Regulators need to incorporate nature risk into prudential regulation, say researchers

Key takeaways

• The EU’s banking sector approaches nature risk unevenly, says a new report, often grouping it under the umbrella of climate risk, resulting in inconsistent disclosure and assessment practices among financial institutions.
• Central banks and financial regulators should provide clear guidance and frameworks, say the authors, to clarify what constitutes nature-related risks and set baseline criteria for incorporating them into prudential supervision.
• The findings echo recent statements by the European Central Bank (ECB), which found that 72% of EU companies are highly dependent on ecosystems, underscoring the growing economic impact of ecosystem loss on the eurozone banking system.

EU banks’ approach to nature risk is uneven, as nature is often approached under the umbrella of climate risk and more guidance from supervisors is needed, according to a report from the Centre for Economic Transition Expertise (CETEx) at the London School of Economics.

Although progress has been made and banks are devoting more attention to the issue, nature risk has only been partially integrated into prudential risk frameworks, resulting in inconsistent alignment between disclosure requirements and assessments.

“What we see is different organisations trying to comprehend the ecological space without being experts in this space,” said Elena Almeida, head of nature at CETEx and one of the report authors.

For example, the European Banking Authority is very comprehensive in its guidance of ecosystems, but considers it to be under the environmental aspect of ESG and “they  talk about very broad environmental risks that may capture all of these [risks]”.

The European Central Bank (ECB) has increasingly taken nature risks into account,  including in its monetary policy approach. An ECB paper found that 72% of euro area companies are highly dependent on ecosystems, with 100 eurozone banks responsible for the biodiversity footprint of 87% of the banking system. Earlier this week, ECB board member Frank Elderson spoke of the need to account for nature in banking supervision, amid growing evidence of the economic impact of ecosystem loss.

More guidance from regulators needed

But more guidance on what constitutes nature risk is needed, the CETEx authors say.

Without clear guidance and frameworks from regulators and central banks, it becomes confusing for banks, investors and supervisors, said Laudine Goumet, another report author and a CETEx policy analyst. Voluntary initiatives and  multilateral standards that combine nature and climate risks can add to the confusion.

“Some banks choose to refer to biodiversity, some banks refer to nature or non-climate, environmental risks. It’s very confusing for supervisors, for the public, because if you open these reports, banks always refer to different keywords or include different things under the same keyword, different definitions,” Goumet said.

The authors make several recommendations to banks and banking supervisors. For banks, they recommend: mapping both physical and transition nature-risks into all prudential risk categories; improving physical and expanding transition risk assessments; leveraging existing data and collaborating with banks; and developing policies and embedding nature risks into governance practices.

Banking supervisors, on the other hand, should include nature-related risks in prudential supervision, provide clarity on what they consider to be nature-related risks, and set baseline criteria for nature-risk frameworks. Guidance on the metrics and methodologies should also be provided, and regulators should set progressive expectations and invest in nature-risk expertise to provide better supervision.

No need to take a siloed approach

Banking supervisors should also try to understand how nature-risk impacts on prudential and climate risks, and how they all interact and consider sharing data with other agencies to better understand the issues, said Goumet.

“We don’t think we need to have a siloed approach, but because these interact so much they should be understood together,” she said.

The paper also notes that banks often only use quantitative metrics but recommends using various methodologies, as relying on one method “can create a false sense of precision”.

But there is no one single measurement when it comes to nature, noted Almeida. Nature-related risks include various ecosystem services like water, soil quality or pollination.

“[Financial institutions] want to look for very simple proxies similar to carbon emissions for climate, but this doesn’t really necessarily translate for nature,” she said.

While financial institutions often cite a lack of data for why they can’t take a multi-method approach, there are a lot of advances in data through satellite imagery and other sources, Almeida said.

“With this report, we wanted to showcase what was already possible with limited information so you can’t use the regulatory rollbacks and rollbacks in information sharing, because we’ve seen how banks have been looking at nature with limited information already,” Almeida said.

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