Siva Ramachandran and Phoebe Chan call on investment professionals to integrate natural capital into their investment process, staff training and risk analysis.
According to the Scottish Wildlife Trust, natural capital is defined as “the world’s stocks of natural assets which include geology [metals and minerals], soil, air, water, and all living things. It is from this natural capital that humans derive a wide range of services, often called ecosystem services, which make human life possible”. Natural capital connects the ‘E’ in ESG to the ‘S’ – and the world is increasingly recognising the benefits of natural capital on our daily lives. These include food production, which not only depends on fertilizer, but also pollination from bees and flies. Trees and vegetation not only absorb carbon dioxide, but also provide a variety of ecosystem benefits such as stormwater management and water filtration, habitat for innumerable species, and even improve mental health.
The addition of natural capital to the regulatory agenda is sharpening investors’ attention. In December 2022, the United Nations Biodiversity Conference (COP15) was concluded with Global Biodiversity Framework (GBF), a landmark agreement intended to guide global actions on biodiversity and natural capital through 2030. Its four overarching goals are: 1) to enhance the integrity and resilience of natural ecosystems; 2) to value and manage biodiversity sustainably; 3) to share the benefits derived by genetic resources fairly; and 4) to finance GBF adequately. These four goals are supported by 23 interim milestones and targets, including preserving 30% of planet’s land, coastal areas and inland waters, and bridging the estimated biodiversity finance gap of USD 700 billion annually.
In the Asia-Pacific context, more markets are incorporating biodiversity as part of their national frameworks and plans. Supported by The Economics of Ecosystems and Biodiversity (TEEB) study, the ASEAN member states have made significant efforts in developing policies on natural capital and resource management over the past decade. The Chinese government launched a programme on Gross Ecological Product (GEP) way back in 2006 to account for the economic value provided by ecosystem products and services. In the rest of the article, we will describe natural capital issues, suggest a few resources for investors who wish to get up to speed on this important topic, and make some recommendations.
Crossing the planetary boundaries
Any discussion on natural capital starts with the nine planetary boundaries within which humanity can develop and thrive, including climate change, ocean acidification, and biosphere integrity. According to the Stockholm Resilience Centre which developed it, till date, five of these boundaries have already been crossed, including climate change, biodiversity loss, biogeochemical (nitrogen and phosphorus) flows, land use (deforestation), and chemical pollution (see chart). The impacts of the breaches are often systemic in nature and cannot be diversified away.
Therefore, investors need to assess biodiversity risks and opportunities in economic, investor, and social terms. The Ecological Threat Register – a study conducted by Institute for Economics and Peace to measure ecological threats – noted that about 5.4 billion people in 59 countries, including India and China, will live under high or extreme water stress by 2040. On the bright side, Academy of Sciences Malaysia (Malaysia’s highest scientific advisory body) in 2022 estimated the annual economic benefits unleashed by southeast Asia’s biodiversity at USD 2.19 trillion.
Data becoming the roadblock
Data is key to understanding natural capital issues. A joint report from Responsible Investor and Credit Suisse recently noted that 70% of investors cited the dearth of data as a key barrier to making investments that incorporate natural capital into the investment process. Although regulators have ramped up requirements for climate-related reporting from both companies and investment managers, most of the standards have come out from the European Commission. APAC is lagging in this regard.
Another pain point lies in the application of data. No investor can ignore natural capital issues, but not all will be able to devote the same level of resources for analysis and integration. Although data on biodiversity systems have been studied by scientists and scholars – such data are rarely presented in an investor-friendly format, or do not lend themselves to easy inclusion in a valuation model. On the retail front, it is hard for investors to understand various natural capital issues and interpret ESG messaging. Risks of greenwashing exist.
Natural capital investor resources
To fairly measure and value natural capital assets, investors need to spend time developing expertise. The following resources are helpful.
- Taskforce on Nature-Related Financial Disclosures (TNFD) was established in 2021 to create a risk management and disclosure framework for organisations to report on nature-related risks and opportunities. The TNFD is modeled on Task Force on Climate-Related Financial Disclosures (TCFD) whose four pillars are governance, strategy, risk management, and metrics and targets. The current framework proposes an internal risk and opportunity assessment approach, using a set of scoping questions, for use by both companies and financial institutions. This will help financial institutions prioritise effort in this area, as they assess their portfolios. The TNFD recommendations are due by September 2023.
- Natural Capital Protocol provides a decision-making framework to identify, measure, and value organisations’ dependencies and impacts on natural capital. The Protocol focuses on biodiversity impacts from operations and long-term financial implications when the organisation is dependent on diminishing natural capital. An accompanying toolkit provides methodologies for natural capital valuation and mapping them against the protocol’s framework. Investors can use the protocol and toolkit to guide their advocacy and engagement with companies.
- Science Based Targets for Nature (SBTN) provides guidance to companies through a five-step process to address environmental issues, namely assess; interpret and prioritise; measure, set, and disclose; act; and track. Instead of attaching a value tag to the resources, this approach helps identify the relationship between the business models and the environment.
A note on green growth
Green growth seeks to attain a “greener” developmental path simply by substituting fossil fuels with clean energy. The reality is more complicated, and models that reframe planetary boundaries as mere extensions of climate change issues do not help prevent catastrophic impacts on natural capital. A good example would be mining metals and rare earth elements for energy transition. The process itself face concerns about land use, water use, and human health and safety. It is not resource-efficient when a rigorous ramp up in mining or a search for substitutes is needed for a small fraction of such metals. In other words, green transition may impose huge environmental, social, and economic costs if it is not managed carefully.
Recommendations for the industry
Unbridled fossil-fuel dependent growth puts pressures on the planet that we rely on for sustenance of life. Policy setters and industry leaders have started recognising the need to manage – and value – natural capital.
To achieve this, data providers should enhance both the availability and accessibility of high-quality biodiversity data with ties to socio-economic data. Increased availability of high-quality data will benefit middle and low-income countries with vulnerable ecosystems.
As for investment professionals, it is significant to level up their literacy and develop frameworks for integrating natural capital into the investment process. CFA Institute calls on the investment management industry to support staff training and learning in natural capital issues. They are encouraged to refer to our latest report – Integrating Natural Capital and Biodiversity in the Investment Process – which outlines various issues through case studies.
Finally, investment professionals are encouraged to incorporate natural capital in their risk analysis. Natural capital has value, and should be reflected by analyst reports, such that more investors can place a proper value on natural capital.
By Sivananth Ramachandran, Director of Capital Markets Policy, India, and Phoebe Chan, Capital Markets Policy Specialist, at CFA Institute.