Sustainable Finance Live: The state of the market and planet

The latest instalment of Sustainable Finance Live, 'Valuing Nature: Better Assessing Financial Risk', commenced with an introduction from Richard Peers, founder, Responsible Risk, who outlined the key issues and challenges facing the financial services industry today, when it comes addressing climate change and biodiversity loss.

Following the introduction, Richard handed over to the first of three keynote speakers – Susanne Schmitt, nature and spatial finance lead, World Wide Fund for Nature (WWF) UK – who described the current state of biodiversity loss, its impact on ecosystem services and natural capital, and what is being done by the industry to address this issue.

Is nature too big to fail? What is the current state of biodiversity loss?

The WWF’s latest Living Planet Index, published in 2020, reveals an alarming decline in nature – estimating that two thirds of wildlife populations have declined since 1970. “In 2019 the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IBPES) quantified the issue in terms of species extinction”, said Schmitt, “reporting that at the current rate, one million species could become extinct in our lifetimes.”

This level of biodiversity degradation threatens to undermine 80% of the United Nations’ Sustainable Development Goals (SDGs) – including those related to poverty, as well as nature.

The economic impact of nature degradation is becoming clearer by the day.

Between 1992 and 2014, the WWF notes a 40% slump in natural capital. This is a concerning statistic, as natural capital – defined as the stock of renewable and non-renewable natural resources, from which we derive our physical products and ecosystem services – is an irreplaceable pillar of the global economy. Indeed, “half of our GDP is dependent on nature-based economic activities”, noted Schmitt.

This issue is sharpened when it comes to low income countries, where many citizens derive their livelihoods from nature. In fact, in the least developed countries (LDCs), natural capital contributes to around half of the total wealth.

Clearly, in order to maintain a stable economy and financial system, we need to ensure nature remains stable.

There are promising developments in this area, pointed out Schmitt – and the financial services industry is beginning to wake up and respond to the issues it faces.

In June 2020, for instance, De Nederlandsche Bank published a landmark study, 'Indebted to Nature', which found that “Dutch financial institutions alone have EUR 510 billion of exposure to biodiversity risks, like disruption of animal pollination. The assets at risk represent as much as 36% of the assets the central bank assessed across Dutch banks, pension funds and insurers.”

More recently, in April 2021, financial regulator Network for Greening the Financial System (NGFS) launched a joint research project with London School of Economics-run organisation Inspire, in order to better quantify the impact of finance on the provision of key ecosystem services, as well as the consequences of biodiversity loss for financial stability.

These examples represent just some of promising research and action that is underway within the financial services industry, and, hopefully, marks the beginning of positive change for the environment.

However, in addition to initiatives like these, the financial services industry needs better access to high quality, granular, asset-level data, in order to effectively measure and respond to nature-induced risks. Indeed, biodiversity-based targets – like those prescribed to climate change and global temperatures – will soon be necessary, too.

According to Schmitt, the current decade must be the epoch of climate and biodiversity action. By 2030, the global community must become “nature positive”, and restore ecosystems, in order to avoid catastrophic and irreversible alterations to the biosphere.

Evidently, the job that lies ahead of the financial services industry is to make nature more bankable and investable. The upcoming Sustainable Finance Live workshops will drill down into exactly how this should be done.

The benefits of using science-based data to assess financial risk

Earth Knowledge’s Frank D’Agnese echoed Schmitt and stated that while there is no temperature-based goal for nature recovery, businesses can work towards:

• no net nature loss by 2024,
• achieving nature positivity by 2030, and
• full recovery by 2050.

Drilling down into specific examples and components of natural capital, D’Agnese explains how climate change and habitat fragmentation can impact physical assets. Further, using an Earth Knowledge case study, he continues to explore how in hindsight, science-based data could have supported companies like Pacific Gas & Energy (PG&E).

Science-based data can help establish mitigation and adaptation plans and support the financing behind changes to business models, operations, and risk models. The two-year period between September 2017 and October 2019 was a critical time for PG&E; the energy company experienced a drop of 93% in value when their stock hit an all-time low.

Citing the water cycle and landscape health as the biggest drivers of nature loss, climate change, land conversion and habitat fragmentation, D’Agnese added that other indicators such as pollution, invasive species and disease must also be taken into consideration. Earth Knowledge, for example, “do this for every location around the globe and we do it at different points in time: historical, present, and forward looking.”

He continued: “We do this as a way of informing users about their sustainability, their operational and economic risks, and the opportunities through what we call forward looking intelligence, which is storable data, current data, and probable or likely scenarios for the future.”

Understanding that a healthy ecosystem equals a resilient ecosystem is of paramount importance. D’Agnese highlights that when calculating the impact of these indicators, the ecosystem must be thought of in the same way that we would think about our bank accounts.

“If we had too many withdrawals and not enough deposits in our bank account, we go into a state of overdraft. Same thing happens with our ecosystem. And the same thing happens with the water cycle. If that happens, the ecosystem would no longer in a healthy state and no longer has a healthy function, and it becomes therefore vulnerable.”

Using California as an example, D’Agnese explained there is a recurring pattern where periods of drought would be followed by extreme rainfall and while this provides enough soil moisture to grow tall grass and increase the volume of forest undergrowth, the landscape is still in an unhealthy state.

This weather would be followed by summers with extremely high temperatures, strong winds and ultimately, wildfires. D’Agnese said: “We had a repeating spike in what we call climatic water deficit. This is a lack of soil moisture in the landscape.

“And what we noticed is that the California fires of the last six years coincide with spikes in this very high landscape drought. […] Actually, in the case of the Tubs and the Nuns fire, which occurred in Sonoma County in 2017, our earth systems model, utilising this climatic water deficit indicator, was able to predict the likelihood, and the exact locations of these damaging and costly wildfires.”

Looking at these cycles in the context of PG&E stock, a similar pattern emerges, but in this case, a pattern that impacted the financial viability of the energy provider. The North Bay fires of 2017 and the subsequent investigations concluded that the PG&E infrastructure was the cause of the fires and in under a year later, the Campfire in Northern California unfortunately led to 85 fatalities and PG&E ultimately announcing bankruptcy.

All industries need to be looking at science-based data and evaluating trends in important components of risk. In addition to the awareness of hazards on the horizon, the probability, the magnitude, and the duration of these hazards must also be calculated. It is with these predictive science-based tools that businesses can better understand their impact on nature and in turn, better understand nature's increasingly variable impact on their businesses.

How investment manager Mirova addresses natural capital

Rounding out the day one’s ‘Lean Back’ sessions, Philippe Zaouati, CEO, Mirova, spoke to the challenges of how investment managers can effectively address biodiversity through the firm’s strategy around natural capital.

Created seven years ago, Zaouati built the firm within with the French investment bank Natixis, as a company fully dedicated to responsible investment in financing sustainable development. Setting out with between three and four billion euros initially provided by Natixis, Mirova invested mainly in conditional equity and bonds before deciding to diversify and grow across different asset classes, using its ESG research team as the core of our investment processes.

Today, Mirova manages around €22 billion across listed, unlisted, and real assets. Within real assets the firm are large investors in the energy space including renewable energy, hydrogen, clean mobility and electrification of vehicles.

On the topic of natural capital specifically, Zaouati explained that five years ago when meeting with the Secretary General of the UN Convention to Combat Desertification (UNCCD), Monique Barbu, he was told that “the Convention wanted to create an investment fund dedicated to the restoration of land. Monique clearly didn’t want to create another ‘UN’ fund, but instead wanted to have the private sector really involved and the best way to do this is through the creation of a private investment fund.”

The UNCCD then made a request for proposal to which Mirova placed a bid, which Zaouati claims was a something of a guess. “To be frank, we at the that time had no clue about what investing in natural capital was, but our intuition was that what we had made in the energy space in the past, in addition to using traditional project finance tools to finance natural capital, was clearly something worth trying.”

Mirova was selected by the UNCCD and signed the partnership just before it was announced at the COP21 in Paris, 2015. While this was a significant step for the firm, it was only a few months later that they realised the complete lack of a structured pipeline of projects.

This realisation informed how Mirova was to spend its next two years: first, how to structure the fund itself and second how to build a pipeline. To build this pipeline Mirova engaged with various stakeholders, NGOs, corporates, commodities trading companies, governments, multilateral development banks, and partnerships with the European Investment Bank and Agence Francaise de Développement.

“Today, five years later a lot of things have changed, and we now have a lot of opportunities to invest even if this question of pipeline is still an issue.”

In terms of building out the fund’s structure, the key was to attract private money.

However, “in order to attract private money, the perception of risk by an investor is very high for these kind of investments as they feel these sectors are very risky. To a certain extent this is true – it is new, there is no maturity, there is no track record, it’s mostly in emerging countries where there is political risk, sometimes currency risk, and these risks must all be hedged.”

To attract investors the solution for Mirova is to de-risk where possible. The structure is simple, said Zaouati, with the fund allocating junior and senior shares, the former taking the around 20-30% of the shares which hold the greatest risk. These investors are generally governments or corporate foundations, while the majority of the investment comes from private donors looking for the more attractive, less risky, senior shares.

This fund, Zaouati stated, is now sized at around $200 million, and throughout the course of establishing its first natural capital fund, Mirova now manages additional funds to tackle other axis’ within the sector. These include sustainable agriculture and restoration of land, ocean conservation, and forest conservation.

“Today, while we of course see a lot of interest from institutional investors, we are increasingly seeing appetite from corporates. This interesting as corporates, like L’Oréal for example, don’t want to just buy carbon credits from the market, they want to create their own pipeline and projects in order to compensate and create their own carbon credits.”