Growing awareness that natural systems are stressed or even close to breakdown is prompting asset managers to look closely at nature-based risks and investee companies to understand their environmental impacts and dependencies.
Read this article to understand:
- Why natural capital matters
- Why addressing climate change and biodiversity must go hand in hand
- The risks of nature depletion and the investment opportunities arising from rethinking relationships with the natural world
Earth needs diversity to maintain complex equilibria. Yet species are dying out at an alarming rate,1 undermining millions of years of evolutionary research and development.
“Data on the Sixth Great Extinction of species is shocking,” says Julie Zhuang, portfolio manager of the Aviva Investors Natural Capital Transition strategy. “These mass extinctions are mostly attributed to the explosion of the human population and intensive use of natural capital – the stock of assets, including living things, geology, soil, water and air - via industrialisation over the last century. Exploiting nature has fuelled global GDP growth but will lead to damaging economic effects over the longer term.”
Earth needs worms living in frogs. It needs bacteria in the soil to clean water,2 plants to fuel and sequester carbon, pollinating insects to enable fruits to reproduce, birds to disperse seeds and animal predators to control weightings in the food chain. Nature provides another important service as well – psychological relief, soothing in hectic times.
The natural world produces an abundance of plants with medicinal properties. It operates as larder, energy factory, water tower, air-conditioning unit, fertiliser and pesticide producer, provider of cleaning and recycling services and offers flood control. It supports billions of people directly, living off the land and another three billion or so reliant on wild-caught and farmed seafood as a primary source of protein.3 It is also increasingly being used for design inspiration, in biomimicry, to feed into research projects, when human imagination fails.
But outside traditional societies, these ecosystem services – benefits from the natural world – have been undervalued and underappreciated.
Figure 1: What nature provides
Source: Aviva Investors, May 2022
Nature’s role in economics
The error of failing to see human societies as part of the natural world or price the damages arising from human actions is becoming increasingly obvious. “Unfortunately, nature is currently free to exploit,” says Eugenie Mathieu, senior impact analyst and Earth lead on Aviva Investors’ Natural Capital Transition strategy. “Cutting down virgin forest for new farmland or releasing battery chicken effluent into local rivers is essentially free of charge.”
That pricing failure has contributed to a world where humans are using too much resource to build and make (see Figure 2) and are creating mountains of waste – with long-term consequences.
“It’s a vicious cycle,” says David Craig, founder and former CEO of Refinitiv, one of the world's largest providers of financial market data and co-chair of the Taskforce on Nature-Related Financial Disclosures (TNFD), the group working on a framework for managing and reporting nature-related risks.
“The degradation of nature is creating substantial risk to the global economy because there is very little we do that does not use natural resources. But climate change is also degrading nature and that is impacting the natural resources that will support and absorb carbon, affecting seagrass, ocean reefs, forests, savannas and so on.” (More from Craig, here.)
But the mood is changing. COVID-19 – a likely nature-based disaster – comes hard on the heels of other dramatic events. Three billion non-human animals were killed or displaced by wildfires in Australia in 2019 and 2020;5 a scale so large it is difficult to comprehend. Human costs were enormous too; recent estimates put insured losses at over $1.4 billion.6
Searching for metrics: Local issues, global problem
The situation is becoming increasingly urgent, because “people have begun to appreciate the quantum of risk,” Craig says. He flags the stress tests carried out by central banks in Brazil, the Netherlands and France, which threw up some startling numbers.
Agreeing standardised metrics to capture the state of the planet has not been achieved
“The French study found 40 to 50 per cent of bank loan books are exposed to nature,” he says. “That’s considerable, particularly if you marry it with the scale of environmental degradation. If you start putting the factors together, it means switching from “‘Let's care for pandas” to a serious assessment of economic risk and reality.”
But agreeing standardised metrics to capture the state of the planet, with the aim of managing better outcomes for all, has not been achieved.
“The factors are contextually sensitive to location and industry; it matters where you are,” says Craig. “There is no single number to capture this complexity, although there may be a set of numbers that achieves it. Water use is measurable, as is land use, then there is STAR (Species Threat Abatement and Restoration) for biodiversity, and other metrics are surfacing as well. We will get to a set of numbers, but it will never be as simple as climate.”
Moving towards a common nature-risk framework
Companies are increasingly experimenting with how to quantify biodiversity impacts. Meanwhile, the TNFD – co-led by Elizabeth Maruma Mrema, executive secretary of the UN Convention on Biological Diversity, and Craig – is attempting to fast-track an agreement on a framework for nature-risk accounting, so companies can incorporate a natural-asset view into their accounts.
Helping organisations focus on how changing conditions in the natural world might impact their financial performance
The hope is that this will encourage consistency, helping organisations focus on how changing conditions in the natural world might impact their financial performance and what might happen in future scenarios, with the goal of channelling investment to more sustainable outcomes.
Early work by the members of the TNFD is based around the four pillars (governance, strategy, risk management, metrics and targets) already established by the Task Force on Climate-Related Financial Disclosures (TCFD). The TNFD released its initial proposals in March 2022, which will be refined in 2022 and 2023.
Why investors need to better understand ecosystem vulnerabilities
This is far from a conceptual exercise; nature risk is relevant and elevated, now. In Japanese fisheries, for example, catches have been drifting down for more than 15 years.7
Outside fisheries and agriculture, many other companies are exposed to dwindling supplies of water, as the percentage of the planet affected by drought has more than doubled in the past 40 years.8 Recent analysis suggests certain agri-businesses and consumer products companies could be subject to significant earnings hits (40 per cent plus of pre-tax earnings) from water scarcity.9 Other earnings effects might come for companies using waterways for transport; think of how low water levels in the Rhine forced chemicals producer BASF to close some operations in 2018 when it was unable to obtain the raw materials it needed.10
There are opportunities for companies developing circular economy ideas
If water scarcity becomes more of an issue, it is reasonable to expect that polluters will face greater scrutiny, leaving themselves open to fines and litigation.
The more positive side of the coin is the opportunities for companies developing circular economy ideas, developing technologies to use resources more sparingly, devising nature-friendly solutions and targeting sustainable development. These are all growth areas being explored by researchers, entrepreneurs and investors.
“Investors can also allocate 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 - and engage with them to move further and faster,” Zhuang says. “Companies doing the right thing now should outperform in the long run, as measured both by financial returns and their impact on nature.”
There are specific opportunities in agri-food production, one of the areas most responsible for carbon and methane emissions, biodiversity loss, soil depletion and heavy water use. Reducing food waste is another priority. With more eyes on ecosystem monitoring, there may be positive earnings impacts for companies improving the management of biodiversity and environmental risks.
Measuring and comparing nature-risk: A portfolio manager’s perspective
“A single greenhouse gas emissions figure can show meaningful differences between companies in different sectors, but with biodiversity, every sector has very different impacts that are not easily measurable or comparable.
Investors need to gain a picture of the risks that are relevant on a sectoral basis, using data from a variety of sources. Independent or non-profit groups, such as the World Benchmarking Alliance, CDP, Forest 500, the Zoological Society of London’s Sustainability Policy Transparency Toolkit, the Farm Animal Investment Risk and Return Initiative and the Fashion Transparency Index, have all carried out research into sector-specific biodiversity impacts.
Another useful tool is ENCORE (Exploring Natural Capital Opportunities, Risks and Exposure), developed by the Natural Capital Finance Alliance in partnership with the UN Environment Programme, which assesses the impact of 177 sectors on 11 aspects of nature, including soil and water pollution, ecosystem disturbance and GHG emissions. Our proprietary transition risk model draws on these datasets, as well as others.”
Portfolio Manager, Aviva Investors Natural Capital Transition strategy