Double materiality: Why nature risk and climate risk are two sides of the same coin

Material financial risk is an issue which has likely been thrust to the top of many a boardroom agenda right across the world in 2020.

With the rug having been swept from underneath the global economy by the coronavirus crisis, huge numbers of companies, investors, and auditors have been forced to confront the resiliency of their business and supply chains, particularly in relation to non-financial threats. Many will not have liked what they discovered.

Scarcely has the reappraisal of material risks been clearer than in the oil and gas industry, which saw the prices tank to unprecedented levels in April sparking thousands of job losses as business plans were torn up. Since then a number of major players - including Shell, BP, and Total - have announced multi-billion dollar write-downs in the value of some of their untapped oil reserves amid the looming threat of being lumbered with stranded assets as the shift to green energy escalates. Analysis by Carbon Tracker last week tallied up total oil sector write-downs at $87bn over the past nine months, thanks to a combination of lower oil demand and the accelerating clean energy transition.

Whether these write-downs were accelerated significantly by Covid-19 or simply part of a longer ongoing trend, they clearly demonstrated that the risks posed by climate change and the net zero transition are now firmly on the radar of some of the world's biggest fossil fuel companies.

But while the need to measure and account for climate risk has grown to prominence in recent years, with over 1,000 organisations worth a combined market capitalisation of $12tr having now signed up to the voluntary guidelines on the Taskforce on Climate-related Financial Disclosures (TCFDs), there has been comparatively little attention played to the related risks posed by nature and biodiversity loss.

Of course, nature-related risks are arguably even more complex to tackle than climate risks, due to the myriad threats such as water scarcity, soil erosion, ocean acidification, chemical pollution, and even - as starkly illustrated by Covid-19 - disease transmission all causing very different regional impacts.

Yet, as a research paper released last week by UCL's Institute for Innovation and Public Purpose (IIPP) - which is founded and directed by award-winning economist Mariana Mazzucato - points out, these nature-related risks are already taking heavy tolls on the global economy, and urgent action is required to combat such escalating threats as soon as possible.

"Nature-related impacts are already occurring within the short-term horizons of financiers, business people, and financial supervisors," says Katie Kedward, a policy fellow in sustainable finance at IIPP, and lead author of the paper alongside her UCL colleagues Josh Ryan-Collins and Hugues Chenet. "Whilst the worst impacts of climate change are foreseen in the coming decades, I would argue that for some aspects of nature loss, they're already here."

Given its suspected zoonotic origin, Covid-19 is the most glaring example to date, but the paper also points out that numerous other risks are worsening. For example, the population of pollinators such as bees have long been in declineposing a threat to the around 75 per cent of food crops worldwide that are dependent on animal pollination. Then, of course, there are the devastating wildfires in California and Amazon rainforest deforestation, concerns over which have been growing even more acute in recent years, with knock-on impacts for businesses and supply chains. Only yesterday the UK government proposed new fines for businesses that source products linked to tropical deforestation, highlighting the growing inter-related legislative, environmental, and reputational risks businesses are facing.

"The same transition risks and physical impacts in terms of supply shocks, changes to demand and potential systemic consequences which could apply to climate change are arguably already happening to nature-loss," Kedward tells BusinessGreen.

As such, moves are now being made to try and address these growing risks. Last month the UK and Switzerland alongside 10 major banks and insurers threw their weight behind a new initiative aimed at creating a global framework to measure and publicly report the financial risks posed by nature, biodiversity, and habitat destruction. Their aim is to establish a Task Force on Nature-related Financial Disclosures (TNFD) to draw up a set of voluntary risk accounting guidelines in 2022 that would sit alongside the now well established TCFD framework.

But Kedward warns that just broadly copying and pasting the TCFD approach onto other environmental threats would be a flawed approach "because these important environmental risks are very different to climate change when you interact with them". Moreover, she emphasises that 2022 is too far into the future for businesses to start the process of accounting for the risks of environmental impacts that are already happening right now.

"I think [the TNFD] is a worthwhile initiative, but the timelines which they're looking to operate in raise alarm bells," Kedward says. "They're not looking at releasing any kind of risk disclosure framework until 2022, by which time you've then got to get financial institutions or corporates used to the framework and actually deploying. So it's not a very urgent solution compared to the urgency of the problems at hand."

Despite the pandemic having shone a light on zoonotic disease and supply chain risks, as long as wildfires continue to burn and forests are felled to make way for palm oil plantations, it seems nature-related risks are still not being taken seriously enough by many companies, financiers, and governments. Yet growing numbers of these same organisations are beginning to take account of climate risk - both physical and transitional.

As Kedward points out, climate risk and nature-related risk are intrinsically linked, and a failure to address one can serve to undermine efforts to address the other. Deforestation, for example, is taking place at an alarming rate across the world right now, and in addition to the immediate biodiversity, supply chain, and reputational risks it poses, it also has clear knock-on climate change impactsa. Similarly with soil erosion, mangrove destruction, and loss of peatland, all of which pose myriad threats to both climate and nature.

"Climate risk and nature-related risks are fundamentally interconnected, so any efforts to try and estimate quantitatively, or otherwise, impacts from climate change are likely to be underestimating those impacts unless those efforts also take into account the positive feedback loops from biodiversity loss and other issues and how they can contribute to climate risk themselves," Kedward explains. "You can't just assess these risks in isolation - that estimate would be almost meaningless."

Which also leads to what Kedward calls 'double materiality': businesses and financiers being both exposed to, as well as responsible for, environmental impacts.

"There's a lot of recognition that climate change and nature loss pose threats to the financial system, which has exposures that it needs to manage," she explains. "But there's less recognition that it is a two-way street. The financial system, through the way that it allocates capital, also contributes to the emergence of these threats by facilitating the harmful business activities that give rise to them."

Or, to put it another way, failing to tackle nature-related risks today can not only undermine any efforts to assess future climate risk, but direcly increase those risks. "Nature-related financial risks actually may emerge endogenously from behaviours within the financial system itself," says Kedward.

Deforestation is a "classic example", she argues, highlighting a report last year by NGO Global Witness which found more than 300 banks and investors - including global names such as Barclays, HSBC, Santander, Bank of America, and JP Morgan - continue to back agribusinesses responsible for producing commodities such as palm oil, beef, and rubber that directly drive rainforest deforestation. Some of these institutions have developed their own deforestation policies but have failed to follow them, yet many have no such policies in place at all, while government regulation of the financial system in this area is piecemeal at best.

And herein lies the problem, the IIPP paper argues. Non-financial reporting guidelines such as the TCFDs and the proposals for TNFDs are too often voluntary, rather than mandatory. Moreover, these efforts focus solely on environmental risk exposure, but not on environmental impacts, and therefore "they don't pay equal attention to the drivers of these problems - these anthropogenic pressures", Kedward argues.

The paper maintains that existing regulations and voluntary risk reporting efforts are therefore insufficient for addressing complex, systemic nature-related financial risks, which cannot be effectively managed through 'market fixing' efforts such as disclosure and quantitative risk estimates alone.

Instead, the paper calls for a new, more proactive approach from financial regulators - and central banks in particular - to help reduce the flows of finance to environmentally unsustainable activities. In essence, it would require a more robust "precautionary approach" to financial supervision, focused on actively discouraging the financing of harmful corporate activities.

"Central banks' main focus at the moment is on scenario analysis, but the information they are taking from that is almost seen as a prerequisite to any further action, and we argue that this is insufficient," Kedward says. "Instead, they should be taking preventative action to manage these risks. Central banks and financial supervisors have a responsibility to intervene where these risks intersect with the financial system, and we argue that where that's relevant for their mandates is discouraging the financing of clearly harmful corporate activities, such as deforestation, for example."

To that end, the UK government's announcement yesterday that it plans to table new legislation that could see firms fined for using products sourced from illegal tropical deforestation, backed by due diligence public reporting requirements for certain commodities, could be a promising start.

And with the UN's Biodiversity Summit taking place next month ahead of next year's global COP15 biodiversity conference - all as momentum builds towards the crucial COP26 climate summit in Glasgow in November 2021 - now is the perfect time to be having conversations around nature and climate risk, as well as their regulation and management, argues Kedward.

"We've released this paper at the right time," she says. "It's coming onto people's agendas - from corporates to banks and central banks - and I think it feels like many are just starting to almost learn about the risks involved. It's very much at a learning stage at the moment."

Addressing these complex, interlocking risks to nature, the climate, and the global economy is undoubtedly a hugely challenging task, but it begins with the recognition that climate risk and nature risk - while posing different threats to the financial system - are also two sides of the same coin.

 

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