Translating biodiversity and nature risks into financial risks
Major improvements need to be made for the financial sector to accurately identify biodiversity and wider nature-related risks, explains Hugh Miller, analyst, green finance and investment team, Organisation for Economic Co-operation and Development.
Natural capital, including biodiversity, provides the ecosystem services upon which economic activities depend. Globally, the ecosystem services delivered by biodiversity – including pollination, nutrient-cycling and carbon sequestration – are estimated to be worth $125tn-$140tn annually, over one and a half times the size of global gross domestic product. However, biodiversity – including the diversity within and between species, and the diversity of ecosystems – is in jeopardy worldwide.
The economic and financial implications of biodiversity loss are often uncertain, but they have the potential to be severe. Local impacts – decreased agricultural production, diseases affecting timber and the sudden collapse of fish stocks – can have cascading effects along supply chains. This in turn could lead to inflationary pressures and even systemic financial risks. Estimates from the World Bank suggest nature-related risks will have severe direct impacts, particularly for low- and lower-middle-income countries, around 7%-10% of GDP. However, this excludes the feedback loops and indirect impacts from nature and biodiversity loss.
Biodiversity loss as a source of financial risk has already been acknowledged by central banks through the publication of biodiversity impact and assessment studies. These studies found between 35% and 54% of assets held by financial institutions are highly or very highly dependent on ecosystem services.
The next great challenge is to accurately identify and translate biodiversity risks into financial risks. This is imperative to enable financial markets to adequately capture the value of biodiversity and the risk of biodiversity loss in financial valuations and risk management practices. While data, metrics and initial scenarios are rapidly evolving to assess the impacts and dependencies on biodiversity, it is insufficient to adequately assess biodiversity-related financial risk.
Biodiversity impact and dependency results need to be translated into metrics which can be examined alongside financial decisions to ensure biodiversity risks are integrated into financial institutions’ risk management. There are three pivotal improvements which need to be made.
First, there are significant data gaps in the state of natural capital. Disclosure will be necessary to understand the impact and dependencies of economic activities on ecosystems. The Taskforce on Nature-related Financial Disclosures, an international initiative aiming to give firms a picture of their environmental risks, will play a leading role in developing and harmonising disclosure standards.
Second, metrics for individual ecosystem services are necessary to understand the impact of biodiversity loss on businesses. These metrics must establish the link between the provision of ecosystem services and the revenue and costs for individual corporates.
Third, scenarios will be key to connecting the depletion of natural capital to the provision of ecosystem services and the impact on costs and revenues for businesses.
The progress made in assessing climate-related financial risks offers a partial roadmap for the incorporation of biodiversity-related financial risks within financial decision-making. However, the multidimensionality of biodiversity adds further complexity in measurement and assessment, with multiple metrics necessary to adequately assess the risk.
The loss of ecosystem services may not be homogeneous in their impacts and require different actions from central banks to counter the risks. For example, the loss of animal pollinators may have substantial implications for the cost of food, and therefore have relevance for monetary policy under the price stability mandates of central banks.
Moreover, the direct impacts from biodiversity loss are largely localised, with responsible economic activities often coinciding with the economic activities dependent on the same ecosystem services. Hence, the challenge of reconciling these localised impacts with the interconnected globalised nature of financial markets, and how the risks propagate throughout the system, is yet to be resolved.
Central banks need to start assessing and acting on biodiversity-related risks, wider nature-related risks and the compounding risk effects regarding climate. The OECD is developing a methodological framework for central banks to assess and translate biodiversity-related risks to financial risks. For the longevity and sustainability of finance and the global economy, it is imperative that the challenges presented by biodiversity and climate change are tackled before ecosystems collapse or there is irreversible climate change.