Mid-Year Outlook 2023
Explore our “Mid-Year Outlook”, the investment strategy update from Barclays Private Bank.
By Damian Payiatakis, London UK, Head of Sustainable & Impact Investing
While nature surrounds us, investors might have little idea of the critical role it plays for businesses and economies. More than half of the world’s gross domestic product (GDP), or approximately $58 trillion of economic output, is highly or moderately dependent on nature1.
Loss or damage to the value of environmental and ecosystem assets have implications for investors’ portfolios. Unfortunately, human activity is increasing the threats to nature2, and therefore to investors.
While some investments offer possibilities to protect and restore nature, this article aims to improve your awareness of the potential biodiversity risks that might lurk in your portfolios.
Through a financial lens, nature might be seen as a stock of environmental assets. According to the United Nations, these can be defined as “The naturally occurring living and non-living components of the Earth, together constituting the biophysical environment, which may provide benefits to humanity.”3
More simply, this includes renewable and non-renewable natural resources, ranging from plants and animals to air, water, soil and minerals. These stocks have value, both intrinsically and to the organisations and people who benefit from them.
Natural capital can be found in four “realms” – land, ocean, freshwater and atmosphere – which fundamentally differ in how they operate and function, according to the Taskforce on Nature-related Financial Disclosures4. Beneath these realms, thirty-four “biomes”, such as savannas and grasslands, lakes, or coastal inlets and lagoons, classify areas that share similar features, based on similar levels of precipitation and temperature.
Within realms and biomes, environmental assets and associated ecosystems provide services that benefit people, companies, and the global economy (see diagram).
This might include natural resources like timber for housing, or freshwater for industrial processes. Other assets and ecosystems could help to regulate and maintain natural cycles around climate, water or nitrogen. For example, according to a 2018 Oceanography article, oceans have absorbed more than 90% of excess heat caused by human activity since 19715. Finally, nature provides personal experiences or intangible services for cultural, recreational or tourism purposes, such as hiking through national forests, or hotels sited along coastlines.
Companies benefit from these ecosystem services, individually or combined, to generate financial value. Moreover, they can profit from many of these services without having to “purchase” them from nature.
Seeing nature as a type of capital recognises that even apparently ‘free’ resources financial value. These resources reduce in value that reduces when lost or damaged. Moreover, adverse changes to this capital’s worth can hit the value of the economic activities and businesses that rely on it.
Simply, if overfishing causes a fish stock to collapse, then so too does the associated fishing industry. Or, if over-extraction of freshwater, combined with climate-induced water scarcity, causes extra water stress, industries such as textiles and mining might no longer be able to operate.
Governments, regulators and industry are increasingly recognising the importance of nature to their economies and our ability to sustain life. For instance, more than 190 governments made commitments in December 2022 at the fifteenth United Nations Conference of the Parties (COP-15) to the Convention on Biological Diversity that solidified global goals and ambitions around biodiversity6.
Protecting the environment is also moving up the political agenda, reflected in various countries combining legislation, regulation and fiscal spending to preserve and restore biodiversity. For example, biodiversity is embedded in the European Union’s Taxonomy Regulation7 and the Sustainable Finance Disclosure Regulation.
In the UK, most future planning permissions granted in England will be required to demonstrate at least a 10% biodiversity net gain8. Last year, the US government launched a $1 billion America the Beautiful Challenge to support ecosystem restoration projects and accelerate land, water and wildlife conservation9.
In May, the Taskforce on Nature-related Financial Disclosures (TNFD) published its fourth iteration of its draft disclosure framework for final consultation, ahead of its planned publication later this year10. As a parallel framework to Task Force on Climate-related Financial Disclosures (TCFD), which has become a leading framework adopted by governments and central banks for mandatory climate disclosures for companies and stress testing for banks, it’s possible to envisage TNFD will be similarly mandated.
A starting point for investors to understand potential portfolio risks from biodiversity requires an understanding of the drivers of biodiversity loss. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) identified five direct drivers of biodiversity loss11.
The first, and biggest12, driver of biodiversity loss is a change in land and sea use. For example, removing forests for agriculture or cattle usage, mining for minerals or metals, repeated river or marine dredging, all change the biodiversity of the associated biome.
Second is climate change. Changes to weather patterns or increases in water temperatures and acidity can affect near-shore marine ecosystems, for example. The next driver is pollution, primarily from chemicals and waste. Excess nitrogen and phosphorus from fertilisers damages freshwater or marine biomes13. Microplastics in oceans are finding their way into fish14.
Over-exploitation of natural resources is the fourth driver. From marine fish and trees to precious metals and water, humans have, at times, consumed more of these resources than are available or renewable.
Finally, invasive alien species can negatively affect ecosystems by causing the decline or even extinction of native species. As non-native animals, plants, fungi and microorganisms out-compete local biodiversity, the original ecosystems services can be damaged.
Biodiversity loss has significant implications for companies. Broadly this is either due to their dependency on biodiversity or their impact on it.
Companies depend on biodiversity, as direct or indirect inputs, to generate value. Sectors such as forestry, agriculture and fisheries directly rely on natural capital and ecosystem services for their business well-being. But other sectors may have indirect, but critical, reliance on environmental assets. For example, the use of freshwater in textiles, utilities, food and beverage, data centres, or mining operations.
Here, the physical risks of such natural pollinators vanishing, might lead to higher costs for food producers, or the loss of stocks, as invasive species push out the more valuable native species. In addition, companies will face the transition risks, around reputation or market dynamics, from any potential backlash from consumers and investors for over exploitation.
Businesses also impact biodiversity through their operations or their goods and services. For example, pesticide runoff into water systems can cause fishery stocks to collapse, while construction might fragment or damage local ecosystems.
For industries impacting nature, they face a broad range of transition risks, from regulatory changes that will drive higher costs and, again, consumer or investor pressure. Companies that damage natural environments could face litigation risk with any related additional legal costs.
These financial material risks mean investors will need to assess underlying threats to environmental assets and ecosystems that affect your sector or company allocations.
In looking to assess the biodiversity risks in portfolios, notably, investment practices are still nascent. While frameworks, approaches and biodiversity data providers are being developed, investors can start by looking from a broader macro or micro level.
For instance, from a macro perspective, developing a deeper understanding of global dynamics and sector-specific risks could provide a useful baseline. And while the investment capabilities might be nascent, scientific research and civil society organisations are long-standing across nearly every theme or sector. Prioritising sectors can be driven by interest, or more pragmatically, a review of current industries in your portfolios.
Recent analysis from PwC has highlighted sixteen industries with high or moderate nature dependency1.
For these industries, the economic value coming from business activities could either fail financially (high dependency) or is likely to experience a material reduction in financial returns (medium dependency) due to particular ecosystem disruptions.
This contrasts with activities with low dependency where there may be limited material financial effects from ecosystem disruptions. (see chart).
The impact of the environment on a range of industry sectors, with reference to their supply chain, direct operations, or immediate customers.
At the micro-level, investors can evaluate biodiversity risks for assets or companies in their portfolio. Investors will need an appreciation for risks at the industry or biome level, along with an understanding of the local contexts or locations, to fully assess the risks. Here, one component of the TNFD framework, can provide structure to investors’ thinking. While designed primarily as a company disclosure framework, the TNFD guides companies to locate, evaluate, assess, prepare (LEAP) for biodiversity risks15.
While LEAP guidance is intended to support voluntary internal, nature-related risk and opportunity assessments, using the same structure can make investors’ efforts more comparable. Thereafter, as metrics, targets, data and reporting continue to standardise, and improve, investors can include such items to their due diligence processes.
Incorporating nature into investing is difficult to achieve, not least as it is a relatively new concept. But even if current methods are far from perfect, they are better than nothing, given the level of biodiversity risk commonly faced by investors’ portfolios. As well as the risks to “our economies [which] are embedded within Nature, not external to it”16.
The loss of biodiversity seen in recent decades is accelerating and becoming more visible17. Given many companies’ dependence on nature and its associated scale, environmental loss and damage can be expected to hit investor returns, ultimately.
Longer-term shifts in ecosystems, while not as obvious today, have deeper implications for companies and communities. If the natural world cannot be preserved and regenerated, then society faces even greater risks. Investors should prepare accordingly.
Explore our “Mid-Year Outlook”, the investment strategy update from Barclays Private Bank.