The idea that human actions are bringing natural systems close to breakdown, threatening livelihoods and financial stability, is making asset managers think harder about nature risk and the environmental dependencies in investee companies.
This episode of The AIQ Podcast asks what we know about the state of our planet.
As climate change accelerates, oceans acidify, deforestation and soil erosion continue and species are lost, we explore how much investors and financial regulators understand about nature risk – and why it matters.
Tune in to learn more about:
- Why nature matters to economies and markets
- How climate change and biodiversity must be addressed together
- Why underestimating nature risk could be costly, and how creating more sustainable relationships with the natural world could drive investment opportunities
Nature risk: What we know, and why we should care
The unexpected arrival of a frog in a washing machine in the English city of Cambridge recently led to a new discovery: a parasitic worm never seen before. This particular worm had travelled more than ten thousand kilometres inside the frog, hidden in a suitcase carried by a traveller returning from Mauritius.
The worm became one of more than 500 new species recognised by the Natural History Museum in London in 2020. It was added to a long list of officially recognised life forms, made up of around 8.7 million species. Other finds included a monkey, several snakes, bees, beetles, barnacles and seaweeds.
These discoveries illustrate a vitally important ecological point: despite some enormous breakthroughs in science, there are many, many things we don’t know about the natural world.
“Understanding the natural history of species is crucial to understanding those assets widely. But as a planet, we don’t know more than half of what we have got!”
That was Professor Andy Purvis, Life Sciences Research Leader at The Natural History Museum, explaining how much we have to learn in the museum’s 2021 Annual Science Lecture.
We are in the foothills when it comes to understanding our planet, where a single millilitre of sea water – about the size of a sugar cube – might contain one million bacteria and ten million viruses.
But we do know Earth needs diversity to maintain the complex balance between different lifeforms.
And, apart from these extraordinary new discoveries, we know are living through a period of rapid environmental destruction and species loss – all accelerated by our own actions.
This is now proving a significant threat for the global economy and some of the world’s most vulnerable people, according to Elizabeth Maruma Mrema executive secretary of the UN Convention on Biological Diversity.
Elizabeth Maruma Mrema
“The loss of biodiversity – of species of plants, animals, microorganisms and genetic diversity – is both an ecological and economic emergency. The businesses that we finance, invest in and insure depend on biodiversity.”
Because each species on the planet contains irreplaceable genetic information, and because each life form is linked to many others in a complex web, there may be costs for future generations if we do not care for other living things. Biologists Andrew Beaty and Paul Erlick warn about this in their book Wild Solutions: How Biodiversity is Money in the Bank.
Andrew Beaty and Paul Erlick
“If species are like safe deposit boxes, we are destroying the contents before looking inside.”
So, Earth needs worms living in frogs. It needs bacteria in the soil to clean water, plants to fuel and sequester carbon, pollinating insects so fruits can reproduce, birds to spread seeds and animal predators to control weightings in the food chain. Nature provides another important service as well: psychological relief. It can calm us in hectic times.
The natural world is a larder, an energy factory, a water tower, air-conditioning unit, and a fertiliser and pesticide producer. It delivers cleaning and recycling services and flood control. It is increasingly used for design inspiration, in bio-mimicry, to feed ideas into research projects, when human imagination fails.
But outside traditional societies, these benefits have been undervalued and underappreciated for years – partly because of the way we look at the world.
“We have really made a mess of things by creating models of growth and development in which nature does not appear at all!”
That was Professor Partha Dasgupta from the University of Cambridge explaining one vital problem. There are no models being used by treasuries, central banks or international organisations like the World Bank that show the human economy embedded in and dependent on nature – which it quite clearly is.
That approach has contributed to a world where the demand for natural resources far exceeds supply. Humans are simply using too many resources to build and make – and not cleaning up. It’s nothing less than disastrous, Dasgupta believes.
Professor Partha Dasgupta
“This is a crisis situation. There’s no question about it. The gap between demand and supply is increasing. It’s large already but it’s increasing. And that’s coming from a variety of studies in earth sciences, ecological sciences, environmental sciences and a few contributions from an economist as well….This cannot go on because these systems are very non-linear.”
The Canadian Conservationist Harvey Locke agrees. Locke is a leading thinker on landscape conservation, and now responsible for taking the International Union for Conservation of Nature forward in exploring global biodiversity goals.
“Look at the size of the global economy. It’s just enormous compared to what it was 50 or 100 years ago. Wow, did that work! Except – we're now destroying the context for all human life, including the economy. We're changing the climate, we're destroying the oceans with overfishing, we've over-cleared the land, we’ve caused an extinction crisis and forecasts suggest we could lose up to a million species. That's like throwing all the rivets out of all the aeroplanes and saying: ‘Let's continue to fly’. We just can't continue this way. We’ve got to change.”
Breaking the cycle needs a shift in strategy. One of the big ideas is for humans to do less, to commit to leaving large swathes of land and ocean alone, so that ecosystems can recover. Locke recently set this out in a paper titled ‘A Nature-Positive World’. The proposal, to halt and then reverse the loss of nature, was picked up by members of the G7 before COP26, the last international climate conference.
“Trudeau, Biden, Merkel, Johnson and Macron all signed this thing saying the world must not only be net zero or carbon neutral; the world must also be nature positive. In other words, we have to halt extinctions and reverse biodiversity loss by 2030 and protect at least 30 per cent by 2030. So, that’s how these ideas are starting to come together on the global stage.”
But will people really ever agree not to use large parts of the planet? And how we will we deal with the tricky question of how we manage the rest? The success of conservation movements worldwide is patchy, and the world failed to meet any of the last set of biodiversity targets agreed in Aichi in Japan in 2010.
But the mood seems to be changing after COVID-19 and recent climate-related disasters. There is growing understanding of the close relationships between climate and biodiversity risk – because the natural world sequesters carbon – and more appreciation of vulnerabilities, system-wide.
For example, leading central banks have begun stress testing, to see how much of the loan books held by large financial institutions are exposed to nature. The process has thrown up some very large numbers, according to David Craig, co-chair of the Taskforce on Nature-Related Financial Disclosures.
“The Dutch have done it, the Brazilian government have done it and the French government are doing it. And they found 40 to 50 per cent of bank loan books are exposed to nature. That’s considerable, particularly if you marry it with the size and scale of environmental degradation, where we are losing around a football pitch of primary rainforest every six seconds.”
“When you start putting that together, I think this is switching, if I am blunt and honest, from “‘Let's love the pandas” to a serious assessment of economic risk.”
But the process is not straightforward, because there are no simple, standardised metrics which capture the state of the planet. In each and every location, the challenges are different. It’s not like looking at climate and measuring warming gases, where there is a single measure used everywhere.
Assessing nature impacts is much, much more complex, according to Eugenie Mathieu, Earth lead at Aviva Investors.
“It is much harder for policymakers and investors to assess a company’s impact on nature than its carbon emissions. For example, a major chocolate manufacturer might have 500,000 farmers in its supply chain. How can we measure the impact of each? How many trees were felled for new plantations? How many insects were killed by their pesticides?
The difficulty is that biodiversity impacts are entirely local. It relates to how many trees are cut down, how you pollute the waterways and manage waste. It is unlike the carbon emitted into the atmosphere, where we have a common metric – carbon dioxide equivalent – and you can estimate the carbon footprint pretty accurately from readily available data. In that case, you can look at how much fuel was used to get a product to market and how many tonnes of fertiliser were applied.”
Nevertheless, some companies, like the cement producer Holcim, are already pledging to become nature positive, setting targets to improve biodiversity in quarries and reducing water consumption. But it’s early days, because the concept is so difficult to measure and prove.
Meanwhile, polling suggests few companies are giving nature risk the attention it deserves. For instance, of the 9,700-plus companies recently surveyed by CPD, only half of one percent said they were thinking strategically about nature risk. In contrast, 97 per cent said they had climate risk on the radar.
That failure could prove an expensive mistake. Those causing environmental damage could be hit with legal costs. There might be direct costs for those that don’t understand the vulnerabilities in their supply chains and reputational costs for those that heedlessly degrade the natural world.
Meanwhile, the TNFD is attempting to fast-track an agreement on a framework for nature-risk accounting, so companies can incorporate a view on their exposure to natural assets into their accounts.
The idea is that this will encourage organisations to focus on how changing conditions in the natural world might impact their financial performance, with the ultimate goal of channelling investment towards more sustainable outcomes.
“One of the things we are looking at in our risk management framework is: how do we identify the natural assets that revenue is dependent on or assumed in the cost base. A few companies have a tiny line that accounts for, say, water used. But if that water source disappeared, it is likely to cost a lot more to replace it. So: how we do think about the natural asset on the balance sheet?”
The TNFD’s early work is based around the four pillars already established by the Task Force on Climate-Related Financial Disclosures. Around ‘governance’, ‘strategy’, ‘risk management’ and ‘metrics and targets’.
“When you start talking about externalities that you have not factored into your business models, the asset managers start taking that very seriously, because they know they have regulatory, financial and fiduciary responsibilities to factor in such externalities. They are thinking: We need to focus on this and start doing it quickly.”
It is important to realise this is not just vague and conceptual. For example, humans have a shocking record of eating species into extinction. If we look closely at Japanese fisheries, catches have been drifting down for more than 15 years. Situations like this have dangerous implications for investors, if the decline in stocks is masked. Here’s John Willis, Planet Tracker’s Director of Research, explaining the problem:
“Fishing ports fail, their catches fails, consumption falls. That’s all pretty obvious. Look at the whole seafood supply chain. Then all the company’s financials collapse… But they didn’t! And the reason they didn’t is that management is not completely stupid. They started cost cutting. They started acquiring to get around it. But you eventually get to a stage where you’ve played every financial trick you can, and you are out of options. And that is what has happened now.’
Outside fisheries and agriculture, many other companies are exposed to dwindling supplies of water, as the amount of the planet affected by drought has more than doubled in the past 40 years. It’s thought some agri-businesses and consumer products companies could be subject to big earnings hits – 40 per cent or more of pre-tax earnings – from water scarcity.
Other earnings impacts might come for companies using waterways for transport; think of how the low water level in the Rhine forced chemicals producer BASF to shut some operations in 2018 when it couldn’t obtain raw materials.
And, if water scarcity becomes more of a problem, it is fair to expect polluters will face more scrutiny, leaving them open to fines and litigation.
What about the positive side of the coin? There could be opportunities for companies developing technologies that use resources sparingly, delivering nature-friendly solutions and targeting sustainable development. These are all growth areas being explored by researchers, entrepreneurs, and investors.
“We see opportunities for investors allocating capital to transition leaders in their respective industries – companies that are moving in the right direction in terms of their management of natural capital and environmental risk. We need to engage with them to move further and faster. We believe companies doing the right thing now should outperform in the long run, as measured by financial returns and the overall impact on nature.”
That was Julie Zhaung, portfolio manager at Aviva Investors. Her colleague and co-manager, Jonathan Toub, sees specific opportunities in agri-food production, an area responsible for high levels of carbon and methane emissions, loss of biodiversity, depletion of the soil and heavy water use.
“We have around one third of the entire surface of the earth used for cropping or animal husbandry, but those activities use around three quarters of all available freshwater.
Rather than more intensive farming, we need precision and regenerative agriculture, with more efficient use of fertilisers and irrigation.”
Reducing food waste is another priority, Toub believes, in an extraordinarily wasteful chain.
“One third of the food produced for human consumption, around 1.3 billion tonnes, is lost through supply-chain issues or from food simply being thrown away. This is enormously costly given the drain on the land as well as the fuel, water, seeds, fertiliser and man hours that have gone into producing the food. We need to improve the efficiency of agricultural production and supply chains urgently.”
There are so many uncertainties in an environment where nature and climate appear to be locked in a vicious cycle. But if there is one positive takeaway from this alarming situation, it must surely be that the penny has finally dropped: more people seem to be waking up to the fact it is not possible to keep clearing, burning, building, consuming, and dumping waste without being more mindful about the consequences.
But real change will only begin when we shift our attitudes to the natural world. Let’s end with a look at how Gretchen Daily, the Bing professor of environmental science at Stanford University, described the challenge in a recent lecture at MIT.
“Rather than an all-you-eat buffet, we need to have a sense of scarcity and we need some table manners. We need to be investing in our life support systems rather than seeing them as a set of one-time, exhaustible resources.”
If you would like to find out more about the views of the leading analysts and academics featured in this piece, please go to AIQ’s Investment Thinking at www.avivainvestors.com/aiq.
Thanks for joining us.