Climate change has been and remains at the top of the agenda for financial institutions, driven by increasing investor demand, regulation and litigation risk. Questions around governance, risk management, disclosure, public commitments and client due diligence are just a handful of the complex and wide-ranging topics which financial institutions have been grappling with in this area.
Biodiversity and climate are interdependent; changes in either can drive losses or gains in the other. However, biodiversity – or more specifically the protection and restoration of nature - has become an important objective in its own right and, as we explain in this post, this poses risks for financial institutions which are developing in much the same way as climate risks.
What is biodiversity and how does it impact financial institutions?
First, what do we mean by biodiversity? It means the variety of plant and animal life in the world and the ways in which different species interact with each other and the physical world around them. The current focus is on taking action to either restore habitats that have lost biodiversity or prevent it from being lost in the first place. Biodiversity has intrinsic value as part of the natural wealth of the planet, but it is also valuable to human beings culturally, socially and economically. We recently wrote about biodiversity and what it means for businesses in the wider economy.
As we have seen with climate, financial institutions are important in a biodiversity context as there is an increasing focus on shifting global capital flows towards greener activities that contribute to emissions reduction and the protection of nature (so-called nature positive outcomes). Financial institutions will increasingly be expected to be aware of how their business impacts on biodiversity, where their dependencies are and where the potential material financial risks arising out of biodiversity loss lie, and also to incorporate biodiversity considerations into their business strategy, governance, risk management, and public disclosures.
What developments should financial institutions be aware of?
COP15 and global targets
COP15, the most recent UN Biodiversity Conference, took place in December 2022. Much like the Paris summit for climate (COP 21), a number of non-binding global targets were set for 2030. This included increasing the level of available financial resources by mobilising at least $200 billion per year in funding (public and private) to implement national biodiversity strategies and action plans. The targets also include an agreement to take action to ensure that large and transnational companies and financial institutions monitor, assess, and disclose their risks, dependencies and impacts on biodiversity through their operations, supply and value chains and portfolios. At COP15, 150 financial institutions signed a statement calling for governments to adopt a post-2020 Global Biodiversity Framework.
Regulators and central banks beginning to focus on biodiversity
As explained in the Network for Greening the Financial System (NGFS)'s report in 2021, there are many parallels between climate and biodiversity when it comes to the risks to financial stability, with both posing physical and transition risks. This puts biodiversity firmly in the sights of central banks and supervisors. In 2022 the NGFS issued a statement on Nature-Related Financial Risks, which recognised both macroeconomic risks and risks to individual financial institutions, noting that more work is needed on the relationship between nature and financial systems, including the bridging of data gaps, to understand how the risks should be measured and managed.
In the UK, the FCA is gradually extending its ESG strategy to cover biodiversity; the FCA’s Director of ESG noted this month that positive, sustainable change goes beyond climate change and involves looking at other environmental issues, such as biodiversity and nature, and it is now encouraging financial institutions to incorporate these wider elements into their ESG strategies and approach to matters such as governance and incentives. The Bank of England (in accordance with its obligation to consider how it can support biodiversity under the Environment Act 2021) is also exploring the materiality of nature-related financial risks and how they might arise. It has recognised the challenges in identifying and assessing nature-related financial risks and intends to share its findings on UK-level risks later in 2023.
Although there is no requirement for mandatory disclosures on biodiversity in the UK, the Taskforce on Nature-Related Financial Disclosures (TNFD) is developing a global framework for voluntary application, with the full framework for market adoption expected in September 2023. If this follows the pattern of the TCFD, financial institutions in the UK may be required to provide TNFD disclosures on biodiversity in the near future. The TNFD has also created specific disclosure guidance for financial institutions. France already requires financial institutions to disclose biodiversity risks and their targets and strategy for reducing their impacts on biodiversity under Article 29 of the French Law on Climate and Energy.
EU leading the way
The EU has the most developed strategies so far in relation to biodiversity. It has set biodiversity targets for 2030, which include unlocking €20 billion per year to implement its biodiversity strategy, and investing a significant proportion of its climate action budget in nature-based solutions. Next year, its Corporate Sustainability Due Diligence Directive will introduce due diligence obligations on certain companies across their supply chains, requiring them to report on and address adverse impacts, including in relation to biological resources.
The European Central Bank made specific reference to the risks caused by biodiversity loss in its 2020 supervisory guide on climate-related and environmental risks. The tone from the ECB on climate and biodiversity is strong, and all banks under its supervision must comply with its expectations on material climate-related and environmental risks by the end of 2024. In a speech in December 2022, Frank Elderson (a member of the Executive Board of the ECB) made clear that financial institutions should manage biodiversity risks in the same way as any other material risk.
Looking forward – what can financial institutions expect?
Developments in approaching and managing biodiversity risks are likely to follow a similar path to climate risks. Most financial institutions have made climate commitments, such as net zero commitments, or other commitments to reduce involvement in particular industries, or to assess new clients or projects in a way that is consistent with the Paris Agreement. If they have not done so already, we can now expect financial institutions to come under pressure from NGOs, shareholders and others to set and adhere to public commitments on biodiversity.
As regulation and attention on the existence and management of biodiversity risks intensifies, and disclosure of biodiversity risks becomes more commonplace (and ultimately mandatory), the risk of biodiversity-related complaints and litigation will increase for financial institutions. NGOs are already beginning to focus on a lack of adequate biodiversity strategies within the financial sector, and we can expect to see them targeting the institutions they perceive to be lagging behind to force a change in policy. Shareholders will also be mindful of how biodiversity strategies (or the lack of them) impact on the value of the institution, and therefore on their shareholding.
However, one important difference between climate and biodiversity risks is measurement. Unlike climate, where global performance ultimately comes down to one metric – concentration of greenhouse gas emissions in the atmosphere – biodiversity is a multi-factor, localised concept requiring complex and context-specific measurement methods and data. For financial institutions, relevant metrics include exposure to clients and other business partners with high or medium dependency on nature, or to clients operating in or near to key biodiversity areas, critical habitats or endangered species. Other metrics include the share of investments in investee companies with sites located in or near areas of biodiversity importance and the degree to which lending or financing is exposed to material transition or physical risks. As a result, financial institutions will need to consider more tailored approaches to understanding their impacts and dependencies on biodiversity when building their governance, risk management and client engagement processes.
Overall, 2023 looks set to be an important and unfolding year for biodiversity, requiring financial institutions to track and respond to rapid developments in measurement, risk management and stakeholder expectations.