Consecutive heatwaves in Europe with changing precipitation patterns are already exposing several regions (mainly southern) to meteorological drought. This is causing severe damage to economic, human, and natural systems. Drought episodes are among the multiple adverse effects of climate change. Thus, it is vital that investors stress-test economies for exposure to drought to screen for risks in their portfolios.

Scope’s Macroeconomic Climate Stress Test (MCST) models the notional exposure of economies and sectors to drought and other climate risks. Applying the MCST to EU countries, future droughts under the NGFS disorderly scenario could cost a hypothetical EUR 32.7trn between 2020 and 2050, representing 3.3% of the bloc’s total GDP.

Seventy per cent of modelled drought-related losses are in the five biggest EU economies (Figure 1). Northern EU countries (Germany, France, Netherlands) are the least exposed to drought risk but hypothetical drought-related losses in Italy account for 30% of the total expected loss in the EU and 43% of the expected loss of the Big Five economies.

Drought could cost Italy EUR 10 trn over the 2020-2050 period, equivalent to a cumulative 8.3% of the country’s per capita GDP over the same period. This would place additional burdens on debt-financed public expenditure to cope with drought risks, driving up Italy’s debt-to-GDP ratio and increasing the cost of long-run refinancing.

Figure 1: EU economies driving drought-related loss

L/H axis: Future drought-related impact measured in loss-to-GDP (%)
R/H axis: country’s loss relative to total drought related loss in EU countries
Source: Scope ESG Analysis

Agriculture most exposed sector

At sector level, agriculture is the most exposed to drought risk, with modelled cumulative losses of EUR 1.8 trn, equivalent to 9.8% of sector revenues. Food products, beverages and tobacco; and Wholesale and retail trade have exposures are of 6.8% and 6.7%, respectively. Other economic sectors show relative drought-related losses ranging between 4% and 7% of the total expected loss in the EU.

Figure 2: EU economic sectors driving drought-related loss

L/H axis: Future drought-related impact measured in loss-to-GDP (%)
R/H axis: Sector’s loss relative to total drought related loss in the EU
Source: Scope ESG Analysis

2,745 country-sector combinations

Scope’s MCST provides projections of climate risks at the country-sector level, covering 45 economic sectors and 61 countries and regions for a total of 2,745 country-sector combinations. The MCST derives the contribution of economic activity to total country drought risk from three factors:

1. The sensitivity of the economic activity to historical droughts (in-house developed sector-level damage functions).
2. The exposure of the country to future droughts depending on the climate scenario.
3. The weight of the economic activity in the country’s per capita GDP.

MCST results need to be interpreted bearing in mind that simulations assume that future adaptation at the country-sector level mimics historical adaptation, which will underestimate the potential for coping strategies to limit drought risks. And the model does not incorporate additional extreme events strongly dependent on droughts such as wildfires, which can underestimate the economic cost of extreme heat and dry periods.

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