Economic and financial consequences of water risks: The case of hydropower

Abstract

Reduced water availability poses risks for many economic activities. This paper studies how water risks affect hydroelectricity generation in Europe and the US and whether these risks are priced in by financial markets. To this end, we build a novel dataset for the period 2015–2022, which combines plant-specific hydroelectricity generation with geo-specific water physical risks and equity returns. We find that water risks, measured using model-based aggregate water risk metrics as well as precipitation anomalies, are significantly associated with reduced electricity generation, although the effect disappears after two months. We then link the power plants in our sample to the equity returns of their owners to investigate whether financial markets adequately price water risks. Using a portfolio sorts approach, we find weak evidence of a negative risk premium. Given the real negative effect of water risks on generation, we conclude that the lack of a positive risk premium amounts to mispricing of water risks by financial markets.