The European economy is not drought-proof

23 May 2025

By Andrej Ceglar, Francesca Danieli, Irene Heemskerk, Mark Jwaideh and Nicola Ranger

The euro area economy depends heavily on natural ecosystems and the services they provide. These include clean water, flood protection, carbon sequestration and healthy soils. However, nature is increasingly under threat.

The consequences of human activities, such as land take, pollution, climate change, invasive species introduction and overfishing, undermine ecosystems. That happens through chronic, long-term degradation and acute shocks amplified by climate extremes.^[1]

ECB research shows that 72% of euro area firms are critically dependent on ecosystem services. The same firms account for three-quarters of all corporate bank lending in the region, which makes it an issue for financial stability.^[2]

So far, this reliance on ecosystem services is based on individual dependencies.

The ECB is working with the University of Oxford’s Resilient Planet Finance Lab to extend our understanding beyond dependency analyses; we aim to more accurately map the economic and financial risks that the degradation of ecosystems poses across regions and industries.^[3] Together, we developed the Nature Value at Risk (NVaR) framework^[4]. This allows us to shed more light on the complex interdependencies of the loss of natural ecosystem services and the impact they have on the European economy.

The value of nature at risk

The NVaR framework captures the financial risk associated with the loss of ecosystem services at a sectoral level. At its core, NVaR combines the following three elements.

A systemic risk score, captured via location-specific information on sectoral activities and the status of ecosystem services. It takes into account hazards, exposures and vulnerabilities, calculated using Earth observation data, model data and survey data.

Sector dependency, reflecting how heavily each sector relies on ecosystem services.

Financial supply-chain linkages that trace the flow of services and commodities across borders.

The results highlight the portion of a sector’s economic output that is lost when the ecosystem service declines.

Surface water scarcity is the most significant risk to the euro area’s economy, our findings show. Under an extreme but plausible drought with a 25-year return period, nearly 15% of economic output would be at risk. This is caused by a shortfall in water supplies coming from rivers, lakes, reservoirs and upper soil layers, and amplified by persisting drought conditions, excessive withdrawals and unsustainable consumption.

Any stress on water resources can have cascading impacts across multiple economic activities. For example, dry soils reduce agricultural yields; water scarcity affects manufacturing by disrupting operations and increasing costs; and low rivers diminish hydropower inflows, constrain electricity generation and impede inland shipping.

Chart 1 presents the share of sectoral economic output at risk from surface water scarcity for each euro area country across 12 sectors.

Although southern Europe experiences the heaviest water scarcity pressures, our analysis shows that central and northern European countries are increasingly at risk as well. Of all sectors, agriculture is the most exposed, suffering the largest proportional output losses. Up to 30% of agricultural sectoral output is at risk in southern European countries, with the risk declining further to the north – falling to around 12% in Finland. Manufacturing, mining, water-supply utilities, construction, and accommodation and food services also face substantial impacts; over 20% of their output is at risk in southern Europe and more than 10% elsewhere.

Over the longer term, the effects of persistent water shortages can spread through commodity markets, driving up water and food prices and contributing to broader inflationary pressures.^[5]

Beyond its direct economic impact, water scarcity can also undermine financial stability: it can increase the probability of firms not being able to pay for their loans. That in turn amplifies banks’ loan exposures.

For this reason, we also analysed the loans of 2,500 euro area banks that were granted to non-financial corporations at a sectoral level. We found that more than 34% of their total outstanding nominal amount – that is over €1.3 trillion – is currently extended to sectors exposed to high water scarcity risk.

Within the non-financial corporate portfolio, manufacturing represents the largest share of at-risk exposures, followed by wholesale and retail trade, real estate, construction and electricity production.

Surface water scarcity is not the only water-related risk critical to the euro area economy.

Groundwater supply is also under widespread pressure from abstraction and pollution.^[6]

Natural, undisturbed floodplains are shrinking, so less area is available to absorb water and offer protection from floods.^[7]

Low quality of water could muddy the economic outlook, as Europe’s waters and aquatic ecosystems are still severely affected by chemicals.^[8] Declines in measured or perceived water quality have already led to a sharp reduction in recreational visits in affected areas. This results in economic losses exceeding €100 billion per year.

Beyond these, the degradation of other ecosystem services, such as climate regulation, further compounds these risks.

Research is key to managing climate and nature risks

The detailed results of our analysis will be published later this year.

Preliminary findings presented in this post already highlight the importance of integrating nature-related risks into financial risk assessment frameworks, particularly for water-related risks.

Eventually, as the results above show, it is not only firms that suffer from degradation of nature. The high concentration of loans in sectors heavily vulnerable to surface water scarcity also exposes banks to significant potential financial losses. And that could potentially trigger financial instability.

Fully understanding these complex risks and related uncertainties requires more research and further development of risk analysis tools.

It is vitally important that central banks work closely with the scientific community because this can improve our data, modelling and risk assessments. After all, nature-related risks are not just environmental concerns; they are systemic economic risks that demand an integrated and informed response.

The views expressed in each blog entry are those of the author(s) and do not necessarily represent the views of the European Central Bank and the Eurosystem.

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