Why should the finance sector care about natural capital?
James Hulse, Advisor to the Natural Capital Finance Alliance
At Responsible Investor’s RI Europe conference this week, there is a session on ‘Investing to stop the degrading of the natural environment, or avoiding naturally critical sites’. But why would an investor want to do this? Surely the job of an investor is to maximise financial returns for their beneficiaries, not to save the planet?
As Mark Carney, Governor of the Bank of England, has pointed out, this is a tragedy of horizons. In the very short term, taking natural capital into consideration is unlikely to make much difference to investment returns. In the medium to long term though, such factors become critical for continued economic growth and corporate earnings.
Companies rely on natural capital to do business — whether it is raw materials, water, flood protection, biodiversity or pollination, nature provides most of the capital for the production of goods. Eroding that capital by overuse, or failing to understand the possible risks and opportunities involved, can materially affect corporate earnings and ultimately make or break companies’ business models. For example, deforestation in the Brazilian Amazon by soy producers is affecting rainfall in the region — these are rainforests, after all. Studies have shown that within the next decade or so, there may be so little rainfall in the region that growing soy will not be viable. This is a staggering example of generating short-term earnings by selling off assets. Unfortunately, those assets belong to us.
Looking at the long game
Long-term investors such as pension funds and foundations have long-term liabilities and therefore it is incumbent upon them to avoid investments that will erode long-term returns for their whole portfolios. Companies involved in deforestation, for example, are harming long-term economic growth for the whole world by accelerating the increase in greenhouse gas emissions and affecting biodiversity and climate regulation for the planet. It cannot be consistent with long-term fiduciary duty to invest in such companies.
So how do investors avoid these companies? How do they know which companies are using natural capital responsibly? There is no definitive answer to this yet, but there are a number of strategies and tools which investors can use to identify potential risks and opportunities. Firstly, investors can undertake a natural capital assessment of their portfolio. The Natural Capital Finance Alliance (NCFA), in collaboration with the Natural Capital Coalition and VBDO, the Dutch Investment Forum, has produced a guide — ‘Connecting Finance and Natural Capital’ — which can be used by investors to undertake an analysis of natural capital impacts and dependencies across their holdings. The NCFA also provides tools which can be used to look at scenario analysis, such as droughts, and later this year the organisation will be launching the Advancing Environmental Risk Management (AERM) platform which will enable investors to understand the natural capital dependencies of every sub-sector in the investable universe and to identify natural capital hotspots for further analysis.
The effects of natural capital degradation are already beginning to impact portfolio returns, through droughts, flooding, stranded assets and other mechanisms. Smart investors are seeking an information edge that will enable them to anticipate and react to these trends. Looking through a natural capital lens can highlight previously unseen risks and opportunities that may ultimately lead to better financial returns. Can investors afford to ignore natural capital?