Mobilising efficient capital for biodiversity-positive economy

The aforementioned report found that approximately half of the banks’ credit portfolios are allocated to firms that are highly or very highly dependent on one or more ecosystem services. Meanwhile, according to the State of Finance for Nature in the G20 report, over half of the world’s GDP moderately or highly depends on nature and ecosystem services.

Linh Nguyen, Finance lecturer RMIT University Vietnam

These services, classified into 21 different categories by ENCORE under the Common International Classification of Ecosystem Services, refer to the benefits that humans receive from nature. Such benefits enable and facilitate our business production processes. Examples include bio-remediation which provides us with clean air and water, or flood and storm protection which helps reduce damages and avoid costs for our society.

A 2022 report by the Network for Greening the Financial System and the International Network for Sustainable Financial Policy Insights, Research, and Exchange study group on biodiversity and financial stability emphasises the exposures of the financial systems towards the degradation of ecosystems. They categorise biodiversity-related financial risks into physical and transition risks.

According to the report, physical risks are related to “the degradation of ecosystem services on which economic actors depend”. Examples of physical risks include land use changes leading to adverse impacts on business operations, which in turn influence the ability to pay by borrowing firms and consequently the credit risks of financial institutions. Sea level rises and changes in the coastal habitats can also affect coastal assets and companies operating near coastal areas, leading to significant business and financial risks.

On the other hand, transition risks “result from the misalignment between the impacts on biodiversity associated with financial institutions’ portfolios and developments aimed at reducing or reversing the damage to biodiversity and ecosystems”, as explained in the report. Examples of transition risks include changes in policy or consumer preferences affecting firms, especially those that have a negative biodiversity impact, which in turn influence financial institutions.

Additionally, there can be other subsets of biodiversity-related financial risks including liability risks and reputational risks, according to an Organisation for Economic Co-operation and Development report from 2023. For example, when the public awareness about biodiversity increases, firms with a negative impact on the biodiversity can face a huge pressure as well as reputational loss, potentially leading to financial losses. Although such risks can threaten the stability of the financial system, they are still poorly understood and unpriced by market participants.

There have been countless efforts from numerous institutions, governments, and individuals to address this grand challenge. Almost 100 nations around the world have incorporated biodiversity values into their national accounting systems, and financial resources available for biodiversity through international flows doubled between 2011 and 2020, according to the Convention on Biological Diversity.

In 2022, representatives of 188 governments finally approved the historic package of measures to address biodiversity loss. Notably, the main targets for 2030 include mobilising at least $200 billion per year in domestic and international biodiversity-related funding from all sources, both public and private, and raising international capital flows from developed to developing economies to a minimum of $20 billion per year by 2025 and $30 billion per year by 2030. Financial institutions, especially banks, play an important role in this capital mobilisation towards a biodiversity-positive economy.

There are several important suggestions for banks/financial institutions to consider. Firstly, raising awareness about biodiversity risks and their relevance in the banks/financial institutions is essential. To achieve this, we need collaboration from multiple stakeholders across sectors including the government, relevant organisations, financial institutions, universities, and media.

Secondly, before making biodiversity-related decisions, financial institutions/banks need to properly measure relevant biodiversity risks. This is a vital step for financial institutions to better understand, assess the risks, and then make relevant decisions such as evaluating their borrowers’ loan applications.

However, this is not an easy step. Biodiversity itself is difficult to measure, thus, measuring biodiversity risks is even more challenging. Also, according to the report, there is a lack of a consistent framework for firms and market participants to disclose and measure biodiversity risks. The good news is there is a continuous effort from numerous organisations and governments worldwide to develop the biodiversity risk disclosure and measurement framework.

Thirdly, financial institutions/banks should develop appropriate valuation models of natural capital. According to the System of Environmental Economic Accounting, natural capital can be defined as the supply of renewable and non-renewable resources that provide benefits to people. Banks/financial institutions should embed the natural capital as well as biodiversity-related risks into their project valuation, risk management, as well as credit assessment.

Lastly, appropriate monitoring of the execution of biodiversity-related strategies/actions is also important. This is usually conducted at a board of directors or top management team level. Indeed, governance plays a vital role in corporate sustainable outcomes, as a study by our research team shows that appropriate corporate governance bundles or combinations of multiple governance mechanisms are associated with enhanced performance.

How to best navigate the ESG challenges in banking Environmental, social, and governance (ESG) considerations have become increasingly integral to investing and corporate strategies across industries, especially the financial sector.