Nature bites back
Earlier this year, the Task Force on Climate Related Financial Disclosures (TCFD) firmly acknowledged that climate change is a material risk to the performance of companies and a systemic risk to the financial sector. The recommendations by the group, which may well form the basis of regulation for financial institutions in many G20 countries, identify a series of climate-related risks, including physical risks, which are considered to have material impact on financial performance.
Acknowledging climate change as a material risk should make the finance sector realise what environmentalists have known for decades – that all economic activity is underpinned by nature and destruction of ecosystems compromise growth and development. In recent years, scientists have also warned that some ecosystems have climate stabilization functions, and their destruction will have systemic effect even without the exacerbating role of climate change.
Financial capital needs to get back to a state of equilibrium with natural capital
While measuring the carbon intensity of investments is a useful first step to understanding the impact of climate change on a portfolio, looking at the role of natural capital helps investors and companies to create a fuller picture of environmental factors and, importantly, their dependencies on natural capital. To fully understand natural capital-related risk, investors will need to answer questions such as, ‘how is my portfolio exposed to droughts in the US’ or ‘what would be the impact of pollination collapse on my portfolio?’
The potential for losses is huge, according to a recent analysis of portfolios of major banks, carried out by the Natural Capital Finance Alliance (NCFA), in partnership with Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH, and global modelling experts RMS. By piloting the Drought Stress Testing Tool on bank portfolios in Brazil, China, Mexico and the US, it showed that drought has the potential to pose a systemic financial risk to financial institutions; for the most exposed portfolios, extreme droughts could increase loan default losses ten-fold.
How the NCFA can help assess the risk
The Drought Stress Testing Tool is one of the tools that the NCFA provides to help investors and other financial institutions to assess this exposure. We also provide a framework to identify and report on physical and other risks and therefore provide a credible source of information, which can help financial institutions integrate natural capital risks into their products and services as well as highlighting new opportunities.
And the opportunities are there. The Sustainable Development Goals (SDGs), which include sustainable water availability, sustainable use of ecosystems, deforestation and biodiversity, sustainable agriculture, resilient infrastructure, sustainable consumption and marine conservation - all-natural capital-related - have been enthusiastically adopted by governments and companies who are increasingly prioritising these issues.
As the leading initiative on natural capital and the finance sector, the NCFA helps financial institutions to understand the link between natural capital and the performance of their assets and portfolios.