What is nature-related risk and how can asset managers consider it?
As financial markets adjust to the reality of climate change, climate risk is now top of the agenda for asset managers and institutional investors.
Asset management groups like BlackRock consider sustainability as their ‘standard for investing’ (BlackRock 2022). Along with other big players, they assume climate risk as an investment risk.
International groups like the Taskforce for Climate-Related Disclosures are creating a framework for company disclosures on climate impact and risk. Moreover, industry leaders are similarly proactive in driving climate risk into decision making, with COP26 organisations like the Glasgow Financial Alliance for Net Zero (GFANZ).
Overall, both asset managers and the companies they invest in are transitioning towards a more sustainable economy. They reduce climate risk through accurate reporting, prioritisation of environmental concerns and even stewardship.
In terms of finance, assets that meet environmental, social and governance (ESG) criteria will reach $53trn by 2025, representing more than a third of the expected total AUM (Bloomberg 2021).
A critical development to consider within this landscape is the expanding scope of these actions to mitigate climate risk.
For example, more than half of the world’s economic output ($44trn) is dependent on nature (TNFD 2021). This is increasingly factored into climate risk considerations.
The final statement from COP26 even highlights the importance of ‘protecting, conserving and restoring nature and ecosystems’ in delivering on the target 1.5-degree global temperature rise specified in the Paris Agreement.
This article will cover what biodiversity risk looks like and how the finance sector can factor it into their decision making.
What does biodiversity risk look like?
Over the next ten years, the top five global risks will be environmental.
Biodiversity loss is the third most severe (WEF 2021).
This is not surprising considering that the IPBES announced that biodiversity is declining faster than at any time in human history (Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services 2019).
Nature related risks include issues such as:
The World Economic Forum’s 2022 report links it to many other risk themes from ‘livelihood crisis’ to ‘involuntary migration’ (WEF 2021).
Moreover, biodiversity loss threatens 80% of the UN’s sustainable development goals (SDGs) (IPBES 2019).
The conclusion is that biodiversity loss has complex risk ramifications. As a result, it cannot be considered in separation to climate risk.
For example, David Craig, co-chair of the Taskforce on Nature-Related Disclosures (TNFD), described nature-based carbon absorption solutions as by far the most effective methods. In comparison, mechanical carbon absorption won’t be ‘cost-effective’, ready to ‘operate at scale’ or ‘efficient enough’ to hit net-zero targets ‘by 2030 or even 2050’ (David Craig 2021).
This makes maintaining nature a critically important part of the carbon-reduction discourse.
Moreover, the breadth of the risk caused by nature loss and the focus on nature in international efforts to limit climate change have a secondary risk implication for asset managers: transitional risk.
Suppose industry actors, policymakers and asset owners are transitioning towards a nature-positive economy. In that case, asset managers need to rapidly align their portfolios (NGFS 2021).
For example, groups like the Convention on Biological Diversity (CBD) represent a big step in ushering in nature-positive financial regulation (NGFS 2021).
Issues with factoring biodiversity into financial risk management
According to asset managers, data remains the primary barrier to factoring environmental, social and governance (ESG) criteria into investment decision making.
BNP Paribas found that 59% of managers reported data as their biggest ESG issue, citing the following reasons:
-Quality and consistency issues.
-Inconsistent data across asset classes.
-Conflicting ESG ratings.
-Ineffective data for scenario analysis.
(BNP Paribas 2021).
The data gap is even more significant when it comes to biodiversity risk.
There is a lack of quality biodiversity data at scale, meaning asset managers or institutional investors cannot accurately assess risk and impact.
In particular, the current data and reporting mechanisms do not accurately reflect the complexity of impact on nature.
This gap is the next challenge for green finance.
How can we manage nature-related risks?
Solution 1: Cooperation
First and foremost, nature risk needs to be closely integrated into the broader global climate response.
The two issues need to be managed in tandem, with 60% of carbon being absorbed from the atmosphere by nature since the industrial revolution (David Craig, TNFD Co-Chair 2021).
Organisations like Finance for Biodiversity and COP-26 initiatives like the ’Race to Zero’ financial sector commitment to limiting deforestation represent an acknowledgement of this.
Solution 2: A framework for consistent reporting
The Taskforce on Nature-related Financial Disclosures is creating a risk management and disclosure framework for organisations.
Their framework, expected by 2023, will likely be the basis for future financial regulation and reporting scope so that investors can accurately assess nature-risk.