How can investors assess impacts on nature?
How can investors assess impacts on nature?
The topics of natural capital and biodiversity are far-reaching and encompass a number of subthemes including deforestation, sustainable food and water, pollution, as well as the circular economy.
Policy momentum is building and investors and regulators are increasingly attuned to corporate environmental performance beyond simply impacts on climate change.
Not only this, but progress on policy and reporting frameworks for climate change can serve as a blueprint for nature-related risks, potentially enabling a much swifter response.
But what do we mean by natural capital and biodiversity, why are they so essential to the functioning of our economies and how are they relevant to corporates and investors? Here we explore these questions, the sectors that are most exposed and how we can go about assessing exposure in detail.
Nature generates value; with nature loss we lose that value
Governments, investors and corporates are alive to the threat posed by inaction on climate change. Net zero targets now cover well over 70% of global emissions and GDP, and corporates are starting to follow suit. Broader environmental threats get much less air time, but this is starting to shift.
This year the World Economic Forum identified biodiversity loss and ecosystem collapse as one of the top five five risks in terms of likelihood and impact in the coming 10 years, behind infectious diseases, climate action failure, and weapons of mass destruction.
What is natural capital? Natural capital refers to the stock of renewable and non-renewable natural assets, including everything from soil, forests, air, water, geology, and all living organisms.
What about biodiversity? Biodiversity is an important element of natural capital and, put simply, refers to the variety of living things in a given area. This variability is vital for the healthy functioning of ecosystems which in turn provide a multitude of goods and services that underpin our economies. These include everything from direct goods such as food, energy, and medicinal resources, to services provided by nature, such as water filtration, crop pollination, carbon sequestration, climate regulation, and flood protection, to name just a few.
Some $44tn of economic value generation (>50% of global GDP) is either moderately or highly dependent on nature, according to the World Economic Forum (WEF).
The services that nature provides, termed “ecosystem services”, almost always go unpriced, resulting in their excess use. In some instances they are even negatively priced through environmentally harmful subsidies – in the agricultural sector, for example, total well over $100bn per year.
This has resulted in ecosystem decline and degradation as well as rising ecological scarcity. Natural forests are declining at unprecedented rates, wetlands are disappearing, 30% of corals have already been killed and a further 75% are at risk of bleaching, and vertebrate species populations have declined by close to 70% since 1970.
To put this in perspective, this level of nature loss is tens to hundreds of times the average rate over the past 10 million years, and is on par with previous mass extinctions (of which there have been five in the last 450 million years – all as a result of natural rather than human causes).
A quick overview of the science
There are five key ecosystems that are of systemic importance:
Important carbon sink; provide ~80% of world's oxygen.
Critical in rain cycle.
Important source of food and livelihoods.
Coral reefs are natural wave barriers.
Key threats include overconsumption, pollution, tourism, and climate change.
Includes mangroves, lagoons and tidal marshes.
Highly biodiverse environments and important carbon sinks (can sequester more than twice the amount of carbon of tropical rainforests).
Key threats include tourism and development.
Includes ground ice and permafrost, swamps, marshes, rivers and lakes.
Freshwater ecosystems account for 1% of all freshwater but support 55% of all fish.
Very fragile, higher extinction rates than marine and terrestrial species
Key threats include overuse, pollution and water diversions
Tropical rainforests, temperate forests and boreal forests.
Highly biodiverse (~80% of terrestrial animals and plants found in forests) and important carbon sinks.
Key threats include deforestation, wildfire, agriculture and urbanization.
Peatlands are wetland ecosystems. They are waterlogged, which slows the process of decomposition, resulting in acumulation of peat or turf
Largest store of carbon on land and important in regulating water flows to minimise flooding and drought.
At risk of peatland drainage.
These are distributed across “biodiversity hotspots” – defined as areas that hold very high numbers of species of plants and animals, and that are under threat of habitat destruction and disruption. There are currently 36 biodiversity hotspots across the globe.
Biodiversity hotspots are under threat from five direct drivers of nature and biodiversity loss:
- Land and sea use change
Activities that change the natural environment and result in habitat destruction and fragmentation, including agriculture, deforestation, mining, infrastructure and urbanization.
- Natural resource use and exploitation
Direct extraction of living organisms resulting in habitat destruction and fragmentation such as hunting, fishing, logging, and harvesting.
- Climate change
Climate change adversely affects genetic variability, migration patterns, ocean acidification, and species richness.
Includes industrial waste, fertiliser runoff, and plastic pollution.
- Invasive species
Can pose threats to indigenous species; caused by transport, climate change and tourism.
The link between natural capital and climate change
The natural environment and biodiversity play a vital role in limiting climate change. Forecasting suggests that forests and other natural ecosystem solutions will account for over a quarter of the mitigation needed to limit global temperatures to within 1.5 degrees C by 2050.
Given the scale of action required to forestry and other natural carbon sinks, decarbonisation strategies and policies must consider broader impacts on natural capital and biodiversity.
The potential economic impacts are large: the World Bank estimates that a partial ecosystem collapse could cost 2.3% of global GDP (or $2.7 trillion) per year by 2030. These impacts would be disproportionately borne by developing nations given reliance on pollinated crops, forest products and limited ability to switch to alternative modes of production.
There are a number of transmission channels through which this macroeconomic deterioration can occur. Biodiversity risks impact companies through business disruption, stranded assets, as well as changing demand and increased costs – all of which can hamper profitability. The aggregate impacts of this can result in reduced productivity, price shifts, capital destruction, and labour market frictions.
Macroeconomic transmission channels for nature related financial risk
Physical risk: land and sea use change; overexploitation; climate change; pollution; invasive specices.
Transition and reputational risk: changing policy landscape, and investor and consumer expectations.
Impact on companies
Disruption of activities or supply chain.
Raw material price volatility.
Adjustment or relocation of activities.
Market risk: risks to investments.
Credit risk: rising risk of default.
Liquidity risk: liquidation risks; cost of debt refinancing.
Business risk: legal, regulatory and reputational costs.
Source: University of Cambridge Institute for Sustainability Leadership, Schroders.
Nature and biodiversity risks as the next frontier for corporates
Risks surrounding nature and biodiversity loss are highly relevant to companies, which are embedded in the natural environment through their dependence and impact on natural resources. We see four key risks for corporates:
Operational and supply chain risks
Exposure to geographies in which nature loss is occurring through direct operations and supply chain. This can disrupt business continuity, for example through water shortages or reduced rainfall leading to lower crop yields. This is particularly relevant for companies operating in regions with higher exposure to nature-related risks, and for end markets that are reliant on goods and services provided by nature, including the food, agricultural, apparel and forestry industries.
Australian agricultural income declined by 46% in the 2002/2003 drought. Mismanaged species introductions as agricultural pests estimated to cost $100 billion per year. Flooding linked to deforestation in South Asia in 1998 estimated to cost $24 billion. Soil erosion in Europe estimated to cost €53 per hectare per year.
The policy landscape is still nascent when it comes to regulating nature-related risks, in large part due to difficulties in measuring and reporting on these risks. Momentum is building, with major economies committing to ambitious nature goals and regulation starting to follow suit. Moreover, climate disclosure and reporting frameworks provide a blueprint for nature-related reporting.
EU proposal to reduce fertiliser use by >20% by 2030 poses material risk to sales for chemical companies.
China’s securities regulator moved to ban IPOs that have violated environmental protection rules in 2016.
Risks to consumer and investor sentiment
Consumers and investors are increasingly attuned to environmental issues, presenting a risk for laggards, who may suffer reduced demand for their products and services or an increased cost of capital.
A study found that 82% of consumers would be willing to change product purchases in favour of sustainable palm oil. Investors have threatened to divest from companies associated with deforestation in the Amazon.
Includes any fines or pay-outs that may arise as parties seek compensation for losses associated with nature loss, and also covers legal costs, insurance and financing costs.
Examples: Deepwater Horizon explosion in the Gulf of Mexico in 2010 cost BP >$18bn in fines.
A number of sectors are particularly exposed to these risks, either because of greater dependence on natural resources to produce their services and products, or through greater impact on the natural environment through their operations and supply chains.
A key part of the challenge is that there is no universally agreed upon framework or metric to measure impacts on nature, in addition to practical challenges of measurement. Some of the more commonly used methods include Mean Species Abundance (MSA) and Environmental Profit & Loss (EP&L):
MSA is a measure of biodiversity intactness. MSA is given per km2 as a range between 0 to 1, with 1 indicating a fully intact environment. Schneider Electric reported its biodiversity impact in MSA/km2 in 2020.
EP&L quantifies a company’s impact on the environment in monetary terms and includes a number of biodiversity-related indicators, including emissions, land use and water consumption. This approach was pioneered by Kering and has also been used by Philips.
However, these are still fairly infrequently used and it is challenging to draw comparisons. Some of these challenges will be alleviated in time as industry-wide frameworks and standards emerge, as discussed in the next section – but we are still at least a couple of years away from standardised metrics for measuring biodiversity impacts. In the meantime, we can still assess companies’ level of ambition, the quality of their governance and oversight mechanisms, supply chain management and disclosure practices, as well as engagement with wider industry initiatives to tackle biodiversity loss.
Policy momentum and investor sentiment is building
An assessment of intergovernmental progress on biodiversity to date paints a fairly bleak picture. The UN Convention on Biological Diversity (CBD) set a series of targets in 2010, known as the Aichi targets, with a 2020 target date – and not a single one has been achieved.
We see a step change in momentum at the intergovernmental level. The latest UN Biodiversity Summit (COP15) – the first half of which took place in October 2021 and will be concluded in May 2022 – aims to establish the post-2020 global biodiversity framework. The draft plan includes pledges to halt biodiversity loss by 2030; ensure that 30% of land and sea areas are conserved and that 20% of degraded areas are under restoration. The plan also includes commitments to eliminate plastic pollution and reduce pesticide use, as well as redirect and eliminate $500bn worth of subsidies that contribute to nature and biodiversity loss.
The hope is that COP15 will serve as a Paris-equivalent agreement on nature. G7 nations had already committed to a 2030 Nature Compact at the most recent conference in the UK in June 2021, and 196 nations adopted the Kunming Declaration in October, signally broad based political support and paving the way for the adoption of the post-2020 framework in May 2022.
Yet despite this increased momentum, challenges in translating these high level commitments into action still remain. A key takeaway from the intergovernmental process on tackling climate change, which dates back to the 1992 Earth Summit in Rio de Janeiro, is that it can be protracted at best and ineffective at worst. This is in large part due to the voluntary nature of these international commitments and lack of enforcement mechanisms, as former US President Donald Trump’s withdrawal from the Paris Agreement exposed.
The challenge is even greater for broader natural capital risks than it was for climate change given difficulties in measuring and assessing performance. It therefore seems unlikely that international cooperation will be the primary driver of change.
However, these intergovernmental commitments are indicative of growing political support at the national level, and many of these commitments are starting to filter through into national policies and strategies. In Europe, the Commission’s Biodiversity strategy for 2030 plays a central part in the European Green Deal and will establish binding nature restoration targets later this year.
The Sustainable Finance Disclosure Regulation (SFDR) also incorporates a company’s impact on biodiversity sensitive areas under the principal adverse impacts framework. Recent legislation in France (Article 29 of the Energy and Climate Law) will also require disclosure of biodiversity impacts from financial institutions. In the UK, the Environment Bill seeks to set legally binding targets on species abundance by 2030 and introduce a sustainable farming scheme that will provide financial incentives to farmers for conservation and preservation activities.
Moreover, many of the reporting frameworks that have been established to tackle climate change are now being developed for nature. While these may be some years out, we see growing pressure on corporates and investors to effectively assess, manage and disclose on their nature-related risks.
The Task Force for Nature-related Financial Disclosures (TNFD), for example, is set to launch its framework in 2023. This will be modelled on the Task Force for Climate-related Financial Disclosures (TCFD), which sets out best practice in climate reporting and is fast becoming mandatory across numerous geographies.
The Science Based Targets Network is also developing Science Based Targets for Nature (SBTN), which will provide guidance to corporates on assessing nature-related risks and setting effective targets. Nature Action 100+ (NA100) will leverage these frameworks to collaboratively engage with companies that are of the greatest importance to tackling biodiversity and nature-related risks, much in line with its action on climate (CA100).
Beyond this, organisations such as Climate Disclosure Project and Forest 500 are helping to establish best practice.
While there is still a long way to go in creating effective policy mechanisms to address nature-related risks, the direction of travel seems clear. Moreover, progress made in climate action and disclosure can serve as a blueprint for policymakers and investors alike.
Assessing our exposure and impact: Natural capital and biodiversity in our tools and engagements
Issues surrounding natural capital and biodiversity have factored into our research and engagements for many years. Within our suite of proprietary tools, we assess company and sovereign performance on key natural capital criteria, seeking to place an economic value on the environmental externalities that are driving nature loss.
For companies, our tools incorporate measures such as a company’s ecological footprint, its Forest 500 score and whether or not it has a biodiversity policy. We also measure fertiliser use, heavy metal pollution, waste production and water consumption.
At the sovereign level, we assess biodiversity loss using Yale’s Environmental Performance Index. We also assess net carbon emitted or sequestered as a result of i) changes occurring on forest land and ii) net forest conversion from forest land to other land uses. In addition, we look a ocean pollution as well as carbon and other emissions.
We have also engaged over 200 companies on the topic of biodiversity since 2018, including over 100 companies that we spoke to understand the risks associated with plastic pollution across the full value chain.
We recognise that there are myriad challenges associated with measuring a company’s impact on natural capital and biodiversity, in large part because of challenges in measurement and data availability. While our tool SustainEx can help us to understand these broader environmental impacts, there are certain measures that are not captured by the SustainEx framework, and thus require more focused work, which in turn can help us to expand and strengthen the analysis we apply over time.
- Outlook 2022: Asia ex Japan equities
- What is needed to support the Turkish lira?
- Outlook 2022: UK equities
- Q&A: why might worker safety be a driver of positive returns?
- Why diversification and compounding are the keys to successful investing
- Outlook 2022: Global and thematic equities