Original content provided by BDO UK

Nature-related financial risks will increasingly affect the economy and financial systems.

Managing nature decline is urgent. It worsens climate change, leads to biodiversity loss, limits access to water and deepens social inequality. According to the World Economic Forum, biodiversity loss is the third most impactful risk facing the global economy, and the fourth most likely to occur. These risks arise as a result of the depletion of natural resources and biodiversity, affecting the parties and economies that depend on them. Banks, asset managers, insurers and institutions providing alternative finance are exposed to physical, transitional, liability and reputational risks if they finance businesses that have a major negative impact on nature or are subject to the effects.
 

1. Why Financial Institutions (FIs) need to consider nature-related financial risks

Nature-related financial risks can impact operational cash flows, asset values and the wider economy and manifest in several ways, including:

• Physical risks - these arise when natural systems are compromised due to climate, a weather event or to damage to ecosystem equilibria which is the balance within an ecosystem where the components - such as plants, animals, microorganisms and their physical environment - interact to maintain and sustain the ecosystem itself over time¹. For example, deforestation could reduce local rainfall, raising operating costs for numerous sectors.  Nature degradation can lead to stranded assets and credit loss. On the other hand, reducing nature degradation can help prevent wildfires, protecting property values, which are collaterals, in the case of a counterparty default
  1. Cambridge Institute for Sustainability Leadership, Handbook for Nature-related Financial Risks: Key concepts and a framework for identification
• Transitional risks - these relate to the process of adjustment towards a nature-positive economy. Risks arise as a result of abrupt or disorderly introduction of public policies, technological changes, shifts in consumer or investor sentiment and disruptive business model innovation. For example, anti-deforestation legislation increases due diligence costs for lenders and buyers of soft commodities that could be connected to deforestation  
• Liability risk - these arise if parties that suffer loss or damage from the effects of environmental change seek compensation from those they hold responsible. These losses or damages can include potential pay-outs, fines, legal and administrative costs, insurance costs, financing and litigation costs. Fines for oil spills are a prominent example of liability risk
• Reputational risk - these arise when an FI is perceived as a contributor to nature decline or having a negative impact leading to negative publicity, customer loss and ultimately impacting a business’ financial position.

2. What is good practice?

Incorporating nature-related considerations into risk management practices. Nature-related financial risk can impact business strategy, liquidity, loan books and investments. FIs should consider nature risks through identifying exposures, assessing their materiality, testing the resilience and designing risk management controls such as exposure due diligence and management information, which will naturally run parallel with climate change risk management practices.

Larger FIs are already implementing nature-related risk management frameworks based on their conviction that this will make their business more sustainable in the longer term and enhance growth. Smaller and medium-sized FIs are at the early stages of understanding how nature-related issues affect their financial performance and market position.

There will be challenges as this is not an easy task. Many FIs are still trying to get to grips with understanding how climate change is impacting their business, let alone biodiversity. However, having a clear view on nature-related financial risks will help FIs to quantify the actual risks and opportunities associated with their impact and dependencies.
 

3. What is on the regulatory horizon?

The ISSB published in June 2024 its 2024-2026 work plan, which includes a project to research disclosure about risks and opportunities associated with biodiversity, ecosystems and ecosystem services: this could translate in the introduction of a third Standard to complement the existing S1 and S2. 

On a voluntary basis, FIs are adhering to the framework published by the Taskforce for Nature-related Financial Disclosure (TNFD) and the Taskforce has published guidance for FIs on how to get started and disclose around the four pillars: Governance, Strategy, Risk Management and Metrics & Targets. Early adopters will find synergies with the Taskforce for Climate Related-Financial Disclosures (TCFD) and FIs, which will facilitate understanding, implementation and reporting.

In addition, on 11 October 2024, the CFRF, a Forum established by the FCA and the PRA in 2019 published guides on how to start embedding nature risks into risk management frameworks. This shows the direction of travel for nature-related expectations in the UK and elsewhere.
 

How BDO can help

BDO has expertise in sustainability and ESG-related risks risk management and are ready to support you. From risk assessments to strategy development, training, programme implementation, resource augmentation and disclosures assurance, we can support you in your journey towards sustainability and resilience.

If you would like to find out more about nature related financial risks and how we can help you, please reach out to the relevant partner in your local firm.