Environment & Biodiversity - Risk Management - Green Finance & Sustainable Business
Nature: A New Horizon for Risk Professionals?
With a growing focus on nature-related risks, where should financial institutions start? In many firms, there is already existing expertise and capabilities that can be built on, so perhaps it’s not entirely a new frontier.
Thursday, May 11, 2023
By Simon Connell
Nature and biodiversity are fast emerging as topics of interest to risk professionals in financial services. Over a hundred central banks and supervisors in the Network for Greening the Financial System, focused on environmental and climate risk management in the financial sector, have said “…biodiversity loss could have significant macroeconomic implications. Failure to account for, mitigate, and adapt to these implications is a source of risks relevant for financial stability.” In response, nearly half of those authorities are already taking action on biodiversity through research or policy, as shown in GARP’s recent white paper on biodiversity loss.
Consequently, financial institutions are having to rapidly build capability on nature while continuing to enhance approaches to climate risk that have been developed in recent years — with these two coming together for European banks in the form of the ECB’s expectations on climate-related and environmental risks. In response, it is worth thinking about where skills already exist in the industry and where they may need to be developed.
Help Might Be Closer Than You Think
Banks and asset owners may already employ individuals with a multi-decade legacy of managing nature and biodiversity risks, although these teams are often a well-kept secret; a recent UN report, “Unboxing Nature-related Risks” found this is “a siloed subject within many financial institutions.”
These capabilities center on the Equator Principles, first released in 2003 to support consistent management of environmental and social risks in projects through the International Finance Corporation (IFC’s) Performance Standards (PS), including PS6 on biodiversity conservation.
Firms that are signatories to the Equator Principles will have environmental and social risk management teams whose roles are to guide the application of the Performance Standards and Equator Principles to in-scope transactions, lead internal transactional due diligence and engage with external technical specialists who produce the assessments which inform that due diligence. To build capability, the Equator Principles Association and member banks have been collaborating with the oil and gas and mining sectors through the Cross-Sector Biodiversity Initiative since 2013, and they have developed practical guidance on issues such as biodiversity surveys and data sharing.
The mandate and reporting line of such teams varies between banks, with Baringa’s research showing an even split between a separate or shared reporting line for climate and environmental risk teams. Also, there is much greater variance in the size of environmental risk teams, compared to their climate risk counterparts which are more consistently sized. This may indicate a need to invest in these teams to ensure their size reflects the role they will play in supporting their organizations to learn from and extend existing approaches on nature.
Where There’s Smoke, There’s Fire
Broadening our scope beyond transactions, financial institutions — including banks and asset managers — are already likely to maintain sector policies or position statements. These set out the criteria for doing business in a particular sector or in relation to a specific activity. They too have a long history — emerging in an earlier age of ‘ethical’ or ‘socially responsible’ investment. In consequence, many are informed by value judgements and are principally designed to manage non-financial, reputational risks. With this framing, they echo the early days of climate action when banks, insurers and asset managers’ climate approaches started from the same basis. This also helps us understand the results from GARP’s Fourth Annual Survey of Climate Risk Management and why more financial institutions are managing the impacts of their portfolio on the environment rather than the environment’s impacts on their portfolio.
By responding to areas with the greatest stakeholder and reputational pressures, policies are frequently focused on sectors with the highest primary impacts and dependencies on nature — such as agriculture, forestry and fisheries — as well as locations which are highly sensitive. An example is the Cerrado Manifesto specifically targeting deforestation in the Cerrado in Brazil, a biome containing 5% of the world’s biodiversity, signed by 160 institutional investors and consumer goods companies.
As expectations continue to grow these policies are becoming increasingly complex, both in their structure and the effort required to implement them. The University of Cambridge Institute for Sustainability Leadership’s work in the Soft Commodities Compact shows the shared effort required to assess deforestation risks and financial links along supply chains in order to make and satisfy ‘deforestation free’ policies. These include aligning action by different financial institutions such as investors and insurers, deep engagement with corporates, further effort on sectoral standards and advocacy with governments — all areas where significant progress has been made on climate.
Compliance with these policies requires significant information on a company’s activities and operating locations. Financial institutions have worked hard to increase their access to locational information to support physical climate risk assessment. In turn, this information will be relevant in the first ‘Locate’ step of the Taskforce on Nature-related Financial Disclosures’ LEAP process. Reflecting their longstanding existence, environmental risk teams may already have processes integrated into core risk and credit systems for both locational and analytical information, but ensuring these are able to handle increasing volumes of data needed as processes for assessing nature-related risks evolve will take effort.
These types of existing processes often leverage databases of adverse media: allegations that a company has breached laws or regulations such as being involved in environmental crime. Financial institutions may also have experience using these databases in their Financial Crime Compliance teams. For example, the United for Wildlife Financial Taskforce seeks to stop illegal income generated by wildlife trafficking, preventing endangered species from entering the pet trade or providing routes to market for poached wildlife products such as rhino horn or pangolin scales.
Moving From Your Impact on the Environment to the Environment’s Risk on Your Portfolio
Across all these activities, the challenge ahead of us is to translate risks currently being managed on non-financial grounds to ones which can be assessed and managed as financial risks. Work on integrating nature-related risks into financial decisions by the University of Cambridge, through the Banking Environment Initiative and the Investment Leaders Group, has sought to support this shift with a series of use cases ranging from revaluing fertiliser companies in response to EU agricultural policy to water risk in financial indices. Here we see echoes of the early days of climate risk, with limited forward-looking tools such as scenario analysis available to help financial institutions assess changes in risks, impacts and dependencies today may change in a non-linear way as the biodiversity crisis continues, and how to steer portfolios in response.
The commitment by 186 governments to the Global Biodiversity Framework in Montreal in December 2022 brings these transition risks to life, especially the Framework’s target 18 to“eliminate, phase out or reform incentives … by at least $500 billion per year by 2030,” which will alter the economics of a wide range of sectors and their value chains and thus crystallise transition risks. This will result in more instances like Rabobank’s decision in 2022 to increase the expected credit losses on their agriculture portfolio by EUR76million in response to likely Dutch regulation limiting nitrogen emissions.
In responding, financial institutions should differentiate between the climate risk capabilities they have built where there is a linear extension from climate to nature, and those where a different set of capabilities are required. A careful analysis of the European Central Bank (ECB) expectations on climate and environmental risks, for example, shows at least six key areas where there is significant divergence in capabilities between climate and environmental response strategies. These include data and scenarios where biodiversity’s multiple dimensions will require thought in (i) selecting and using scenarios and developing interoperability with existing climate scenarios, and (ii) applying these tools to meet the ECB’s expectations in areas such as collateral valuations.
In closing, there is much new work required as action moves from climate, through the ‘climate- nature nexus’ and into managing the financial risks posed by nature and biodiversity. Where GARP’s recent publication identified that “risk professionals need to build up their capability and expertise in biodiversity,” this capacity and expertise should build on and extend from existing foundations.
Simon Connell is a Director in Baringa Partners financial services practice, where he leads on natural capital. He also holds the position of Senior Associate at the University of Cambridge Institute for Sustainability Leadership (CISL) where he was formerly the Chair of the Banking Environment Initiative.