Why central banks should be concerned about nature loss

The latest IPCC mitigation report put it bluntly: catastrophic climate change is inevitable if current emissions are not mitigated within the next seven years. And yet, climate change is only one facet of the ongoing environmental crisis.

The degradation of nature and the loss of biodiversity also threaten financial stability. Central banks must address nature-related risks as well as those stemming from the climate crisis.

In its latest report, the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) warned that nature is now declining faster than ever. Species are going extinct at around 100 to 1,000 times the normal rate, and this is driven by climate change, land degradation and unsustainable resource use.

These impacts on nature create risks for societies, economic activity and financial stability. Indeed, there are strong links between climate change and other environmental risks: they are two sides of the same coin.

Nature loss is a financial stability issue

Financial assets and the economic activity they underwrite depend upon the ecosystem services provided by natural systems, such as water supplies and fertile soil. At the same time, investments can be linked to impacts on the environment – known as double materiality – and thus promote or hinder the transition to a more sustainable economy.

Recent research – culminating in a new report commissioned by the Network for Greening the Financial System (NGFS) and its research partner Inspire – has highlighted as much. This report finds that accounting for these risks and impacts falls within the mandates of central banks and financial supervisors.

The 114 NGFS member institutions confirmed this in a rare statement published shortly after the report. The collaborative effort of the working group that authored the report has allowed several important issues to be addressed in a short period of time and lays the foundation for expanding the work on climate-related financial risks to a broader set of environmental risks. However, concrete measures for further integrating environmental risks are still lacking.

Urgency of nature degradation requires rapid actions

Building on the network of the NGFS and the work already done on climate-related risks will create an important advantage that should help save precious time. Lessons learned from the work on climate risks can inform the methodologies needed to account for broader environmental risks. Of course, as in the climate case, taking a precautionary approach on environmental financial risks would justify supervisory action even in the absence of fully-fledged methodologies.

To that end, the knowledge embedded in the recent NGFS/Inspire report should be rapidly translated into frameworks that central banks and financial supervisors can integrate in their activities. Although nature-related data is partially available, there is still some work needed to synthesise decision-relevant information for investors and their supervisors.

Concrete, empirical illustrations can showcase possible frameworks of analysis. They would allow central banks and financial supervisors to start acting while additional data is becoming available. First broad-stroke analyses of the financial system’s exposure to (and its impact on) nature have been put forward for France, the Netherlands and Malaysia, among others. These studies have already made important contributions, for instance highlighting that a large part of a company’s environmental risks are likely to be located in supply chains.

Addressing methodological challenges step by step

Future iterations of such methodologies should prioritise companies with supply chains that are more likely to entail environmental risks and initially focus on single ecosystem services. Zooming in on one ecosystem at a time, such as water resources or forestry, would allow existing information on the state of ecosystems to be exploited while limiting the overall complexity. Starting with sectors characterised by risky supply chains would concentrate efforts on the most exposed parts of the economy while establishing a general framework applicable to other sectors too.

First insights into the magnitude of financial dependencies on ecosystems should encourage financial supervisors and central banks to consider broader environmental risks. These include both risks from climate change and the degradation of ecosystem services. The fact that much remains to be done on data and methodologies associated with climate-related risks should not inhibit financial market actors from assessing these broader environmental risks.

Members of the European Central Bank’s executive board have already recognised “the need to further incorporate climate considerations into its policy framework”. From here, it is just a small step to acknowledge the wider implications of environmental degradation.