this but, on a slightly more positive note, since the effects of water use are specific to certain locations, it’s easier to pinpoint who’s causing harm to local communities and ecosystems, including the sources of funding. I don’t think this is fully on the radar of many boards which is why my paper explains why financial institutions aren’t just facing water-related financial risks in their assets and portfolios—they’re also at risk of lawsuits, damage to their reputation, and losing their social license to operate if they mismanage water resources.

Victoria: What do you think are the main obstacles preventing financial institutions from incorporating water-related risks into decision-making?

Annabel: The main obstacles are really twofold. 

First, there’s a lack of understanding.  Climate change is affecting water availability, and water is a major factor in nature-related financial risks. The finance sector often focuses too narrowly on carbon, but risks don’t exist in isolation. This narrow focus on carbon alone is simply not enough.

Second, the policy and regulatory environment isn’t keeping up with the scale of the risks we’re facing. It’s not just about future risks—we’re already seeing significant losses that are only going to get worse. Disjointed policies and incorrect pricing of water are leading to mismanagement. Financial institutions need to realize that just following existing policies and regulations won’t necessarily protect them from water-related financial risks or prevent them from causing harm to water resources.

However, the briefing outlines a practical roadmap that the industry has endorsed to help financial institutions overcome these challenges. There are four key components:

1. Adopt a systems approach: Understand the connection between climate change and water.
2. Assess risks and opportunities: Identify and evaluate how water affects your business and stakeholders.
3. Use change levers: Leverage your influence to promote sustainable water use and management.
4. Document and disclose: Transparency builds accountability, fosters trust, and helps mitigate risks. 

The paper provides more details on each of these steps.