The Future of Finance: Integrating Water and Nature into Central Bank Strategy
Climate and nature related risks will soon be a thing of the past. Not because extreme weather or water events won’t happen, but because they won’t be risks anymore: they’ll be certainties. How can central banks respond to this transition?
President of the European Central Bank Christine Lagarde, noted in June 2024 that climate and nature-related risks pose a unique challenge for central banks, requiring a different response and representing a new type of systemic risk beyond traditional "black swan" events. These uncertainties — combined with political, trade, and technological shifts — necessitate non-traditional macroeconomic tools.
As part of an ongoing series of webinars organized by the Water Resilience for Economic Resilience (WR4ER) initiative, experts from across the finance and resilience landscape came together for the session “Can Central Banks Engineer Resilient Economies?” which focused on equipping countries, communities, and ecosystems for this complex future.
Discussions highlighted the necessity of proactive water resilience measures by financial institutions, alongside crucial government intervention and protection for vulnerable groups.
Enhanced collaboration between environmental ministries and financial institutions was underscored as essential by Josefina Maestu, International Water Advisor to the Spanish Minister of Ecological Transitions. Freshwater security is critical for central banks due to its impact on price and financial stability: “As much as the economy depends on a stable climate and intact nature, it also depends on a stable, resilient hydrological cycle and resilient water-related infrastructure” said Carolin Carella, Research Lead, Greening Financial Regulation Initiative, WWF.
Currently, freshwater considerations are often siloed within the broader climate/nature risk assessments conducted by financial institutions. While resilience is seen as crucial for economic stability, the very concept of resilience needs to evolve and expand in practice to be able to offer solutions for tomorrow’s world. “Our past is not necessarily a useful guide for the landscape in which we find ourselves walking now,” shared John Matthews, Executive Director, AGWA.
Keynote speaker Sjoerd van der Zwaag, Senior Sustainable Finance Officer, Dutch Central Bank emphasized the codependency of resilient economies and the resilience of nature, as its degradation creates significant financial risks with macroeconomic implications. OECD Policy Analyst, Lylah Davies highlighted the need to look at water-related risks, not just as an environmental issue, but as a “financial stability concern that's increasingly relevant for financial supervisors and central banks.”
How central banks are building resilience in the face of uncertainty
Water risk is particularly relevant to the Network for Greening the Financial System’s (NGFS) framework for nature-related risk assessment, and the financial risk posed by the Colorado River Basin is a stark example. A worst-case climate scenario predicts a severe decline in the Colorado River flow, from 90% to 31% by 2050. This reduction in water flow will negatively affect ecosystems and the economy. One direct consequence is the hampered generation of hydropower, impacting energy production for homes and industries in the region.
The Bank of Spain has been conducting their own analysis of the impact of increased aridity in Spain on credit and the macroeconomy. While the increase in aridity has been significant and uneven across regions, this heterogeneity helps identify its impact. They were able to see that total credit declined due to increased aridity, but this impact took 10 to 12 years to materialize. This need to consider long-term impacts makes it difficult for the Bank to adopt measures to combat aridity's impact on credit and overall economic activity. “This delay is referred to as the curse of the horizon,” Angel Estrada, Senior Advisor of the Banco de España Governor, reflected.
In the short term, the impact of recent floods in Spain on both GDP and credit has made the country all too aware of these risks, but the heterogeneous effects of natural disasters on different sectors and loan portfolios continue to complicate their response.
The Dutch Central Bank, which faces different environmental threats, wants to further develop such forward-looking scenarios for nature-related financial risk, creating a compendium of implementation practices for the conceptual framework beyond illustrative cases like Colorado. “Nature-related risks are a source of material risk for the financial sector, and therefore will frequently fall within the mandate of a central bank to act,” van der Zwaag concluded.
Innovative tools for building economic resilience
Angel Estrada, Advisory Office, Governor of the Bank of Spain built on the role the banking sector can — and must — play, focusing on the regulatory and supervisory response to climate risk. Estrada encouraged the financial sector to integrate climate risk into decision-making, particularly physical risks. For central banks aiming to address climate and nature-related risks, standardized reporting, stress testing, and forward-looking scenarios are essential tools.
One such tool is WWF's Greening Financial Regulation Initiative (GFRI) which engages central banks and financial supervisors with a focus on integrating the kinds of nature-related risks van der Zwaag highlighted into financial regulation and supervision and could help close regulation gaps.
Cate Lamb, Freshwater Lead, UNEP Finance Initiative (UNEP FI) covered the UN Principles of Responsible Banking (PRB), and more importantly, how they've been received by central banks.
While the PRB focus on commercial banks, central banks are showing support through the NGFS. The PRB face challenges due to their voluntary nature and current limitations in preventing greenwashing. Lamb echoed Estrada’s call for standardized reporting and better enforcement from central banks, and would “love to see more central bankers working hand in hand with the ministries of environment or ministries of water within their countries, as well as the countries that they depend upon.”
Despite existing obstacles, the PRB are becoming increasingly influential, currently covering a substantial share of global banking assets.
While central banks don't have all the answers, they can use their powers and mandates to address these issues. Kata Molnar, Lead Analyst, Sustainable Finance Department at the Central Bank of Hungary (MNB) shared tools and approached how MNB is already using them to integrate environmental sustainability into its mandate, recognizing climate and ecosystem issues as drivers of inflation and risk.
“We have the opportunity to steer the financial system towards supporting an economy that values and preserves natural capital,” Molnar said. It employs tools like the Green Preferential Capital Requirement to promote green financing while managing environmental risks — Hungary’s green loan portfolio has grown by 50%, now totaling 3.3bn Euros. MNB also collaborates with OECD on nature-related risks and integrates them into climate disclosures and stress testing. However, Molnar concedes that broader central bank engagement with nature and biodiversity in financial supervision remains limited.
Research on scenario development and implementation practices for nature-related risks must continue alongside engagement and dialogue between central banks, financial institutions, and initiatives such as WR4ER. Efforts are underway to develop policy research and build a compendium of implementation practices to assist banks in aligning with nature-related objectives.
The water world has been working on this issue for more than a decade, and while the message hasn’t changed, the messengers have: with central banks committing to water resilience and, in turn, resilient economies.
Speakers
Introduction
John Matthews, Executive Director, Alliance for Global Water Adaptation
Keynote Speakers
Sjoerd van der Zwaag, Senior Sustainable Finance Officer, Dutch Central Bank | Presentation
Angel Estrada, Senior Advisor of the Banco de España Governor | Presentation
Panel discussion
Lylah Davies, Policy Analyst, OECD (Moderator)
Cate Lamb, Freshwater Lead, UNEP Finance Initiative
Carolin Carella, Research Lead, WWF Greening Financial Regulation Initiative
Kata Molnar, Lead Analyst, Sustainable Finance Department, Central Bank of Hungary
Closing
Josefina Maestu, International Water Advisor to the Spanish Minister of Ecological Transitions