Central banks must embrace systemic reforms to avert the biodiversity crisis
Last month the Network for Greening the Financial System (NGFS), a group of over 100 central banks and financial supervisors, in collaboration with the independent research network INSPIRE, published a landmark report examining the links between biodiversity loss and economic and financial risks. The report argues that biodiversity loss poses systemic risks in the same way as climate change and calls for a concerted response by central banks and financial supervisors.
The report was the final output of the NGFS-INSPIRE Study Group on Biodiversity and Financial Stability — of which the authors were members— set up to help central banks and financial supervisors fulfil their mandates in regard to biodiversity-related financial risks. These risks include those related to the interactions between climate change and biodiversity loss, and to biodiversity loss resulting from other human pressures such as habitat degradation and over-exploitation. Accompanying, the report, the NGFS stated that:
“Recent work on the notion of nature-related financial risks confirms that there is ground for considering the impacts and dependencies on nature, including biodiversity and ecosystems, as a source of material risk from a macroeconomic and financial stability perspective… [we are] therefore of the view that nature-related risks are relevant for central banks and supervisors: given the macroeconomic, macroprudential and microprudential materiality of nature-related financial risks, such risks should be adequately considered for the fulfilment of their mandates.”
This is welcome news, since whilst climate change has received considerable attention from the central banking community of the past five years, there has been much less focus on the interaction between the financial sector and the biodiversity crises facing the planet. Also welcome is the recognition of the need to consider not just the impact of biodiversity loss on financial institutions but also the impact of finance on the biosphere: so called ‘double materiality’.
So far, efforts by private financial institutions have focused more upon the development of new financial ‘asset classes for nature’ than actions to rapidly reduce financing to biodiversity-depleting corporate activities. This bias is perhaps not surprising, given that it is far cheaper for firms to pay to ‘offset’ their damages to the environment rather than changing entire business models. The recently formed Taskforce on Nature-related Financial Disclosures (TNFD) will provide a much-needed framework for reporting on negative impacts, but it might be too little too late. The measurement of biodiversity-related risks is extremely challenging due radical uncertainty, and some ecological threats may become financially material in the near term — before complex risk modelling and disclosure frameworks are fully operational.
Moreover, it is increasingly acknowledged that reversing biodiversity loss is not as simple as pricing in ‘negative externalities’. The Dasgupta Review on the Economics of Biodiversity, which was commissioned by the UK government in March 2019, emphasised that ‘pricing and allocation of financial flows alone will not be sufficient to enable a sustainable engagement with Nature’. Meanwhile, economists from the Banque de France have stressed that ‘biodiversity protection cannot be solved simply by solving a theoretical investment gap: it also requires delving deeper into the nature of the relations between macrofinancial and ecological systems.’ A major knowledge gap concerns the incentives and institutional structures which lead financial actors to engage in biodiversity-negative activities.
In our submission to the report, which has just been published as an IIPP working paper, we focussed specifically on this latter issue through an examination of the relationship between finance and the globalised agricultural sector.
Agri-finance linkages have expanded and become more complex with the transition to modern industrial agricultural practices. These focus on increasing the production of a small number of high calorie crops at lower costs through increasing inputs of land, water, energy, and agrochemicals. This ‘cheaper food paradigm’ is responsible for the massive biodiversity impacts of the agricultural sector: for example around 80% of new farmland is estimated to be created through deforestation, especially in tropical regions. With a handful of multinational firms now dominating the processing, trade, and retail of agri-commodities, the financial flows that enable these business models represent a strategic leverage point to accelerate a biodiversity-positive transition within the global food system. One study has identified 16 financial giants with significant equity ownership of agricultural multinationals operating in ecosystems that are approaching critical ‘tipping points’.
Attracted by its appeal as a natural inflation hedge with uncorrelated returns with equity markets, agricultural land has become a major alternative asset class for the financial sector. A range of financial actors — spanning investment banks, asset managers, pension funds, insurers, and sovereign wealth funds — have developed exposures to agricultural land either directly, or through pooled funds and investment trusts. Over 47 million hectares of agricultural land — an area roughly the size of Spain — was transferred from smallholder communities to non-domestic investors between 2000 and 2014, much of which took place on the African continent.
In a review of empirical and case study literature, we find that incentives structures typical to financial investors are systemically associated with land use change and intensive agricultural practices that drive biodiversity loss and degradation (see Figure 1 below). Private equity funds, for example, attract investors with an ‘exit strategy’ that demonstrates how the fund will actively generate value. Within the agricultural space, this implies active transformation of land holdings such as the addition of infrastructure, enforcement of legal title, consolidation of multiple small-holdings, or — most drastically — the conversion of ‘marginal land’ for commercial purposes. Empirical evidence suggests that land acquisitions by financial investors for agricultural purposes disproportionately target forested areas and/or environmentally protected areas.
Figure 1. Financial incentives and practices may actively exacerbate drivers of biodiversity loss
Elsewhere, the ‘own-and-lease-out’ strategies most commonly used by pooled farmland investment funds result in the separation of land ownership from management, effectively removing farmers’ own stake in long-term productivity and reducing incentives to deploy sustainable farming practices. Another key barrier to sustainability is that many relevant financial structures — most notably private equity funds — remain outside of the purview of traditional capital market regulation. Elsewhere, securitised asset vehicles also face unique challenges in complying with ESG disclosure requirements, related to the complexity and opacity of tracing data associated with underlying assets. The need to manage informational asymmetries that may arise from agricultural investment vehicles and ensure there is sufficient market accountability for responsible fund allocation remains an urgent area for further research.
If certain practices within the financial system itself contribute to the emergence of threats to the biosphere, resolving biodiversity-negative dynamics may well require institutional and structural reforms that are unlikely to occur without direct policy interventions. There is a strong case for financial policy makers to prioritise the avoidance of harm by the financial sector, before restoring and offsetting options are considered. We argue for a precautionary financial policy approach, analogous to the ‘mitigation hierarchy’ framework used within some industrial sectors to limit negative impacts on biodiversity, where avoiding impacts are prioritised above more uncertain remediation and offsetting measures. To achieve this, there is an urgent need for more focused empirical work on the origination of financial flows negatively impacting critical ecosystems in order to avoid breaching ecological tipping points. Given the global nature of these dynamics, working in collaboration with organisations such as the International Monetary Fund (IMF) and the Bank of International Settlements (BIS) on this agenda would seem appropriate. Given the high level of complexity and uncertainty around biodiversity loss, we would also encourage central banks to consider closer collaboration with ecologists and other related scientific experts.
The negative impacts of financial flows do not only matter because they may eventually feedback through to the financial system. Financial actors have considerable agency in shaping the future direction of economic activity; the continued financing of environmentally harmful activities enables damaging stakeholders, technologies, and infrastructures to persist (i.e., ‘lock-in effects’). Government policy goals and international targets to reverse biodiversity loss will not be achieved without addressing biodiversity-negative flows of finance.
Read the new IIPP working paper, ‘From financial risk to financial harm: Exploring the agri-finance nexus and drivers of biodiversity’.