Loss of biodiversity – the “Twin Risks” of climate change

• According to the business forum and the Taskforce on Nature-related Financial Disclosures (TNFD), biodiversity loss is one of the greatest global challenges of our time, along with climate change.
  
• The loss of biodiversity also affects financial institutions – they are confronted with high risks when approving loans, through their investment policy or with the threat of reputational loss.
• It is therefore important to integrate biodiversity risk, just like climate risk, in the risk management process of financial institutions. The creation of the TNFD (with its expected frameworks), and the increased regulatory pressure in the domain are expected to be catalysts for this integration.

Awareness of the risks of climate change has grown in society, among politicians and has attracted intense scrutiny from banking regulators and supervisors over the past few years. However, the risks from the loss of biodiversity have so far been very slow in getting the attention of financial market players. The Global Risk Report 2022 of the World Economic Forum classifies the loss of biodiversity as one of the three greatest risks for the next 10 years. In addition to climate risk, banking supervisory authorities are also being strongly encouraged to integrate risks from the loss of biodiversity into risk management processes. Yet, a large majority of financial institutions have continued to focus their efforts on the climate components of climate and environmental risks.

A UN Biodiversity Summit is on the agenda in Montreal at the end of 2022. In line with the Paris Climate Agreement, which heralded the turning point for climate protection, Montreal is set to become a milestone in the protection of biodiversity. It is becoming apparent that legislators and society, in general, will significantly increase the pressure on business to protect ecosystems. The European Banking Authority (EBA) already made recommendations on how biodiversity loss could be integrated into the regulatory framework, but risk management in this area is still in its infancy compared to climate-related issues. In parallel, the ECB Guide on climate and environmental risks goes beyond climate-related risks and incorporates other environmental risks, including biodiversity. Yet, for many banks the work done outside climate-related risks is still highly exploratory. Finally, while several sets of scenarios have been developed and harmonized for financial institutions by the Network for Greening the Financial System (NGFS), no such scenario currently exists for biodiversity risks. 

Biodiversity risks are more difficult to calculate and manage than climate risks. The destruction of ecosystems and the extinction of species cannot be attributed to a single cause. They come about due to a complex and multidimensional network of risk drivers. Therefore, no single course of action can be derived, but rather several differentiated approaches are required.

Actors in the financial and commodity markets are currently beginning to identify the potential impacts of global biodiversity loss, based on different scenarios, and to understand their consequences.

Economic sectors can be exposed to biodiversity risk both through their dependence on ecosystem services and through their impact on nature. Agriculture, forestry, fisheries and livestock are particularly dependent on natural capital, as their production and output rely heavily on ecosystem services.

Other sectors, such as energy, manufacturing, construction, transport, mining and extractive industries, have a particularly negative impact on nature and therefore play a strong role in biodiversity loss, which means that these sectors can also be affected by transitory risks.

In addition to the economic sector, the region also plays an important role in the extent of biodiversity loss. 

Biodiversity loss as an overall risk driver has a major impact on physical and transitory risks in a financial market context. A physical risk such as species extinction can lead to the destruction of capital and the disruption of value chains. Transitory risks arise, for example, from government measures such as restrictions, quotas and thresholds that force companies to act and invest. Operating costs increase and activities have to be relocated and adapted. These drivers are reflected in credit, market price, liquidity and operational risk. 

Overall, it is important for financial institutions to increasingly analyze their clients’ economic activities for biodiversity risks and to firmly integrate the topic into their risk management processes. The first banks are already taking biodiversity drivers into account in their risk inventory or stress testing – it is equally important to view the topic through a “reputational risk lens” and act accordingly. 

We have seen over the past years an increased adoption of the TCFD (Task Force on Climate-related Financial Disclosures) framework in the reporting of financial institutions (see the KPMG studies). In 2021, a new taskforce was created to better explain nature-related risks (besides climate).

The TNFD aims to deliver a risk management and disclosures framework for organizations to report (and act) on nature-related risks (including biodiversity). A “beta” version of the standard was released for consultation in 2022, in order to publish a first version of the framework by September 2023. More details on the TNFD can be found here.

Similar to the impact the TCFD’s recommendations had on the disclosures and actions associated with climate risks, we expect the TNFD to be a game-changer in the way financial institutions manage and report on nature-related risks (including biodiversity).

It is clear that the loss of biodiversity, as a significant risk driver, is linked to climate risk and institutions should now begin to take both climate and biodiversity risks into account, something the ECB has communicated and demanded on several occasions. In the near future we expect the appreciation of the importance of environmental risks (besides climate) to grow.

Time for broadening the “E”-spectrum is now!

Authors: Julien Thiry, Armina Schädle, Pietro Maiorana