Nature loss is approaching a tipping point – it’s time for financial authorities to act
The global pandemic has revealed the human and economic consequences of our cavalier relationship with nature. As well as COVID-19, which has been linked to habitat destruction and wildlife trafficking, the year 2020 has also seen record levels of Amazon deforestation and accelerating species extinction.
The finance sector is slowly awakening to the risks posed by nature loss. A new Taskforce for Nature-related Financial Disclosures (TNFD), led by the UN and financial institutions, aims to establish a framework for banks and investors to disclose environmental risks beyond climate change. Just like the Taskforce for Climate-related Financial Disclosures (TCFD), its climate change-focused cousin, the TNFD assumes that information disclosure will allow markets to ‘price in’ the negative externalities of nature loss and accelerate a shift towards sustainable capital allocation.
More and better information is certainly needed to understand how threats such as biodiversity loss, chemical pollution, and pathogens interact with the financial system. However, even as such information is made available, there are important reasons to question whether market-led initiatives alone are capable of managing the systemic financial risks posed by the loss of natural system functioning.
The limitations of relying on markets
In a new paper in the Institute for Innovation and Public Purpose (IIPP) working paper series, we outline that environmental breakdown consists of a highly complex set of phenomena. It encompasses multiple, interconnected threats whose potential impacts upon our planet will be both historically unprecedented and ultimately irreversible. As such, we argue that widespread nature loss is subject to ‘radical uncertainty’ — representing an ‘unknown unknown’ to which probabilities cannot be assigned. In addition, natural systems have complex system dynamics, such as tipping points, that are ill-captured by conventional risk analysis.
Such multidimensional complexity poses extraordinary challenges for financial modelling. For example, one agricultural firm will be exposed to multiple nature-related risks, including pollinator loss, water scarcity, soil infertility, and pesticide pollution, each of which will have differing impacts depending on the local ecosystem. Replicating such granular analysis up to the financial portfolio level implies an unmanageable level of complexity unless very broad and aggregative abstractions are made.
Moreover, the challenge is to measure not only how the financial system is exposed to nature-related risks, but also how it is contributing to them. This concept of ‘double materiality’ has been recently used by the European Commission in its Non-Binding Guidelines on Non-Financial Reporting for corporates, but has been largely ignored market-led initiatives such as the TCFD and TNFD. This is a serious omission. Through their lending, investing, and advisory activities, financial institutions facilitate the business activities that lead to environmental degradation. Indeed, the Dutch central bank has estimated that the impact of Dutch financial institutions on biodiversity represents the loss of over 58,000km2 of pristine nature, an area 1.7 times larger than the Netherlands.
Such pioneering supervisory analysis shines a spotlight on the failures of leaving environmental risk management to financial institutions alone. Voluntarily developed Environmental, Social and Governance (ESG) and Corporate Social Responsibility (CSR) policies have been around for many years, but have not been effective at materially shifting flows of finance away from harmful corporate activities. An investigation by Global Witness found that more than 300 prominent global investors, including high street banks such as Barclays and HSBC, are continuing to finance agribusiness giants most responsible for rainforest destruction. The rise of agricultural land as an alternative asset class over the past decade has also been linked to accelerated deforestation in high biodiversity regions.
A critical characteristic of nature-related risks, therefore, is that they may emerge endogenously from behaviours within the financial system itself. The failure of financial actors to cease facilitating harmful corporate practices risks ‘locking in’ future impacts, especially as nature loss approaches critical ‘tipping points’. The financial system does a poor job at managing systemic, endogenous risks, as the implosion of the securitised mortgage market during the last crisis revealed.
The role of central banks
Central banks and financial authorities learnt their lesson from the 2008 crash, now using macroprudential policy to prevent asset bubble-related instability emerging in the first place. Yet, in recent efforts to green and safeguard the financial system, central banks have focused almost exclusively on climate risks, neglecting the critical risks posed by biodiversity loss and other environmental threats. This is a potentially dangerous oversight. With climate change interacting with nature loss in a series of reinforcing feedback loops, all efforts to measure and manage climate risk are likely to be underestimating true potential impacts unless nature-related risks are also taken into account. In addition, unlike climate change, where the worst physical impacts are expected to emerge over a period of decades, nature-related impacts are already occurring in the short-term, and well within supervisory time horizons. One salient example is the widespread decline of pollinators, which is already causing reductions in crop production.
Given the structural inability of private financial institutions to manage systemic environmental risks themselves, we argue that central banks and financial supervisors have a duty to intervene where these risks intersect with the financial system. However, the current supervisory focus on climate scenario analysis cannot simply be extended to other environmental threats. Climate scenarios have been critiqued for being overly complex, time consuming, and slowing progress towards actual policy action.
The quest for ever more comprehensive scenario modelling brings to mind Jorge Luis Borges’ famed fable On Exactitude in Science, where cartographers toiling for the most perfect map ended up creating a 1:1 replica of the world before realising the meaninglessness of their task. As former Bank of England governor Mervyn King has argued in his recent book ‘Radical Uncertainty’, fixating on precise quantitative results does not necessarily improve insights for decision makers and at worst can distract from the best course of action.
Towards a ‘precautionary approach’ to managing nature-related risk
Our recent paper argues that financial authorities should use a ‘precautionary approach’ to managing nature-related financial risks. Instead of waiting for, and relying on, better information in the market, the general magnitude and direction of harmful trends should be taken as sufficient incentive for policymakers to act. To build certainty for a green-directed economy, central banks and supervisors — in collaboration with the government — should identify harmful corporate activities that firms must cease facilitating through financing. Such an exclusion list — including, for example, the deforestation of high conservation value areas — should then be embedded within micro- and macroprudential regulation as well as the eligibility criteria for monetary policy operations.
This ‘precautionary approach’ to managing risk requires central banks and financial supervisors to embrace more of a ‘market-shaping’ role. It is time to recognise that central banks are not exogenous to the financial system, as a weather forecaster is to the weather. Rather, they are active market participants whose decisions will feedback and influence market outcomes. In other words, a lack of active intervention is itself a policy choice that carries risks.
Human pressures are pushing nature towards a ‘tipping point’ from which it may never recover. We no longer have the luxury of waiting before intervening. As the Bank for International Settlements has emphasised, ‘the stability of the Earth system is a prerequisite for financial and price stability’. Central banks and supervisors must act now to ensure finance does not continue to harm nature.
