About Natural Capital and the Finance Sector
Note: Please also see ‘Why sign the NCD?’ for a detailed discussion of the macro and microeconomic case for natural capital and finance, and why particular types of financial institutions may benefit from signing the declaration.
What is Natural Capital?
The Natural Capital Finance Alliance (NCFA) defines natural capital as the stock of ecosystems that yields a renewable flow of goods and services that underpin the economy and provide inputs and direct and indirect benefits to businesses and society. From the perspective of the financial sector, natural capital is a subset of environmental, social and governance (ESG) factors that can be material to financial institutions, mainly through their allocations of capital to companies through loans and investments or premiums as part of insurance contracts.
What the NCFA is working towards
The NCFA is an initiative that goes beyond ‘sustainability’. It is about the materiality of natural capital to the health of financial institutions. The NCFA proposes that natural capital-related risks are included in the cost of capital. We are not suggesting monetising or putting a monetary value on a hectare of tropical rainforest or a coral reef. We are looking to clarify how financial institutions are exposed to material natural capital risks through companies, and to encourage financial institutions to allocate capital to ‘natural capital positive’ business opportunities.
How is Natural Capital relevant to the Finance Sector?
As increasing global pressures chip away at stocks of natural capital, businesses face growing challenges. These can come in the form of legal liability, credit risk, volatility, unexpected falls in cash flows, and reputational, regulatory and portfolio risks, each presenting different financial pressures requiring additional mitigating measures. For example, the EU Environmental Liability Directive (ELD) makes companies directly liable for impacts on water resources, fauna, flora and natural habitats. Operators of risky or potentially damaging activities can therefore be held liable for the preventative and remedial costs of environmental damage. In these cases an investor may be left exposed to any litigious action against the operating company which could adversely affect returns.
At the same time, for industries dependent on natural capital, continued erosion of the global resource base presents additional operational challenges. Surging demand in the past decade alone has reversed a 100 year decline in resource prices. Increased demands on agricultural production, as well as associated water and energy requirements from feeding an additional billion people by 2030, will put upward pressure on the price of global soft commodities. These predicted increases will fall well within the investment horizon of pension funds and many loans, and represent supply chain challenges for many downstream businesses. A 2011 report by McKinsey found that 29% of profit warnings from companies in the FTSE were due to increases in the cost of raw materials. For large financial institutions, the exact level of exposure to this financial risk linked to natural capital is often not fully understood. This was highlighted in a recent Ernst & Young study, which revealed that environmental externalities can equate up to 50% of company earnings in a standard equity portfolio.
Such examples show the systemic risk and the product-specific risks related to natural capital. Factoring these risks into lending or investment decision-making processes or reflecting them in the cost of capital or the conditions under which insurance and finance are provided to clients can protect the bottom line.
Case examples of questions the NCFA is looking to answer
How can financial institutions accurately evaluate the nature and types of risks that their portfolios are exposed to in relation to natural capital, and how would this differ among major asset classes (e.g. project finance, corporate finance, equity, guarantees)?
How can financial institutions evaluate performance against key natural capital indicators that affect a company’s and – by extension – portfolio’s financial risk profile as an investee? What measurable natural capital performance indicators – harmonized among financial institutions and meaningfully linked to credit risk – can facilitate opportunities to put in place a structured, quantitative approach to benchmark investees’ performance and encourage companies to do better through the use of risk-adjusted financial premiums?
How can providers of debt or equity capital to agri-businesses and their customers better understand how to embed factors such as ecosystem degradation and water scarcity in credit risk management to control exposure to deforestation and related greenhouse gas emissions? With drivers of deforestation embedded in supply chains of food and consumer goods companies, how can continuing deforestation impact corporate clients that banks service in the agricultural/forestry sectors? How can credit risk management better address exposure to deforestation through land use change due to agricultural production to produce soft commodities (e.g. beef, soy, palm oil)?
Could governments be stimulated to put money into a newly formed Finance Facility that would de-risk investment and finance in projects and companies with lower impacts on primary forests?
Governments are looking to maximise the ‘economic value’ of fisheries, rainforests, water assets and other natural resources to ensure their resources are consumed at a sustainable level, and at a level which contributes to the health of the local communities and the national economy. How can financial institutions contribute to this?
 UNEP FI, 2010. CEO Briefing – Demystifying Materiality, Hardwiring Biodiversity and ecosystem services into finance. UNEP Finance Initiative: Geneva
 McKinsey Global Institute, 2011, Resource Revolution: Meeting the world’s energy, materials, food and water needs. McKinsey & Company
 Ernst & Young, Analysis of profit warnings issued by UK quoted companies, Q2 2011
 PRI and UNEP FI. 2011. Universal Ownership: Why externalities matter to institutional investors