The Network for Greening the Financial System (NGFS) and the International Network for Sustainable Financial Policy Insights, Research, and Exchange (INSPIRE) established a joint study group earlier this year, which seeks to understand the effect biodiversity loss has on financial stability. The group has now published its first vision paper, which discusses the links between biodiversity loss and the macroeconomic and financial systems, and explains the rationale for its work, proposing an initial agenda and research focus.
Biodiversity
Biodiversity is the variety of life on Earth, in all its forms and interactions. It is the most complex and vital feature of the planet. Biodiversity comprises several levels, from genes at one end of the scale to entire ecosystems at the other.
Recent research such as the Dasgupta Review of the Economics of Biodiversity recognises that biodiversity is declining faster than at any time in human history. Policy efforts have been unable to slow the loss and the pressures driving the decline continue to intensify. This loss has a huge impact, and could influence human migration patterns, as well as generate geopolitical instability and conflict (NGFS Report, p.9).
Although climate change and biodiversity are closely linked and both drive economic loss, biodiversity loss is considered sufficiently problematic to justify separate assessment. Seventy-five financial institutions (managing over £12 trillion in assets) have signed the Finance for Biodiversity Pledge, committing to set targets and disclose their annual progress on increasing positive (and decreasing negative) impacts on biodiversity. The vision paper is a positive step towards a comprehensive assessment of the problems posed by biodiversity loss, and proposing solutions for the financial sector.
Biodiversity and the Macroeconomy
The global economy and financial system are entirely dependent on the biosphere, defined as “a narrow zone of the earth where land, water, and air interact with each other to support life”. All companies are ultimately reliant upon clean air, fresh water and fertile soils, but companies also affect the ecological systems that provide these “services”.
The services that ecosystems provide are estimated to be worth around double the world’s GDP. There is an increased focus from policymakers, society, businesses, and financial institutions to stop the decline and begin to restore biodiversity.
The vision paper summarises the findings from several studies that have aimed to quantify our economic dependence on the environment. Around 55% of global GDP depends on “high functioning biodiversity and ecosystem services” (Swiss Re Institute, 2020), and the value of ecosystem services is estimated to be as high as US $140 trillion per year (OECD, 2019).
The vision paper sets out the study group’s aim to “assess impact channels by which biodiversity loss affects the macroeconomy, and how the macroeconomy could be impacted by the need to reverse biodiversity loss”. This assessment will be essential to a fuller understanding of how financial stability could be threatened by biodiversity loss.
Biodiversity and financial linkages
The study group will also assess how the macroeconomic impacts will, in turn, affect financial stability.
Biodiversity loss may pose financial risks to individual institutions and to the entire financial system. A microprudential analysis (analysis of individual financial institutions) is therefore likely to be important. De Nederlandsche Bank is the first bank to have looked at the impacts and dependencies of its financial system on biodiversity. It found that over a third (36%) of investments by Dutch financial institutions are either highly or very highly dependent on one or more ecosystem ‘service’.
This loss, to which various physical and transactional risks contribute, can affect a range of financial institutions and systems through a variety of channels. Physical risks include changing land use, climate change and pollution. Transitional risks include factors such as government measures, technological developments, litigation, and changing consumer preferences.
The vision paper identifies the need for a comprehensive approach to risk management in order to account for how financial institutions are exposed to risks relating to biodiversity and, conversely, how financial institutions contribute to such risks.
The study group concludes that more research is required to better understand and assess the risks, and aims to commission research to evaluate the risks for particular countries.
Next steps for the study group
The vision paper identifies a “premium” on investigating the links between macroeconomic and microprudential analysis. Macroprudential regulation aims to mitigate risk to the financial system as a whole. Therefore, alongside the research into risks, the study group will also examine the potential need and scope for adding a macroprudential perspective of biodiversity loss and the financial system.
The vision paper concludes that a “strategic and structured approach” by central banks and financial supervisors is required. The study group has identified its initial agenda and will explore the role of central banks and supervisors across a range of functions, which will include assessment and monitoring; microprudential; macroprudential; monetary; portfolios; policy; and scaling up.
Summary
Biodiversity loss is a serious threat to the globe and to the financial sector, and a more comprehensive understanding by policymakers and regulators is necessary to limit further damage and repair existing loss.
The vision paper has set out the rationale for the work, structure and aim of the study group. The role of central banks and financial supervisors, and the part they might play in safeguarding biodiversity by adopting a “strategic and structured approach”, is at the centre of the initial agenda.
For more information, contact Patrick Bell, Partner, at patrick.bell@shepwedd.com or Catherine Donald, Trainee, at catherine.donald@shepwedd.com in our banking and finance team.