Humanity needs nature to survive, and so do the economy and banks | European Central Bank

The ECB recently published reports titled ‘Living in a world of disappearing nature: physical risk and the implications for financial stability‘ and ‘The impact of the euro area economy and banks on biodiversity.’ Could you please elaborate on the key findings?Humanity needs nature to survive, and so do the economy and banks. Nature supports human well-being and the global economy through different channels. Think for example of clean water and clear air, but also fertile soils, pollination and timber. Such benefits provided by nature to support human wellbeing and sustain our economy are called ecosystem services. Nevertheless, pressures such as unsustainable land use, climate change and overexploitation of natural resources are degrading ecosystems and the services they provide. Given the high dependencies of our economy and the financial system on nature, this could lead to substantial risks.

Nature-related risks impact companies, and indirectly banks that lend to them, via physical risk and transition risk. Physical risk arises from severe natural disasters or the gradual loss of natural goods necessary for production. On the other hand, transition risk is linked to the uptake in government efforts to protect the environment. Such regulations could limit exploitation of natural resources or outright ban certain polluting products. Finally, changes in consumers’ and investors’ preferences that increasingly decide to distance themselves from impactful industries are also a source of transition risk.

Our first publication on this topic focuses on the assessment of physical risk and thus on the exposure of the euro area economy and financial sector to nature degradation. Specifically, we looked at the dependencies on ecosystem services. Examples of such services are products such as food production, drinking water, timber and minerals, but also the protection against natural hazards or carbon uptake and storage by vegetation.

We found that in the euro area, approximately 72% of companies (or around three million) are highly dependent on at least one ecosystem service. In addition, we found that almost 75% of corporate bank loans in the euro area (nearly EUR 3.24 trillion) are granted to non-financial borrowers with a high dependency on at least one ecosystem service. This means that degradation of the relevant ecosystems will pose economic challenges for such companies and potentially propagate to banks. The figures show the severity of the crisis and underline how vital it is for all economic actors to prepare and navigate the green transition, where nature conservation and restoration represent an essential element.

The paper also performs an innovative sensitivity analysis on the dynamics of expected losses of euro area banks’ credit portfolio due to biodiversity losses. It shows that if the world will follow the current emission pathway and continue exerting high pressures on nature, the euro area banks’ losses due to biodiversity loss could be on average almost three times higher than in a scenario characterized by less resource‐intensive lifestyles, more resource‐efficient technologies and increased climate regulation. The biggest losses would be felt in countries such as Germany, Lithuania, Ireland and Belgium. The reasons behind these results can be attributed to reliance on resource intense technologies and to a relatively high reduction of species intactness in central, western Europe and Ireland under the adverse scenarios.

Our second paper focuses instead on transition risk and, most importantly, on the analysis of the climate-nature nexus.

In the euro area, we see two possible drivers for certain businesses possibly facing transition risk: one driver could be due to the uptick in government efforts to protect the environment. The other possible driver could be changes in consumers’ and investors preferences.

Considering climate change and land-use change as two primary drivers of biodiversity loss, the combined impact of euro area companies on nature is equivalent to the loss of 582 million hectares of “pristine” habitats worldwide. This equals roughly 60% of the European land area. This measure integrates the loss of biodiversity as a consequence of already observed land conversion due to current economic activities and takes into account potential biodiversity loss in the next 100 years due to GHG emissions produced in 2021. This footprint is generated when companies exploit land for economic activity and when they emit greenhouse gasses. For example, agriculture impact biodiversity almost entirely through land use, while electricity production impacts nature almost entirely through GHG emissions generated while burning fuel.

Locally, euro area companies generate an impact equivalent to the loss of 398 million hectares. They also generate substantial degradation abroad, through the import of intermediate goods. The paper found that German companies have the largest impact on biodiversity, while French banks finance the largest share of the total biodiversity footprint. Therefore, the euro area economy is susceptible to possible changes in regulation that could limit these impacts.

Finally, the financing of global impact on biodiversity is highly concentrated: ten banks with the highest share of impact account for the financing of 40% of the total global impact caused by euro area.

 

As a central bank, our primary mandate is safeguarding price stability. This requires understanding all aspects that might influence the economy and the financial sector. Our paper, together with many others, highlights how degradation of nature can indeed impair production processes and consequently affect the creditworthiness of many companies.

Nevertheless, it is undeniable that research is still in an early stage and needs to be enhanced before biodiversity and nature loss can be fully considered at the same level of other macro-economic risks. For example, compared to climate, nature risks have much more complex transmission channels, involving interdependencies and tipping points. However, the challenges of the unknowns are not discouraging us to continue our work on how nature could impact price stability, financial stability and risks for banks.

 

Looking at our results, a couple of aspects stand out that differentiate nature-related risk from other types of risk. First is the multidimensionality. In our analysis, we consider 21 ecosystem services. This complicates the assessment of risk given that the interdependencies and the degradation of multiple ecosystems could cause cascading effects leading to amplification of impacts. Moreover, the clustering of relevant ecosystem services can be strongly heterogeneous across different sectors.

A second aspect is the exposure of companies and banks to nature through the supply chain. Nature risk is a global phenomenon, yet it is extremely regionalized. Every single jurisdiction is different, with its own characteristics and vulnerabilities. For example, a region can be exposed to flood risk and therefore depends on ecosystem to protect against flooding. Other regions can be strongly exposed to droughts, and thus they depend critically on capability of ecosystems to provide freshwater. The interconnectedness of the economy, which often relies on the outsourcing of intermediates goods, makes it vulnerable to these differences. Moreover, contrarily from what happens in climate, nature-preservations regulations are often jurisdiction-specific. This makes transition risks even more heterogeneous and difficult to manage. In this vein it is also important to mention that the supervisory arm of the ECB issued expectations for banks on managing climate-related and environmental risks and it closely monitoring how European banks are adjusting their practices to manage these both risks.

 

The paper identified various strategies that companies can employ to mitigate nature-related risks. One effective approach involves diminishing physical risks by reducing reliance on resource-intensive production methods and transitioning towards more sustainable operational practices, fostering a sustainable coexistence with nature. In summary, cutting companies’ contribution to environmental pressures will decrease the likelihood of future acute events, thereby reducing physical risk. Reducing the impact on nature can also limit the transition risk associated, making companies less susceptible to changes in regulations and consumers and investors preferences. Finally, a more comprehensive mapping and understanding of the supply chain, including its dependencies and impacts on nature, are pivotal for discerning upstream risks.

For banks on the other hand, this dependency on nature-related risks is indirect. This means that their activity is not directly dependent on nature, but only indirectly through their exposure to companies (e.g., through direct loans or by holding securities). For financial institutions, it is therefore important to be able to map their portfolios’ exposures and impacts. In doing so, we should put emphasis on the emerging global disclosure guidelines, frameworks and standards, such as the TNFD, the International Sustainability Standards Board (“ISSB”), and the European sustainability reporting requirements, which will provide much needed reliable data for banks and supervisors.

 

Climate change and nature loss are inextricably intertwined, with interdependencies and reinforcing mechanisms (feedback loops). Although climate change and nature risks are different with regard to their time horizon, hazard dependency and spatial manifestation, they can amplify or mitigate each other. Therefore, they should not be considered in silos. However, we are also aware of the non-trivial challenges of modelling them combined.

In our recently published paper, we investigate the combined physical risk for companies and banks due to their vulnerability to nature degradation and climate change. Specifically, we examine two case studies where compound physical risk can materialize: surface water provision with drought risk, and flood risk with the ecosystems protecting against it. In the former case, we find that the highest compound impact amplification exists in the agricultural, manufacturing and electricity production sectors, especially in Spain, France and Italy. On the latter, we find that for flood risk the highest potential for compound impact amplification exists in the energy production and the agricultural sector, especially in Latvia, Lithuania and Slovenia.

 

 

Andrej Ceglar is a climate scientist at the Climate Change Centre of the European Central Bank (ECB). His work is currently focused on assessment of physical and transition risk from climate change and nature degradation. He completed a bachelor study in meteorology at the Faculty of Physics and Mathematics, and holds a PhD in agro-meteorology from the Biotechnical Faculty, both University of Ljubljana. Before joining the ECB, he worked as a scientific officer at the Joint Research Centre (JRC) of the European Commission and assistant professor for climatology at the University of Ljubljana. His research is focused on climate change impact and adaptation assessment, dynamical and statistical climatology and biophysical modelling. He is especially interested in predictability of climate system on seasonal-to-decadal time scales.

Simone Boldrini is a financial stability analyst at the European Central Banks. He is currently working on the developments of climate scenarios to assess banks exposure to climate risks and nature-related financial risks. He holds a bachelor and a master degree in Economics from Bocconi University, Milan.