Managing Nature-related Financial Risks

Managing Nature-Related Financial Risks: A Precautionary Approach for Central Banks and Financial Supervisors written by three University College London researchers identifies a number of Nature-Related Financial Risks (NRFR) to companies and financial systems. These include biodiversity loss, water scarcity, ocean acidification, chemical pollution, zoonotic disease transmission and other non-climate environmental risks.

NRFRs are amplified by the financial system, presenting potentially systemic threats to financial and economic stability. The paper examines how financial authorities should react to these environmental threats beyond climate change.

The paper shows that environmental breakdown threatens the real economy through supply shocks for firms dependent on ecosystem services, through demand shocks from changing consumer preferences, and from shifts in policy, regulatory, technology or trade environments.

These and other changes will also have second- and third-order systemic effects, with the potential for “huge, complex and permanent socioeconomic costs that are impossible to predict”.

“Multiple interconnected threats are characterised by non-linearities and complex system dynamics,” the authors say, “while the potential impacts upon the planet are likely to be both historically unprecedented and ultimately irreversible.”

While much of the paper describes the ways in which nature degradation poses systemic risks for finance, it also outlines how the financial system in turn facilitates the business activities that cause environmental degradation in the first place.

This concept of ‘double materiality’, in which the financial system increasingly faces the same systemic risks it helps create, requires that financial authorities to not just react to this risk, but act and change towards a rapid transition away from climatic and ecological breakdown. The environmental policies of several emerging economy central banks are outlined as examples of what other central banks can do.

The authors argue that because NRFRs are systemic, endogenous and subject to radical uncertainty, they cannot be sufficiently managed through “market-fixing” approaches based on information disclosure and quantitative risk estimates.

Instead, they propose that financial authorities adopt a precautionary policy approach involving preventative action and a greater use of qualitative risk management methods to support a controlled regime shift towards more sustainable capital allocation.

The paper concludes by suggesting that central banks begin mitigating these risks by excluding fossil fuels and other damaging environmental activities from their financing, regulatory and monetary policy toolkits.