The importance of pricing in nature-related financial risks
We depend upon nature whether it be through the healthy functioning of our oceans or forests, or of nature’s ability to absorb a vast number of emissions through carbon sinks. The way we have built our economy also means that roughly half of world’s GDP (£36 trillion) per year is dependent on nature for the goods and services it provides.
However, nature is currently significantly depleted with 50% of all forests lost in the 20th century, with this number only increasing. This level of forest loss, combined with the effects of climate change, can create knock-on effects such as local rainfall cycles failing thus affecting the conditions in which we grow food. Cascade this risk across vital food crops and we have significant consequences to global food security on our hands.
Why is it important to look at nature-related financial risks?
‘Nature-related financial risks’ may seem a strange and esoteric concept. But on closer inspection, its relevance could not be clearer.
To begin, much of the emphasis in relation to environmental risks has been historically concentrated on climate change, and understandably so given its effects. This has meant much of the business world accepting the concept of climate-related financial risks, encouraged through the adoption of the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD)1. Now renewed focus has been on a sister initiative, the Taskforce on Nature-related Financial Disclosures, which aims to shift finance towards nature-positive outcomes. Climate change and nature loss are intertwined; biodiversity loss can contribute to increased global warming e.g., through a loss of carbon sinks, sparking even worse climate change effects. Thus, the cycle continues, and it’s clear that risks associated with climate change and nature need to be analysed as one.
As we are so dependent on nature for society to function, it comes as no surprise that nature loss can create a material risk to businesses. For example, many securities are highly dependent on nature. In a recent study, Banque de France showed that 42% of French financial institutions are highly dependent on nature meaning that the current and future state of nature is increasingly important and any physical, transitional or liability risk ought to be priced into the asset.
Policy and regulation are also driving investors to act on serious issues related to nature. For example, the EU Taxonomy on Sustainable Finance considers “protection of healthy ecosystems” as one of its six environmental objectives, with the expectation that businesses will soon need to show how they substantially contribute to this objective. At COP26, we also saw more than 100 world leaders sign the Glasgow Leaders’ Declaration on Forests and Land Use, effectively looking to end deforestation by 2030.
Consumer and technological trends are showing an increased focus on nature. For instance, in the UK during the COVID-19 lockdowns, interest in nature had grown by a third as people realised its inherent health benefits. This may result in changes in consumer behaviour, to reflect more nature-friendly consumption. Advances in technology have enabled solutions like Earth Observation satellites to be able to quantify nature loss. This provides more information for consumers to make better informed decisions, increasing the pressure on governments and private sector to act on these risks.
Given these trends, it’s clear that pioneering investors in nature will position themselves as leading financiers of the nature economy and potentially gain first-mover advantage. This is filled with opportunities to create more resilient and attractive investments.
How businesses can start to account for nature-related financial risks
For businesses to start to account for nature-related financial risks, the Cambridge Institute for Sustainability Leadership developed a four-step framework:
- Assess the type of risk, e.g., physical, transition, or liability2
- Understand how the risk manifests itself, e.g., through a decline in water security or upcoming policy and regulation
- Evaluate what impact this will have on your business, e.g., disruption in the supply-chain
- Analyse the resulting financial risk, e.g., through credit, market, liquidity, or business.
A simple example scenario might be the case of an agricultural business, which faces the threat of crop failure due to the physical risks associated with clearing a forest into farmland. This land use change can create a knock-on reduction in water security, as the cleared land may disrupt local water supplies from a nearby creek. If these conditions persist, the farm could become unsuitable to grow crops and mean that the farm asset has become a stranded asset.
This chain of events could produce significant financial risks. For example, the business’ creditworthiness could decrease if yields worsen chronically and the business defaults. In addition, the investor could risk losing part or all their investment or require cashing out earlier than their investment horizon, realising lower gains than anticipated.
Assessing different nature-related risks and how they may materially impact your business is a step in the right direction toward solving them. However, identifying risks only goes so far. Being one step ahead by integrating these risks into financial decision-making can be vital and often makes common sense, especially if the risks are severe or likely to recur.
Given the potential severity of the impacts at stake, it is essential for a business to recognise the value of nature on which they are dependent and map their exposure to different physical, transitional and liability risks. Quantifying and modelling the assets across different scenarios can give greater confidence in the level of risk. Ideally the business would get buy-in at the senior level, so nature-related financial risks are embedded into risk management and corporate strategy. Thus decisions around nature-related risks can be made more proactively.
What might this mean for businesses now and into the future?
This link between business and nature is truly game-changing, empowering business to clearly see how their activities affect , and are affected by, nature. Embedding this understanding into financial decision-making can create related opportunities for investors to push for greater sustainability-focused initiatives. In the case of the agri-business in the above example, investors should advocate to eliminate deforestation to secure the farm’s crops from failure. They are incentivised to do so as this would also mitigate financial risks were the crop to fail as a direct result of land use change. This could promote farmers taking up regenerative farming practices that improve soil health, limiting the need for continued land clearing.
Once nature-related risks are integrated at a wider scale, businesses will have to ensure they have a set of answers to tough questions on their environmental impact. As sustainable finance regulation develops, regulators will be at the helm to ensure investors play their part in embedding positive action towards nature or run the risk of poor exposure on sustainability matters.
Ultimately, integrating nature-related risks into business requires a shift in the way we see ourselves coexisting on this planet. The road ahead is not easy, as our impact on nature continues to be highlighted through scientific report after report. However, the sooner we scale this new way of linking business to nature across all industries, the sooner we can restore our natural world.
- The Task Force on Climate-Related Financial Disclosures (TCFD) was created in 2015 by the Financial Stability Board (FSB) to develop consistent climate-related financial risk disclosures for use by companies, banks, and investors in providing information to stakeholders
- Physical risks can arise when natural systems are compromised resulting in benefits that people obtain from the natural environment to degrade. Some examples include reductions in air or water quality. Transition risks can arise from efforts to address environmental change. Some examples include changes to regulation and policy, technology, consumer or investor sentiment. Liability risks can impact companies or financial institutions through for example pay-outs and fines, legal or administrative costs or insurance costs.
Sancroft works together with a wide range of businesses across a breadth of sectors to tackle sustainability issues. If you would like to find out how we provide bespoke expert sustainability guidance to your business, please contact Ilkka.Saarinen@sancroft.com or Felix.Gummer@Sancroft.com.