A week before the 2019 World Economic Forum in Davos, the Natural Capital Finance Alliance (NCFA) has launched the world’s first step-by-step guide to help financial institutions conduct a rapid natural capital risk assessment — “not just greenhouse gases, but also how to build wider ecosystem resilience from rainforests to coral reefs.” All sectors of the economy are increasingly exposed to damaging economic disruption as depletion of nature accelerates. The guide has already been piloted by 5 banks in Colombia, South Africa, and Peru, including First Rand in South Africa, which said it “enabled us to look at our portfolio in a new way.”
In order to begin the new year by defining priorities and shaping global, industry and regional agendas, the World Economic Forum Annual Meeting brings together leaders of global society:
- The heads and members of more than 100 governments
- Top executives of the 1,000 foremost global companies
- Leaders of international organizations
- Relevant non-governmental organizations
- The most prominent cultural, societal and thought leaders
- Disruptive voices of the Forum’s Young Global Leaders, Global Shapers, and Technology Pioneers
The NCFA, a collaboration between UN Environment Finance Initiative and Global Canopy, was set up in 2012 by a group of pioneering financial institutions which saw the need for a better understanding of how finance both depends on and impacts nature in order to manage risks and unlock opportunities. Since its inception, the NCFA has developed tools and methodologies to incorporate natural capital risks and opportunities into financial analysis. These include a framework for addressing deforestation risk in commodity production, tools to incorporate water stress into traditional financial analysis for bonds and equities, or mechanisms that allow users to stress test their credit portfolio under a number of drought scenarios.
The NFCA guide, “Integrating Natural Capital in Risk Assessments: A Step-by-Step Guide for Banks,” identifies ways in which businesses depend on the environment, how these dependencies are threatened by environmental change, and the resulting risks for financial institutions. The guide aims to help global banks to better understand how the pollution of oceans or destruction of forests, for example, may affect their financial future by combining a comprehensive knowledge base with environmental scenarios and location-specific asset data.
It is part of a wider project by NCFA to help financial institutions understand and integrate the risks they face because of environmental degradation into their risk assessment methods and decision-making tools. It has 2 core elements:
- Rapid Natural Capital Risk Assessment, which allows an institution to quickly identify the areas of highest natural capital risk
- Sector/Asset Analysis, which uses data on drivers of environmental change and the state of natural capital assets, to assess the likelihood of disruption of relevant ecosystem services
Madeleine Ronquest, head of environmental and social risk, Climate Change at FirstRand Limited, said, “The South African economy has a deep dependence on nature and is particularly vulnerable to extreme climatic events, which are becoming more frequent and intense. The severe challenges around the availability and supply of drinking water in Cape Town is just one example of this.”
What is Natural Capital?
Natural capital is a way of thinking about nature as a stock that provides a flow of benefits to people and the economy. It consists of natural capital assets such as water, forests, and clean air that enable economic activity by providing businesses with materials, inputs to production, protection from natural disasters, and absorption of the pollution they emit. Any adverse change in a natural capital asset can have a negative effect on the businesses that depend on it, in much the same way as the impairment of a conventional asset might affect the cash flows of the business owning it. The portfolios of financial institutions are exposed to these natural capital risks that affect the businesses they lend to, insure, or invest.
By focusing on risks to businesses resulting from environmental degradation — rather than on the businesses’ environmental impacts, which have traditionally been the focus of environmental risk assessment — natural capital risk analysis allows financial institutions to see the risks to which they are exposed in a new light. Liliana de Sá Kirchknopf, head of private sector development division, State Secretariat for Economic Affairs in Switzerland, allowed, “The degradation of natural ecosystems poses a material threat to future economic growth. Until now, the financial community was not able to systematically assess and manage such risks.”
Key Findings & Recommendations of the National Capital Risk Assessment
The experience piloting rapid natural capital risk assessments with banks confirmed that the NCFA approach can be valuable for any bank, regardless of its size, geography, or existing risk management processes. Here are some of the NCFA project’s key findings.
- Rapid natural capital risk assessments allow banks to improve their foresight by uncovering risks of which they were previously unaware.
- Rapid natural capital risk assessments can expose systemic risks in bank portfolios which would not have been detected in individual transaction assessments.
- The rapid assessment approach allows banks to monitor the evolution of natural capital risks and their potential impact on borrowers in the future.
- The rapid assessment approach is highly versatile, making it a valuable tool for any bank.
Natural capital risk can be complex, yet a number of methods and resources are available for banks to get an initial understanding of their natural capital risk exposure. Banks can use these resources to significantly enhance the integration of natural capital risk in their systems in the short to medium term. The NFCA project recommendations include:
- Banks can leverage their existing risk processes to embed natural capital risk thinking. Simple adjustments to existing processes can be enough to bring about a much more systematic and comprehensive understanding of natural capital risk.
- Banks can derive significant value from qualitative natural capital assessments. Qualitative assessments can point to regions that are at high risk of natural capital disruption and identify clients with whom discussions on natural capital risk management are needed.
- Banks can increase the accuracy of their natural capital risk assessments by enhancing their data collection and storage processes. Banks should review the environmental and operational information they request from borrowers and complement these requests where necessary to capture information relevant for conducting natural capital risk assessments.
- Considering natural capital risks at the portfolio level is necessary to complement transaction-level assessments. Portfolio assessments are critical to identify regional and sectoral trends and link these more closely to a financial institution’s credit risk.
Niki Mardas, Executive Director at Global Canopy, noted, “This timely report sends a powerful message that when financial leaders consider the environment at Davos next week they must consider not just greenhouse gases, but also how to build wider ecosystem resilience.” Sustainable capital markets must be able to easily integrate their dependence on nature into existing risk management.
The NCFA project makes a further and material advance in environmental and social risk management in banks. The report provides practical guidance and tools for managing natural capital risks, present in many banking portfolios but often hard to identify, assess, and mitigate. Given the increasing erosion of natural capital and the increasing risks that businesses and their financiers face, this report comes none too late for financial institutions around the world who need to begin to take responsibility for the consequences of their investments.
Source: Integrating Natural Capital in Risk Assessments: A Step-by-Step Guide for Banks, Natural Capital Finance Alliance and PricewaterhouseCoopers (Geneva, Oxford, and London), 2018.
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