Embedding nature in financial regulation

Humanity is “embedded in nature” concluded the Dasgupta review on the “Economics of Biodiversity” in February 2021. And it is certainly true that the world, and particularly the financial sector, is waking up to the potential financial impacts that failing to protect nature and biodiversity could have on the global economy. 

The Task Force on Nature-related Financial Disclosures (TNFD) defines nature-related risk as “the potential threats posed to an organisation linked to its and other organisations dependencies on nature and nature impacts”. This includes a variety of environmental challenges such as deforestation, species extinction, pollution and overexploitation of natural resources. Nature-related risk is inextricably linked to climate risk — however, while it can contribute to, or be exacerbated by climate change, it cannot be solved simply by limiting global warming. In order to successfully manage nature-related exposure in a changing world, nature as well as climate must be embedded in financial regulatory and supervisory approaches. 

Financial regulators are starting to develop approaches to nature-related risk, with the European Banking Authority (EBA) confirming in October that 'nature-related risks are part of our mandate'. Earlier in the year, the Bank of England's (BoE) Financial Policy Committee noted the vital role that natural capital plays in mitigating the risks from climate change and encouraged the BoE to develop its understanding of how nature-related risks might arise and their potential materiality for UK financial firms and the wider financial system.

Regulation is at a relatively early stage of development. The first step is to define clear standards and frameworks within which financial services firms can operate.

Taxonomies aim to improve the quality and consistency of information flowing to markets and may help to drive nature-positive change across the economy. The EU has committed to developing a taxonomy that will help to determine the extent to which investments, portfolios and expenditures align to climate and nature-positive economic activities. In the UK, a similar taxonomy has been proposed, but the scope and timeline for applying it and the underlying criteria are yet to be fully defined. 

Under its first draft standard on General Requirements for Disclosure of Sustainability-related Financial Information, the International Sustainability Standards Board (ISSB) also aims to improve the availability and quality of data disclosed on a range of topics, including nature-related risks, where they could be `reasonably expected to influence primary users' assessments of an entity's enterprise value'. 

The EU's draft European Sustainability Reporting Standards (ESRS) go further, proposing that companies report on their direct and indirect impact on the environment and nature, highlighting both entities' financial and non-financial impacts. 

In order to make appropriate disclosures, financial services firms will need robust frameworks to identify, measure, monitor and manage nature-related risks. The TNFD is in the feedback phase of developing a framework for cross-sector use that will be launched fully in September 2023. The TNFD framework is structured in a similar way to the TCFD framework and will likely inform regulatory agendas and be adopted into regulatory strategy in some jurisdictions, in the same way TCFD has been. For more on the TNFD approach see here, here and here.

Despite progress in developing standards and frameworks, firms still face significant challenges when developing their approaches to nature-related risk — most obviously how can or should nature-related risk be measured? There are clear measures for climate risk, based on the increase or decrease in degrees Celsius, which enable potential climate outcomes to be modelled. 

For nature-related risk, the key metrics are less clear, but proposals are being put forward. 

In China, a single numerical measure, Gross Ecosystem Product (GEP) has been piloted. By measuring the monetary value of elements of the natural world (such as the economic contribution made by the river water which flows through Qinghai province), it is possible to calculate the potential impact of a degradation of the natural world. 

The TNFD framework includes recommendations for firms to use in developing their own set of four reportable KPIs — an absolute metric, the rate of change in the metric from the prior year, the intensity of the metric compared to other business activities, and the relationship between the metric and revenue. 

Measures such as these could be important inputs to risk models and form the basis for corporate disclosures. The TNFD plans to publish a standardised set of metrics for consultation in early 2023. Until these metrics are agreed and widely adopted, lack of consistency and comparability in nature-related disclosures is likely to persist.

At a broader level, policymakers have a key role to play in engaging the market by setting clear targets. The second part of COP 15, to be held in Montreal in December 2022, will see delegates of 195 countries and the EU come together to try to finalise the Post-2020 Global Biodiversity Framework, first published in 2021. If adopted in its current form, the framework would set four long term goals for 2050 and 22 targets to achieve by 2030, including a core pledge to protect at least 30% of the Earth's land and oceans by 2030. Regulators could then be instrumental in cascading these targets to the financial sector and the wider economy, driving integration of biodiversity into board-level discussions.

While COP 15 will only consider biodiversity, there are other nature-related risks that could pose significant financial risks to the financial sector — including air pollution, overexploitation of natural resources and increased vulnerability to flooding. We expect the regulatory agenda to evolve to reflect these and other risks.

Although financial regulators have yet to set formal requirements around nature, firms should be considering their potential exposures and approaches to governance, risk management and disclosure. As seen with other ESG-related regulation which developed at pace, firms that fail to engage early on risk having to deploy significant resources to catch up later. And, beyond the formal regulatory framework, investors and other stakeholders are likely to begin demanding more from firms in relation to disclosure of their exposure to nature-related risks and related risk management strategies.