Nature-Related Financial Risks

The Network for Greening the Financial System (NGFS) has released a conceptual framework for assessing nature-related financial risks which provides a “starting point for analysis and action”. The beta version of the framework seeks to enable central banks to collectively address the twin crises of environmental degradation and climate change by establishing a common science-based understanding of nature risks.

The NGFS framework defines nature risks as the negative effects on economies, financial institutions and financial systems that result from the degradation of nature (physical risks) or misalignment of economic actors with action to protect nature (transition risks).

The report states there is “overwhelming evidence” that biodiversity is deteriorating at “unprecedented rates” and finds that this “can have material macroeconomic, macroprudential, and microprudential consequences”. Human demands on ecosystem services, they argue, have “exceeded the ability of the planet to provide such services, resulting in a degradation of nature and its diversity”.

As a result, natural boundaries that maintain the resilience and stability of the Earth, such as its biosphere integrity, have been exceeded. Planetary boundaries indicate the limits of the Earth’s safe operating space within which human civilisation can survive and the report highlights that passing them increases the likelihood of abrupt and irreversible shifts between alternative ecosystem states. The report also shows that such physical risks pose a material threat to financial stability.

To address this, the Kunming-Montreal Global Biodiversity Framework was adopted at Cop15 in 2022 and sets 23 targets to halt and reverse biodiversity loss. Its overarching vision is to protect 30% of land, oceans, coastal areas and inland waters by 2030. The framework will likely entail significant transition risks as it requires alignment of all financial flows with its goals by 2030.

The NGFS principle-based conceptual framework for assessing nature risk has three phases:

1. identify dependencies and exposures: identify critical sources of and exposures to nature risk from microprudential, macroprudential and macroeconomic perspectives. Analysis should be forward-looking and cover sectoral and ecosystem based analysis, localised and systemic impact, and the role of cascading, compounding and contagion effects;
2. assess economic risks: consider direct and indirect micro- and macro-economic risks that stem from exposures. Macro effects include adverse impacts on prices, productivity, investment, socioeconomic factors, fiscal balances, trade and capital flows;
3. assess risk to and from the financial system: nature risks can impair assets, collateral, and corporate profitability and insurability. Analysis should assess the impact of this on traditional risk categories such as credit, market, underwriting, operational and liquidity risk. It should also consider the role of contagion and feedback loops to the real economy which can amplify shocks.

The report is part of ongoing work by the NGFS to mainstream nature risks and concludes by outlining the next steps, which are primarily focused on bridging, modelling and data gaps. The development of forward-looking nature loss scenarios is identified as a key step in better understanding the risks.