How quantitative easing is contributing to nature loss
By Katie Kedward and Josh Ryan-Collins
O n 12 July this year the European Central Bank committed to incorporating climate change considerations in its monetary policy framework. This is a significant acknowledgement by a major central bank that the ‘free market’ cannot be relied upon to price in climate risks, and that proactive policy interventions are needed to ensure that monetary policy is aligned with EU legislation implementing the Paris Agreement. In practice, this means that the Corporate Sector Purchase Programme (CSPP) — the quantitative easing (QE) portfolio through which the ECB provides financial support to the real economy — will eventually support only companies whose business models are compatible with the net zero transition.
This development is laudable and urgently needed; yet it should be appreciated as a first step. In the wake of the COVID-19 pandemic, financial institutions and policymakers are increasingly cognisant of the material and potentially systemic risks posed by biodiversity loss and other environmental threats. A troubling irony is that many aspects of nature loss are emerging in a much shorter time frame than climate-related threats, yet established understanding and action to address such risks by financial actors lags far behind progress made on the climate front.
In addition, the financial risks associated with climate change, nature degradation, and biodiversity loss do not exist in distinct siloes. Rather, these threats are interconnected and often mutually reinforcing. For example, habitat loss can exacerbate climate change through the loss of natural carbon sequestration, whilst the effects of climate change in turn undermine the resilience of ecosystems, contributing to further habitat loss. What this means in practice is that any attempt to account for climate risks in financial portfolios may be underestimating the true magnitude of exposure unless nature loss is also taken into account.
The ECB’s investment activities are implicated in nature loss
In a new joint policy report by the Institute for Innovation and Public Purpose and Common Wealth, we undertake the first ever study of nature-related financial risks on a central bank’s balance sheet, focusing on the ECB’s €310 billion corporate QE portfolio which makes up a fifth of the total Eurozone corporate bond market.
Using a sector mapping methodology developed by ENCORE, we find that over 40% of the portfolio has high dependencies upon ecosystem services, particularly those relating to water, natural hazard protection and climate regulation. The loss of these ecosystem services would cause material financial losses through disruptions to production. We also find that over 70% of the portfolio is potentially associated with significant negative impacts upon nature, especially related to land and freshwater use, and pollution. Companies contributing to nature loss may face financial losses if policy, regulation, and litigation tightens in support of a green transition.
These results are mostly explained by the ECB’s exposure to the manufacturing, utilities, transportation, storage, and real estate sector, which together account for over 80% of the portfolio’s potential nature-related dependencies and impacts.
In additional analysis, we find that the portfolio is also exposed to 3,231 corporate facilities associated with habitat loss, belonging to 94 companies in the portfolio. The ECB is also invested in 22 companies identified by Forest 500 as highly influential in commodity supply chains most associated with deforestation (soy, beef products, timber products, and palm oil). Yet less than half of these companies have identified deforestation as a business risk or have a commitment to ensure deforestation-free operations and supply chains.
Why account for nature risks in monetary policy operations?
Our findings add further evidence on the limitations of relying on ‘market neutrality’ as a guiding principle to allocate funds within monetary policy portfolios: the portfolio is mirroring the failure of credit rating agencies, as well as broader financial markets, to account for nature-related financial risks.
The results also highlight the importance of taking a ‘double materiality’ approach to fully understand nature-related risks. With over 70% of the portfolio potentially contributing to nature loss, the findings suggest that the ECB is not only exposed to associated transition risks, but may also be undermining the EU’s Biodiversity Strategy for 2030, hence potentially putting it in contravention of its secondary mandate to support the broader goals of EU-level economic policy.
Moreover, as banking supervisor for the euro area, the ECB has published supervisory guidance on the need for financial institutions to manage environmental financial risks, including those from biodiversity loss, in their operations. Accounting for these risks within its own investment activities is therefore essential to ensure its credibility as supervisor as well as fulfil its fiduciary duty as a manager of a vast portfolio of assets ultimately representing public money.
Ultimately, central bank balance sheets are now a significant source of public stimulus into the real economy. The ECB’s approach to managing risks within its portfolio will hence have significant signalling power to financial markets and could potentially accelerate the uptake of prudent risk management practices relating to nature.
Policy options
Financial portfolio managers face particular challenges in accounting for nature-related risks. In addition to the lack of established metrics regarding the ‘biodiversity performance’ of individual assets or companies, all economic sectors are both exposed to and implicated in the emergence of multiple nature and biodiversity risks and must variously transition their business practices to mitigate such effects. The considerable heterogeneity in how different companies may manage these risks implies a greater role for counterparty engagement and due diligence.
As a first step, the ECB could promote the accelerated uptake of nature-related financial disclosures amongst counterparties involved in monetary policy operations. A second step could be to implement commitments to ensure the CSPP portfolio is not directly or indirectly exposed to activities which scientific consensus or EU policy consider to be harmful to biodiversity and nature, such as deforestation-related activities.
A major aim of the upcoming COP15 biodiversity conference in Kunming, China is to ensure that finance accounts for the needs of nature. As a major central bank and manager of a substantial portfolio, the ECB can ‘lead by example’ in establishing ‘gold standard’ risk management processes. The recent monetary policy strategy review has made impressive progress on the climate front. It is time to apply the same logic to nature.
