The price of natural capital: nature-related risks and the financial system

October 2, 2023|Written by Scott Speer

Nature is a cornerstone of our planet’s stability, providing essential services that support human civilisation. Yet, the increasing degradation of natural capital and biodiversity poses significant risks not only to our environment but also to the global economy.

Central banks and regulators are beginning to explore the key aspects of nature-related risks and their relevance to the financial system, in order to develop frameworks and initiatives aimed at addressing them.

Valuing nature

As noted in the Dasgupta review commissioned by the UK Treasury, natural capital provides “fundamental natural dividends that nourish and protect us: from basic sustenance through fish stocks or insects that pollinate crops, to soil regeneration, and water and flooding regulation”. The financial system relies on these services indirectly, enabling the production of goods and services that generate profits and drive economic growth.

However, this natural capital is being destroyed. Of the nine planetary boundaries within which human civilisation can thrive, six have already been crossed. The global rate of species extinction is tens to hundreds of times higher than any time in the past 10 million years, while ecosystems are being degraded and destroyed.

The alarming decline in biodiversity poses huge economic risks. Reduced biodiversity disrupts ecosystems, leading to reduced crop yields, increased disease transmission, and decreased water quality. These disruptions can have cascading effects on industries, supply chains, and ultimately, financial markets. Recognising these synergies may therefore lead to more effective and efficient sustainability strategies.

Pricing nature

Numerous studies have highlighted the economic contributions of nature, emphasising its role in regulating ecosystem services and enhancing the resilience of human-environmental systems.

The Whale Carbon Plus project, for example, prices a whale for its natural carbon-sequestering contributions. This is done with the intention of “facilitating financial investment in carbon-storing services”, as conservationists have failed “largely because philosophical and scientific arguments rarely trump profits and the promise of jobs”.

Yet the concept of pricing nature however is contentious and adopting environmental economists’ language is a double-edged blade. As Kate Raworth explains in her book Doughnut Economics, anthropocentric terms such as natural capital and ecosystem services act as a barrier to fully understanding the interconnected and interdependent reality of the world. Putting a price on nature merely “shifts the living world from being man’s material means to being an asset on a balance sheet”.

With economic value comes the concept of ownership. A forest, for example, is connected over and beyond arbitrary national boundaries. Even if countries do put a price on nature, the question of who owns and has the right to sell a natural space is a crucial one if countries are to adopt a green and just transition.

The practice of companies purchasing carbon offsets from nation-states is often labelled as “green extractivism” because of the unfair impact these practices have on Indigenous Communities. Local populations are often displaced from their lands in the name of promoting a green transition. Research has shown that 90% of rainforest carbon offsets have no real environmental benefits, so the issue of determining rightful ownership of natural spaces becomes even more crucial for achieving a fair and equitable transition.

Assessing nature-related risk in financial decision-making

There are valuable lessons to be learned from the experience of integrating climate risk into financial decision-making. Climate change and nature-related risks share similarities in terms of their systemic impacts, data challenges, and the need for a unified framework, hence the inception of the Task Force on Nature-Related Financial Disclosures (TNFD).

Research has shown that adapting climate and nature-related frameworks will save crucial time for central banks to fulfil their mandates of financial stability. To incorporate nature-related risks into financial decision-making, robust concepts and frameworks are needed. The TNFD recently released its final recommendations providing guidance on identifying, assessing, and managing nature-related risks and opportunities.

The TNFD framework consists of several components, including the locate, evalute, assess and prepare (Leap) approach and science-based targets for nature (SBTNs). Leap helps assess the risks associated with the loss of ecosystem services, while SBTN sets science-based targets for companies to halt biodiversity loss.

Central banks and supervisors are beginning to publish communications on the importance of nature-related risks in maintaining financial stability. In 2021, The Network for Greening the Financial System and Inspire established a study group on biodiversity and financial stability. This group assesses how biodiversity loss can impact the financial system’s stability, and has released a conceptual framework for navigating nature-related risks.

What have central banks done so far?

Several central banks have started exploring nature-related risks. For example, De Nederlandsche Bank was the first to stress test the impact of biodiversity loss on the banking sector, concluding that “the loss of ecosystem services would lead to substantial disruption of business process and financial losses”.

Banque de France also initiated research on the links between biodiversity and financial stability. In 2019, an act was passed introducing mandatory reporting on financial risks related to biodiversity loss, as well as dependencies on and impacts to biodiversity.

In the EU, the disclosure framework requires disclosing alignment with all six environmental objectives of the EU taxonomy, including protection and restoration of biodiversity and ecosystems as of 2023, with further regulatory developments expected to strengthen this framework.

According to a 2023 report published by Inspire, Magyar Nemzeti Bank (MNB), Hungary’s central bank, “continues to stay at the cutting edge of integration of sustainability concerns in microprudential considerations”. The MNB assesses financial risks related to the decline in biodiversity and has subsequently developed financial supervisory methodologies to address those risks.

Potential routes forward

Central banks and supervisors are expected to increase their efforts in addressing nature-related risks. This may involve incorporating nature-related stress tests into regular assessments, promoting disclosure of nature-related risks by financial institutions, and providing guidance on integrating these risks into financial decision making.

Despite the similar characteristics of climate and nature-related risks, there are crucial differences; there is no biodiversity equivalent for specific targets such as the 1.5˚C threshold. To combat such challenges, various solutions have been proposed in the form of what the NGFS and Inspire call “narrative approaches”.

To develop narratives for transition and physical shocks, one can start with an inventory of existing biodiversity policies or invent hypothetical policies and transformative changes to mitigate biodiversity loss. For instance, envisioning a system where businesses pay for their biodiversity footprint, akin to carbon pricing. In the context of physical shocks, scenarios involving biodiversity tipping points being crossed can be constructed, as seen in practices by the World Bank and De Nederlandsche Bank.

Just recently, 27 of the world’s largest nature conservation organisations, institutes, business and finance coalitions came together to launch a new initiative aimed at delivering the Nature Positive Initiative, which seeks to halt and reverse biodiversity loss by 2030 from a 2020 baseline.

The rise of ecological economics is certainly not yet mainstream, but there is clearly diverse support for such a paradigm shift.

This article was amended to correct the meaning of the acronym Leap.

This page was last updated October 24, 2023

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