September 2022
 

Risks from natural capital depletion, including the loss of biodiversity, are often overlooked as investment risks or are sometimes considered too broad to assess, prepare for or negate. Here, Insight Investment considers how such risks can be assessed and ways investors can work to mitigate them.

Every year, the World Economic Forum (WEF) publishes a paper entitled the Global Risk Landscape, which incorporates a survey of nearly 1,000 global experts and leaders on their perception of global risks.

The latest survey results, published in early 2022, identified the three most severe risks on a global scale over the next 10 years as climate action failure, extreme weather, and biodiversity loss respectively. Natural resource crises were also cited as one of the most severe risks on the same timeframe.

These risks are linked directly to the depletion of natural capital, the world’s stock of natural assets. Natural capital typically refers to four types of assets:

• biodiversity
• water
• atmosphere
• soil and sediments

The benefits flowing from natural capital to people and businesses are known as ecosystem services. These services are fundamental necessities for human well-being and a bedrock of many aspects of the global economy.

While it is becoming commonplace for investors and asset owners to act on reducing climate change risk in their portfolios, natural capital risk has received less scrutiny. However, progress is being made. Initiatives are in progress to understand the specific implications for investors, such as the Taskforce on Nature-related Financial Disclosures (TNFD), which is developing a framework for disclosures and risk management¹.

In 2020, global consulting firm PwC estimated that over US$40 trillion of economic value generation (more than half of global total GDP) is moderately or highly dependent on nature and its services². Of this, industries highly dependent on nature – such as agriculture, fishing, mining, and tourism – account for around US$13 trillion³.

Businesses do not have to be based in an area of natural capital depletion to feel the effects of this dependency. Of the 20 countries richest in biodiversity, 11 are categorized as key global exporters⁴. Globalization means many businesses will have some potential risk exposure to these biodiversity-rich regions, be that a factory or an office space or a link through their wider supply chain.

Despite the clear importance of natural capital to the global economy, many have historically ignored the – often devastating – effect that human and business activities have had on the biome and the resultant unsustainable depletion of natural capital. A key measure of the depletion of biodiversity specifically is the WWF Living Planet Index. In 2020 it recorded that biodiversity declined by 68% between 1970 and 2016 resulting from land use change, land exploitation, climate change, pollution and the introduction of foreign species .

From an investment standpoint, there are challenges in effectively deciphering the natural capital risk associated with companies. There are no universally agreed metrics to assess a company’s exposure to natural capital risk and it is likely be some time before there is such agreement.

Science-based targets (SBTs), a growing focus of interest within the financial industry, offer a potential way forward. SBTs are measurable, actionable, time-bound objectives, anchored in scientific evidence and research that can be aligned with goals and targets set by international bodies (for environmental, social, and governance (ESG) matters, the UN Sustainable Development Goals are one such yardstick).

There are potential ways to demonstrate that natural capital risk can be meaningfully analyzed, while exploring companies’ dependency and impact on ecosystem services.

In considering this, disciplines such as the following may prove helpful:

• Industry-level materiality assessment – by taking a view on the risk facing a company's industry it is possible to analyze natural capital dependence and impact at an industry level and identify the industries most exposed to different risk types through their value chain.
• Geospatial mapping – assessing a company’s geographic exposure to capital depletion risks by mapping the locations of company operations to capital depletion hotspots. It is important to do this as natural capital is not declining at the same rate globally and to capture the diversity of ecosystem services.
• Mitigation analysis – companies can take steps to both minimize their damage to the environment and to reduce their risk exposure to natural capital assets depletion.

Beyond this, investors can look to analyze and tackle natural capital risk within investment decisions. It can help to highlight some key risks faced by issuers and the potential impacts resulting from these factors on a longer time horizon which are not always adequately incorporated into traditional ESG analysis.