When Water and Climate Issues Turn into Material Risk for Ag Lenders

Some of the most notable impacts of climate change in agriculture are physical risks – such as droughts, floods, changing rainfall patterns, and extreme weather events – which all damage crops. Not all physical risks are material risks, though. 

Material risk is relative and describes a risk that is a concern for a specific business operation, portfolio and, in ag lending, a parcel of farmland.

For example, drought is a material risk for farmers in Idaho and Colorado, while sea-level rise is not. It may be a material risk for farmers in California, though – along with associated risks like flooding, land subsidence, and salinization. Ag lenders must be aware of the material risks that impact their portfolios in order to mitigate them.

This post will explore material risk in the context of climate change, and how GIS can help ag lenders determine which physical risks are material to their portfolios.

Material Risk in the Context of Climate Change

Agriculture is an inherently risky industry. As the U.S.D.A. puts it, “The uncertainties inherent in weather, yields, prices, government policies, global markets, and other factors that impact farming can cause wide swings in farm income.”

Because these risks vary so widely across agricultural regions and impact different crops in different ways, there’s no single risk profile when it comes to assessing the health of agricultural lending portfolios.

A report by Ceres identifies five “financially material business risks” associated with water use and climate change that can lead to reduced profits, stranded assets, and other undesirable effects. These range from “potential losses resulting from external physical events” to “the risk of legal sanctions stemming from a company’s failure to comply with laws, regulations … and codes of conduct.” Ultimately, they write:

“While the severity of environmental and social impacts vary by commodity, region, and company, these collective trends are producing tangible business risks that are increasingly affecting company bottom lines.”

Understanding Material Risk

Ag lenders and investors need to take the time to understand which risks are material to their portfolios and which are not. As noted above, physical risks that are material for a farming operation in one region may not be a concern for a farmer in another.

Ag lenders should look for concentrations of risk in their portfolio to determine whether or not those risks will have a direct impact on their collateral.

Through data, an ag lender may gather that similar physical risks may call for different risk mitigation strategies, depending on the region or crop that’s affected.

For example, water rights and water markets can be very complicated and are varied across states, and a water shortage will be especially damaging to a portfolio that consists primarily of water-intensive crops, with few viable sources of water, in a water-stressed region.

The agricultural industry as a whole is still in the early stages of understanding water and climate risk. A report in Agricultural Systems found that 66% of the studies they sampled “focused solely on production risk” and “only 15% of studies considered at least two types of risk.” They note that “limited attention on multiple risks appears at odds with farmer realities” and that “a shift in research focus to multiple risks may help prioritize risk management.

Ag professionals should take the opportunity to identify and mitigate material risk now, in order to reduce transition risks as the industry responds to drought and climate change.

How Better Water Data Can Help Mitigate Material Risk

Since many of the significant risks associated with climate change have to do with water – drought, reduced snowpack, flooding, extreme weather, etc. – analyzing water data is one of the key ways that agricultural professionals can mitigate material risk.

Granular water data can help lenders and banks identify concentrations of physical risk that are material to their portfolios.

As Agricultural Systems explains: “Given the greater availability of open access data on weather and prices …  a possible path forward is to apply simulation models that have a core of production and market risk and conduct farmer-relevant ‘what-if’ scenarios for institutional, personal, and financial risk.” The Task Force on Climate-related Financial Disclosures recommends a similar type of scenario analysis to identify climate risk.

Financial institutions in particular will face increasing pressure to disclose climate risk, both due to increased interest in ESG and impact investing, and to SEC regulations that require publicly traded companies (“registrants”) to disclose material risks.

These two factors make it imperative for institutions such as agriculture lenders to have a true understanding of water risk.

The Bigger Picture

Identifying material risk is about more than just assessing the viability of a particular crop or performing a water risk assessment before closing a land deal. It also means considering relevant physical risks throughout supply chains.

As the Ceres report points out, “the structure of a company’s supply chain drives not only the business risk but also the strategies employed to manage these risks… It is important for investors to seek information from companies on the nature of their agricultural supply chains and their ability to trace inputs back to the farm level.”

Risks that aren’t material to a farming operation may still be material to other parts of the supply chain and may have an effect on a loan or investment portfolio.

An understanding of the bigger picture must start with local, granular data to ensure accuracy and relevance.

New tools, such as GIS, are making it possible for ag professionals to get that big-picture view and identify links that may not have been visible using traditional methods.

Additionally, cloud-based GIS tools make it possible to aggregate data from multiple sources and share them with other stakeholders, creating a single source of truth to guide risk mitigation policies throughout the supply chain. With access to actionable data, it becomes easier to implement strategies that truly mitigate the business risk that is caused by water risk.

Read about ESG reporting and capital risk in the AQUAOSO Guide.

The Bottom Line

Some of the most damaging effects of climate change manifest themselves as physical risks, including water shortages, rising temperatures, and extreme weather events. But not all physical risks are material to a particular farming operation or loan portfolio.

By using local, granular data to discover and analyze water risk, ag professionals can identify concentrations of risk in their portfolios and create a strategy to mitigate them.

AQUAOSO is a leading provider of water security data for ag professionals. The map-based Water Security Platform makes it easy to monitor water risk across an entire portfolio by collecting data from various disparate sources and funneling the data into the context of unique ag lending portfolios.

In addition, the Portfolio Connect tool provides options for collaborating with other stakeholders and integrating existing data sources.

Reach out to the team at AQUAOSO to get started, or sign up for the newsletter to get the latest water security insights sent directly to your inbox.

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