Drought Stress-testing Tool - Case study

NCFA and GIZ (Deutsche Gesellschaft für Internationale Zusammenarbeit) contracted a consortium led by Risk Managements Solutions (RMS), the global leader in catastrophe risk modelling, in order to develop and design a modelling framework and methodology to assess how drought scenarios affect the corporate lending portfolios of financial institutions. The model looks at the impact of drought on at least eight industries in each of Brazil, China, Mexico and the US. The industry sectors were identified through a consultation process with the partner financial institutions.

The Drought Stress Testing Tool includes a selection of potential scenarios to provide a view of how droughts of different severity, duration and geographic distribution could affect a loan portfolio. For each country, the selected scenarios were selected to highlight varying durations, with two drought scenarios lasting two years and three drought scenarios lasting five years.

In order to make this Tool and framework as user-friendly as possible for financial institutions, it was crucial to integrate financial institutions from the respective regions into the development process. Nine financial institutions representing more than US$10 trillion in assets helped design the Tool by providing input, testing and validating the analytical framework developed by the consortium. The nine banks involved in the project are:

  • Industrial and Commercial Bank of China (ICBC) Ltd;
  • Caixa Econômica Federal;
  • Itaú;
  • Santander;
  • Citi-Banamex;
  • Banorte;
  • Trust Funds for Rural Development (FIRA);
  • Citigroup;
  • UBS

We partnered with a number of these financial institutions to analyse certain loans and compile insights into how the drought scenarios would affect modelled default rates of loans in their portfolios. The data used was real loan data representing limited subsets of these specific financial institutions’ portfolios, and were selected to show a range of impact that could be experienced.

We have appropriately aggregated, summarised and anonymised the data to prevent disclosure of proprietary or confidential information. The findings strongly support the notion that drought is a tangible and material risk for many industries and that it should be considered when assessing loan default rates.

For the full report see here.

Brazil – Portfolio

General

  • The portfolio contains companies across eight different industry sectors, ranging from beverage and tobacco manufacturing to oil and gas extraction to water supply and irrigation, which the participant banks considered to be more sensitive to droughts.
  • Depending on the drought scenario, 65%-70% of obligor companies’ credit ratings were downgraded. This shows that drought events of this magnitude could be highly impactful to these sectors in Brazil.
  • Drought increased the portfolio losses due to default by between 1.5x and 2x depending upon the drought scenario applied, compared to expected default rates.
  • Severe drought events are expected to have a large impact in Brazil due to the country’s heavy reliance on hydroelectric power. Around 75% of Brazil’s electricity supply comes from hydropower, with power output dependent on reservoir water levels.

Scenario impact

  • All five scenarios significantly reduce company revenues and increase overall operating costs.
  • Scenario 5, affecting the main production areas of Brazil, Sao Paulo, Rio de Janeiro and Minas Gerais, is the most impactful because it is concentrated in regions with high industrialisation and production, but all scenarios result in significantly higher expected

losses compared with the non-drought scenario.

  • Scenario 1 has the highest hazard return period; however, this scenario is spread broadly across the country, impacting regions with relatively low production as well as the main economic areas.

Figure 1: Brazil scenario 5. It can be seen that the important economic region that encompasses Sao Paulo, Minas Gerais and Rio de Janeiro is heavily affected

United States – Portfolio

General

  • The portfolio focused on the water utility and petroleum refining industries.
  • Across a five-year period, the overall default probability for the water utility portfolio increased by about 0.5% between the reference year and the five drought scenarios.
  • Certain scenarios imply a potential drop of 75% in revenue and 20% increase in COGS for California water utilities, showing a significant impact due to drought. The impact on the default rate was, however, relatively low, indicating that these companies are able to

withstand severe reductions in revenue.

  • Over five years the overall default probability for the petroleum refining portfolio increased from 0.29% in the reference year to an average of 0.31% across the five drought scenarios – a nominal increase of 7%. The change in default rate increased losses between 2% and 14% depending on the scenario.
  • For water utilities, compared to the reference scenario, the drought increased portfolio losses by between 0.5% and 5% depending on the scenario. The relatively moderate impact on defaults, even though the drought causes significant falls in revenues, is in part because

the credit model includes implied guarantees or some level of government support for utilities.

Scenario impact

  • Scenarios 1, 2 and 3, (all five-year drought scenarios) have a moderate to severe impact on overall expected losses, with overall losses increasing between 2.5% and 5% for water utilities, and 7%-15%, for petroleum refineries. This suggests that water utilities are

relatively resilient, even to long-term droughts despite experiencing significant reductions in revenues.

  • Scenarios 4 and 5 (both two-year drought scenarios) show minimal impact on overall expected losses, with losses increasing by 0.7% for water utilities, and 2% for

petroleum refineries. This shows the relative resilience of US companies to shorter drought scenarios.

“The world is facing a changing climate. Brazil’s water crisis in 2015 made us more aware about the impacts and possible loss to companies, the economy and environment. We at Itaú Unibanco are proud to participate in the Drought Stress Testing Tool as we can now measure the effects of water-related crises to our portfolios. Knowledge of the risks is the best way to mitigate them. The project is bringing us insights to become even better at socio-environmental risk management in our portfolio.”
Denise Hills Head of Sustainability and Inclusive Business, Itau Unibanco

Figure 2: US Scenario 4. It can be seen that both the east and west coasts are heavily impacted by the drought event