Assessing the materiality of biodiversity on financial institution balance sheets
One of the key focus areas for investors, and financial markets in general, is to price risk, to make efficient capital-allocation decisions. Whilst historically this has been achieved by focusing on business, financial and macro-economic factors, the last decade has seen an ever-increasing focus on corporate governance and risk management practices. In terms of risk management, one of the most significant risks that organizations face today relates to climate change.
However, focusing on climate change alone perhaps presents a less-rounded approach to understanding a business’ impact on the broader ecosystem and associated risks. Therefore, a wider approach has to be adopted that can assess a business’ biodiversity liabilities and the risks they present. Initiatives such as "Corporate Valuation of Ecosystems" or "Natural Capital Protocol" have been developed with a view to address this challenge.
These models have tried to introduce conceptual frameworks, methods and metrics that can enable businesses to ascertain natural capital dependencies and impacts. However, these tools do not necessarily provide a standardized approach to ascertaining environmental risks associated with companies and projects. What is in fact needed, is a metric that can be interpreted in a manner that is comparable to existing measures of financial risk.
F4B is working with Basic Roots, an India based financial advisor, to create a scalable and standardized methodology that can be used to evaluate the impact of a business’ activities on natural and semi-natural ecosystems, and the goods and services they provide. Given the need to create a metric that is comparable to other measures of financial risk, our approach will be to ascribe a monetary value to this impact by calculating natural capital net debt for the business. This approach can then be used to calculate the “true leverage” for a given business and to ascertain underlying risk for a number of scenarios. A monetary value enables existing tools used by equity and credit analysts, investors, regulators and other market participants to account for biodiversity related risks.
The proposed approach here is to first identify the ecosystem services that a business interacts with. We intend to use a standardized approach to classify these services, by using existing frameworks such as the Common International Classification of Ecosystem Services. As a second step, an economic valuation of the ecosystem services is conducted. Third, an assessment of irreversible and reversible (restorable and recoverable) impact of the business on the ecosystem is conducted. Finally, natural capital gross debt can be calculated as the difference in the economic value of ecosystem services before and after they have interacted with the business.
Any investments made by the business or company to compensate the ecosystem can be netted off to calculate natural capital net debt. As part of the proposal, we will then deploy this approach to ascertain biodiversity liabilities for up to three financial institutions that are viewed by regulators to be systemic institutions. The analysis will include a summary of natural capital net debt (biodiversity costs) across geographies, product lines, asset classes and business units. Given our focus on ascribing a monetary value through the calculation of natural capital net debt, the output can be used to derive a host of financial analysis metrics such as liquidity, asset base, tangible equity capital and ultimately fair market price.