Widespread environmental degradation due to climate change and other factors is undermining essential ecosystem services – on which our economies fundamentally depend – to an unprecedented extent.

The severe drought in Brazil over 2021-22, linked to climate stresses and Amazon deforestation, resulted in sweeping insurance losses. It is evident that ‘physical’ sources of interconnected climate and nature risks are creating burdens for firms and the institutions that finance them.

Ecosystem tipping points 

An urgent, but overlooked, concern is that continued warming, deforestation and other pressures could push critical ecosystems past ‘tipping points’ in the coming decades. These are non-linear, self-amplifying and likely irreversible shifts in the state of our ecosystems. Crossing them would radically amplify climate risks, producing a ‘new state of the world’ defined by irreversible ecological collapse, as International Monetary Fund economists put it.

Despite uncertainties, scientific evidence suggests such tipping points are not abstract threats. Possibilities include the Amazon rainforest partially transitioning to a savannah under deforestation and drought, mangrove dieback from sea-level rise and land conversion and the retreat of southern boreal forests as rising temperatures and forest degradation catalyse harmful disturbances.

Ecosystem tipping points exhibit systemic characteristics that would lead to cascading effects across regions and sectors, with far-reaching implications for environmental risk pathways. Current trends of environmental and financial policy deregulation are further eroding existing safeguards, potentially accelerating the trajectory towards critical and irreversible thresholds. The interplay of deregulated markets and destabilised ecosystems creates a ‘perfect storm’, which could trigger failures on both fronts.

As for systemic characteristics, first, ecosystem collapse would trigger feedback loops in climate risks. Carbon release from rapidly degrading mangroves, peatlands and forests amplifies global heating, likely pushing global climate targets out of reach. Moreover, the loss of natural buffers increases vulnerability to physical climate hazards.

Second, risks would propagate widely through interconnected ecological and economic systems. Degradation of multiple ecosystem services simultaneously and on a large-scale would lead to non-linear dynamics that constrain adaptation through trade of technology. Initially localised shocks could therefore ripple through supply chains and other global connections.

Third, incomplete scientific understanding hampers monitoring and preparedness for tipping points and their economic effects. Ecosystem tipping points are particularly difficult to anticipate due to interacting climate and non-climate factors and emergent ecological behaviour across scales. As a result, clearly defined ‘thresholds’ of collapse likely remain unknowable.

Finally, ecosystem tipping points represent ‘worst-case’ outcomes of climate change and nature loss. Scientists warn that socioeconomic effects may overwhelm resilience capabilities. This underlines the need to act with precaution to prevent these dynamics from materialising.

Why they matter for monetary and financial policy-makers  

Leading economic institutions, including the Organisation of Economic Co-operation and Development, European Central Bank and European Insurance and Occupational Pensions Authority, now recognise that the collapse of globally important biomes would have systemic and likely irreversible impacts. These have direct implications for central banks’ and financial supervisors’ mandates.

Tipping point dynamics would magnify environmental hazards already contributing to complex (dis)inflationary pressures – relevant to price stability mandates. For prudential authorities, individual financial institutions face growing policy and litigation risks via counterparties that depend on or impact these critical ecosystems.

Perhaps the most direct relevance lies within macroprudential policy. First, because ecosystem collapse is a clear source of systemic risk. Second, because asymmetries are likely between funding flows that contribute to this systemic risk and financial institutions’ individual risk assessments of such activities.

Pathways for risk assessment and management 

There are several actions that monetary and financial policy-makers can take. Improved risk assessment is one avenue. Forward-looking scenario analysis could incorporate compounding, interaction and non-linear ecosystem risks, including shifting from a sectoral to a location-specific approach.

Macroprudential policy-makers could also map endogenous contributions to these systemic risks, by identifying where financial services enable actors that continue to degrade critical ecosystems.

However, these analytical steps should not preclude proactive risk management. Lock-in effects, radical uncertainty and other constraints mean that risk quantification alone will not deliver the market shifts required to reduce these systemic threats.

Monetary and financial policy-makers do have tools (both carrots and sticks) that they can adapt. While these will not alone address the core catalysts of ecosystem degradation, they can play an essential role by ensuring macro-financial policies support – and do not undermine – net-zero and nature-positive transition efforts.