Nature-related risks in the context of financial stability: what do regulators need to know?
Thessa Vasudhevan, Lea Reitmeier, Simon Dikau and Aziz Durrani examine the ‘why, how and what’ of risks to the real economy and financial system deriving from damage to ecosystem services and habitats.
Why does nature matter to financial regulators?
As economies have grown, so too have the demands on the natural world to provide, support, maintain and regulate human activities. The environment and nature are experiencing rapid and pervasive degradation, as evidenced in IPBES assessments and the Dasgupta Review on the Economics of Biodiversity, to an extent that could greatly impact the real economy. A World Bank report estimates that a partial collapse of ecosystem services such as wild pollination could result in a decline in global GDP of up to $2.7 trillion annually by 2030.
Central bankers and supervisors are beginning to acknowledge that broader environmental risks beyond climate risks, sometimes referred to as ‘nature-related’ or ‘nature risks’, are significant to the macroeconomy and financial system. They are recognising that economic activities are disrupted when ecosystem services are harmed. This disruption includes damage to physical assets and infrastructure, and disruption to business operations and supply chains (such as the effects of extreme weather events and flooding, or the spread of infectious diseases, including COVID-19). Entities operating in affected regions may experience severe economic losses, which could transmit to the financial sector, with lenders and equity holders facing non-performing and impaired loans as well as losses and write-offs in equity values. Financial institutions and investors may then reduce or stop lending to or investing in related segments of the real economy. This could create a negative loop that could lead to economic and financial instability.
Financial institutions are exposed not only to external physical risks from nature’s decline: they can also contribute to the build-up of such risks through the activities they finance. These activities could negatively impact the environment, contributing endogenously to environmental risks. Since ensuring financial stability is one of the key mandates of central banks, either explicitly or implicitly, it is critical to better understand the scope of such risks and to start taking preventative measures before such drastic consequences materialise.
How can financial regulators better understand these risks?
While substantial advancements have been made globally in the past few years on how to measure and account for nature (e.g. through the establishment of the Taskforce on Nature Related Financial Disclosures – TNFD), there is still much work that needs to be done on the practical incorporation of environmental risks (beyond climate) into financial frameworks. Addressing nature-related risks is particularly challenging for central banks and supervisors because the contributions and exposures to these risks are not necessarily symmetrical or linear. The way business activities contribute to and are exposed to nature varies. Some activities are characterised by particularly degrading and harmful impacts on the environment, while others have a high reliance on ecosystem services.
‘Impact and dependency’ studies can help to shed light on potential financial exposures to nature-related risks while acknowledging local variations (examples include the Netherlands, France, Brazil, Bank Negara Malaysia, and Mexico). Of significance from a supervisory and regulatory perspective, such studies can provide insights into differences in the exposures of individual banks to these risks, and how systemic consequences could materialise.
For example, if 5% of a bank’s portfolio were exposed to crop production activities that had dependencies and impacts on a range of ecosystem services such as pollination, soil quality and erosion control, disruption to those ecosystem services could affect food production and food processing supply chains as well as crop yields, potentially creating food security and commodity price issues that would have cross-sectoral impacts. Eight per cent of the same bank’s portfolio might be exposed to mining activities, which can severely degrade soil and fragment habitats, and 15% to real estate activities, which can involve clearance and degradation of habitats, causing loss of biodiversity and natural capital on the construction site and surrounding areas.
It is easy to see that the ‘entry points’ of these risks could be highly varied yet interconnected. A single financial institution may not be exposed directly or significantly to a particular source of nature-related risk, but the overall impact to the system could still be highly material.
Further work exploring particular concentrations of risk exposures could be helpful to the designing of appropriate supervisory responses. Focusing on static exposures is only the start, as environmental risks can have wider macroeconomic implications, including potentially affecting the competitiveness of an economy. Given the risk of contagion and deep uncertainty over tipping points and ecological regime shifts, it is difficult to estimate the exact channels through which these risks might evolve and materialise over time and the magnitude of these changes.
Further complicating matters is the interconnectedness between biodiversity loss and climate change, with potentially compounding effects, and the trade-offs between climate policies and environmental harm. Despite some overlaps in climate and biodiversity-related risks, disregarding either, or having a narrow focus on the single metric of greenhouse gas emissions, would certainly underestimate risks and miss cascading or second-round impacts to the financial sector. Scenario analysis could thus be helpful to explore the complex and dynamic nature of these environmental risks, especially through regional scenarios that could better reflect local contexts and incorporate both biodiversity and climate change aspects. Nonetheless, central banks should be cognisant of the challenges of scenario design and analysis, and be clear of the purpose of conducting such an exercise.
What are the next steps for policy?
Further work is in progress to better conceptualise these risks, for example through academic research, a Network for Greening the Financial System (NGFS) task force and a project between the OECD and the Hungarian central bank. This includes better understanding transmission channels (including contagion and feedback channels), identifying risk hotspots (on geographical/ecosystem/economic sector scales), exploring potential cross-border impacts, and understanding differences between direct and indirect risks. To complement the work being carried out on a conceptual level, financial regulators could start to identify key nature-related risk drivers relevant to their contexts, and trace the connections between financial sector lending or investment activities and risk hotpots. In this context, the financial sector should carefully monitor their lending and investments to ensure they do not support activities that will further harm the natural world. Central banks may also consider setting rules that would limit banks from holding such higher risk exposures, potentially even subjecting them to additional capital surcharges, where appropriate.
It is important to note that central bank policies cannot substitute for broader national and international government action. Environmental regulations are fundamental to tackling the causes of environmental degradation and nature loss. However, given their financial stability mandate, central banks and supervisors must play an important complementary role to this, at the very least by strengthening supervisory oversight and addressing knowledge and data gaps around such risks. They can leverage their experience in assessing the financial materiality of risks and communicating financial and economic risks to their citizens, institutions and governments.
The complexity of nature risks requires intense and effective collaboration across all government agencies, and central banks and financial regulators can partake in this, or convene experts and relevant authorities to analyse risks and design policy actions. In addition, cooperation with regional partners and sharing experiences with international counterparts could be practical and cost-effective measures to build collective capabilities.
The endogeneity, non-linearity and complexity of nature-related risks have prompted calls for precautionary approaches to managing them. Under this approach, macroprudential policies would be employed in a pre-emptive way, aiming to mitigate systemic financial risks that are too onerous and time-sensitive to estimate or enable market actors to self-adjust. These approaches can take the form of improving the efficacy of environmental regulation by integrating them into monetary policy and financial supervision, where mandates and remits allow financial policymakers to do so. At the extreme, governments may deem some economic activities to be too damaging to the economy and financial system and hence may significantly discourage or even ban them. In this manner, credit flows can be steered in the economy depending on the contribution to environmental harm (e.g. establishing clear regulations to prohibit the financing of harmful activities within and around protected areas).
Such approaches would require stronger coordination with other government departments and stakeholders, and a willingness to exercise discretion in the face of uncertainty. As the Dasgupta Review puts it, “there is a need to identify and reduce financial flows that directly harm and deplete natural assets”. Designing policies to manage the financial sector’s impact on nature would therefore be part of a risk management approach to address environmental risks, in order to support financial stability within economies.
Thessa Vasudhevan is a Policy Fellow, Lea Reitmeier a Policy Analyst, and Simon Dikau a Distinguished Policy Fellow at the Grantham Research Institute on Climate Change and the Environment. Aziz Durrani is a Capacity Development Expert at the ASEAN+3 Macroeconomic Research Office.
The authors would like to thank the participants of a roundtable on ‘Nature Impact and Dependency Studies in Southeast Asia’ held in Singapore in April 2023 for their contributions, which have informed this commentary. The roundtable was organised by the International Network for Sustainable Financial Policy Insights, Research, and Exchange (INSPIRE), with the ASEAN+3 Macroeconomic Research Office (AMRO). Participants came from Bank Negara Malaysia, Bangko Sentral ng Pilipinas, Banco de México, Bank Indonesia, Ministry of Finance Thailand, Japan Financial Services Agency, Monetary Authority of Singapore, WWF Singapore, Asian Development Bank, World Bank, IMF and the OECD. The roundtable took place on the sidelines of the Annual Plenary Meetings of the Network for Greening the Financial System (NGFS), and the meeting of the NGFS Taskforce on Nature-related Risks in Singapore.
The views in this commentary are those of the authors and do not necessarily represent those of the Grantham Research Institute, the authors’ host institutions or the roundtable participants.