Biodiversity provides a range of nature services to humans, including regulating the climate, cultural benefits and providing a vast range of raw materials. Businesses across the globe rely on these services, but as nature declines this can affect the long-term sustainability of current operating models and create additional exposures for financial firms. These risks can crystallise through typical transmission channels of credit risk, market risk or liquidity risk, to name a few.
As such, the financial sector is looking at how to identify, manage and mitigate biodiversity risks, and factor them into long term business planning.
Rashim: Biodiversity’s a recurring topic of conversation with our clients, but what does it actually mean in a financial context?
Irina: In a nutshell, the term refers to the full range of life on earth, including the variety of living organisms, such as plants and animals that occupy certain areas. For financial services firms, their direct actions can influence biodiversity, for example, by continuing to fund industries and projects that lead to loss of nature. Or by working with firms across their supply chain that use non-renewable resources.
The FCA reviews sustainability linked loans
Rashim: How does biodiversity apply to financial services?
Irina: There is a growing sense from regulators that firms don’t really understand that link between biodiversity losses and the financial sector. But we need to stop looking at these as separate, unrelated issues. The financial sector still has a lot of investment wrapped up in industries that just aren’t sustainable, and are actively damaging nature and reducing biodiversity. As biodiversity declines, we lose so many societal and cultural benefits, but there’s also a real financial risk there.
If the natural resources a business relies on stop being available – that’s a material risk to that business. If public opinion changes and customers simply stop buying non-sustainable products – that's a material risk too. The financial sector is financing these businesses, with loans, credit and investment. If those customers’ businesses decline, that means losses for their banks, lenders or investors.
Rashim: What can lenders and investors be doing?
Irina: We really need to start thinking about transition financing. How are we going to reduce investment in harmful industries and start investing in more nature-positive business? Controlling that flow of cash is really critical to keep things moving in the right direction and prevent further damage to the environment. It’s also essential to reducing the financial risk, by reducing exposures to nature loss.
To understand the scale of the issue, the Green Finance Institute flagged an investment shortfall of £44-£100 billion to help the public sector meet nature-related outcomes in the next decade alone. So, the demand for transition finance is there – it’s up to firms to make the most of those opportunities.
ESG ratings – do proposed regulations go far enough?
Rashim: That transition is going to take time – so what should firms be doing right now?
Irina: Absolutely, it’s not going to happen overnight. But there’s no time like the present to get the ball rolling with transition financing – the sooner the better.
Firms also need to think about their current exposures and really look at where they’ve invested in non-renewable industries, or ones that are actively harming nature and biodiversity. Whichever way you look at it – those industries aren’t sustainable and they won’t be around forever. So, firms need a plan for how they’re going to manage and reduce those exposures over time – without creating financial instability. In some instances, that’ll mean exiting a particular market entirely, and firms need to be able to do that safely.
As with climate risk, it’s important to think about exposures in terms of physical risks (ie actual changes to nature and biodiversity), and transition risks (where firms need to respond to legislation or guidance to slow biodiversity loss). Both of these channels can affect client and counterparties’ business models, reducing their profitability (in some cases overnight), and in turn increasing exposure for financial firms.
Rashim: What regulation currently exists around biodiversity?
Irina: There are lots of conversations going on about what the financial sector should be doing to manage the risks of nature loss. So far, that hasn’t translated into regulation, but it’s probably a matter of time. Realistically, it’ll probably follow much the same trajectory as climate risk – which people also didn’t understand that well to begin with, and has now become pretty well established.
The most obvious comparison is the Taskforce for Nature-related Financial Disclosures (TNFD) framework, which is structurally very similar to the Taskforce for Climate-related Financial Disclosures (TCFD) framework. Over the last few years, we’ve seen the TCFD framework morph from good practice, to a phased mandatory roll out in the UK, to its merger with International Sustainability Standards Board’s (ISSB). We’ll probably see similar outcomes with TNFD too.
We may also start seeing new taxonomies emerge to standardise terminology and support future regulatory frameworks on biodiversity. There’s also growing need for science-based thresholds and targets in this space, to set meaningful goals and improve accountability.
Rashim: How soon are we expecting to see change?
Irina: Biodiversity was a big topic at last year’s COP Summit, which called for urgent action to halt environmental degradation and biodiversity loss. As a result, 196 nations signed the Kunming-Montreal Global Biodiversity framework to “halt and reverse biodiversity loss” by 2030. It’s an ambitious goal that really shows the urgency of the issue. But meeting that target’s going to be tough.
To get there, world leaders need to drive forward regulation and legislation to improve disclosures, standardise metrics and track progress. It’s already 2023, so we’re looking at seven years to get new rules in place, and make meaningful change. With such short turnarounds we’re going to see heightened transition risk for the financial sector, which firms will need to carefully manage. Starting early will put firms in a better position as good practice inevitably turns to regulation. But there are also big opportunities there, to support transition finance and get on board early with more sustainable business practices.
TNFD: Getting started with nature-related disclosures
Rashim: How do firms get ahead of the curve on biodiversity?
Irina: The most important thing is to start early. Firms need to start by identifying and mapping their bio-diversity risks, and put effective risk management tools in place to minimise financial exposures. There are two key approaches here – firms can either view it as a standalone risk, or as a cross-cutting risk that’s factored into existing risk management frameworks. Either is fine, as long as the end result is effective. Firms also need to start thinking about how they can effectively channel investment towards nature-positive goals.
For more insights and guidance, contact Irina Velkova.