Sustainable Finance Live: How to value nature and better assess financial risk

On the back of the learnings gathered from Sustainable Finance Live’s opening case studies and panel Q&A, a raft of keynote speakers - representing organisations such as Elastacloud, Redsand Ventures, EBRD, Cervest, Federated Hermes, Verisk Maplecroft and Ashurst - drilled down into the challenges and opportunities associated with executing investments that effectively support biodiversity.

Biodiversity, natural capital, and ecosystem services

Indeed, supporting biodiversity is a critical mission for any environmentally conscientious investor. As explained by Richard Peers, founder, ResponsibleRisk, biodiversity - the variety of flora and fauna that exists in any given ecosystem - is key to maintaining the planet’s stock of natural assets, such as soil, air, water. Also known as natural capital, this stock of natural assets drives a wide range of ecosystem services that support human life: including the natural pollination of crops, food ecosystem productivity, and extreme weather mitigation.

As such, without sustained investment into biodiversity preservation, the delivery of ecosystem services will break down - threatening to not only create considerable financial risk in areas such as insurance and asset ownership, but to degrade human welfare in general. Indeed, “any sector you look at”, said Ingrid Kukuljan, head of impact and sustainable investing, Federated Hermes, “has some sort of dependency on nature that needs to soon be converted into a net-positive impact.”

Yet, before widespread progress can be made in this area, investors require investees to closely define the biodiversity and natural capital impact of any project in question. In the primary markets, investors can work with companies on this, and use science-based data and analytics to funnel their capital toward areas of low transitional risk. In the secondary market, however, investors are essentially “following the word of others”, noted Peers.

Unfortunately, reliable decision-grade data - gathered using calibrated and triangulated digital devices - which can, for example, quantify negative impacts across value chains, is less than abundant. This makes the ‘bankable’ case for nature continuously challenging - and the globe’s stock of ‘green’ investors, limited.

Once such investor, Mirova - represented at Finextra’s event by Philippe Zaouati, CEO - said it took them “five years, from start to finish, to build a fund that brought together all relevant stakeholders, in order to invest in [their] first major natural capital projects”.

Clearly, the true value of natural capital - which supports 50% of global GDP - “needs to be embedded into all financial models, so that externalities can be adequately priced in”, stated Maya Hennerkes, ESG lead financial intermediaries, European Bank for Reconstruction and Development (EBRD).

On the bright side, there are initiatives emerging that look to drive nature-related financial disclosure - and, in turn, preserve natural capital - such as the Taskforce on Nature-related Financial Disclosure (TNFD), pointed out Hennerkes. Due to launch early 2021, the TNFD will be tasked with delivering a framework to catalyse nature-related financial disclosure by the end of 2022.

There exists an alignment between the nature conservation world - which requires access to funding for its sustainable projects - and the financial world, which is eager to identify bankable sustainable projects to finance.

However, both worlds must ensure the impact of the project on nature - as well as the dependence of the project on nature - is quantified accurately, in order to facilitate the flow of long-term capital from asset owners to sustainable projects.

If biodiversity is to be preserved via large scale investment, projects themselves must demonstrate a strong business case, through traditional metrics like return on investment (ROI), minimum price variation (MPV), cost and risk. These remain fundamental to building a portfolio that effectively supports ecosystem services.

“Biodiversity investment is like insurance”, said Sebastian Mynott, Chief Operations Officer, Applied Genomics. “No one wants to pay for it, but we need to do it in order to protect ourselves against worst case scenarios.”

NFTs and challenges associated with natural capital credits

During the second workshop, industry leaders collaborated to discuss how while the financial services industry is keen to invest in projects that restore ecosystems and can sequester carbon, change must be compartmentalised and verified. These ‘units of change’, that could be produced, traded, performance-tracked and accounted for, are beneficial for landowners, their tenants or any entity that generates sustained revenues from land. Natural fertility, vitality and the value of land assets also needs to be considered.

However, a persistent problem is that ecosystem recovery, otherwise known as ‘rewilding’, is difficult to scale with current natural climate solutions. Further, it is cumbersome to create business models that enable land asset owners to transition towards what is referred to as ‘bankable’, nature-based, rewilding models, that can be linked to natural capital credits. Natural capital credits being carbon credits that demonstrate combined carbon, social and biodiversity benefits.

A non-fungible token (NFT) investment model could connect rewilding with investment models. Alongside this, NFTs could help solve the supply-side challenge that is associated with natural capital credits. Paul Jepson, nature recovery lead at Ecosulis, kicked off proceedings and echoed that while market demand for natural capital credits is growing, the supply of bankable projects is limited if we are to restore ecosystems. To address this problem, Jepson suggests “buying the rights to rewild.”

By introducing the ability “to rent the right to restore ecosystems,” Jepson believes that a portfolio of 30-year leases enabling financial players to rewild the land could become a bankable asset, one that could be invested in. “People are more willing to lease land than sell it. Leases also have the flexibility to deal with the complexities of land ownership, land tenure and so forth.” Jepson continued to explain that after a special purpose vehicle (SPV) has been set up and it has acquired the leases to rewild a portfolio of different areas of land, the ecological integrity of all land will need to be assessed.

Improvements will need to be measured on a scale, and it is this scale that carries the opportunity for conversion of units of change into tokens. In addition to this, rather than creating one token or remodelling, or scaling, from one instance, tokens can be split into different categories so that buyers can purchase stakes in rewilding projects. Where does the NFT come in? The token - which would be located on a permanent blockchain - would take the form of digital art. This art would be embedded with data on location, evidence of the state of the ecosystem and over time, changes occurring on the land in question, as mentioned previously.

A smart contract would provide the holder of the token with perks, usage rights and the ability to resell that token, Jepson explained. He reiterated that this would encourage organisations to invest in the social ideal of restoring ecosystems over a timescale of 20 to 30 years, with overarching aim of achieving climate neutrality through bankable projects.

Toni Caradonna, CTO, Porini Foundation, followed up and explained the connection between digitalisation, questioning what the impact of tokenisation would be on financial services. “As we get clawback over data - something that we lost with digitisation - this has made an impact on the intermediate role of banks. It is important that we see there is disruption, slow but happening, in this intermediary space. When we think of tokenising, it’s something I can invest in and get return on investment.” Caradonna continued to say that if it is to be considered a financial market tool, it must be regulated, compliant and not increase concerns around anti-money laundering.

Summarising, he added that it is of paramount importance to differentiate between the art market and the financial product market. On programming on the blockchain, Caradona stated that the smart contract must be programmed to ensure the project is bankable and uses an infrastructure that does not carry reputational risk.

Creating insightful data for effective decision making

Sustainable Finance.Live’s third workshop session centred on a core problem statement aimed at tackling the complex issue of scenario planning for financial services firms, to measure their exposure to biodiversity loss. Springboarding from the PG&E case study that Frank D’Agnese, President and CFO of Earth Knowledge had detailed during earlier sessions, the group was encouraged to hypothesise alternate courses of action it may take as company board members if it were in similar shoes to the utility provider (ahead of its demise) in 2017.

Structured around a series of poll questions, the group canvassed the fundamental challenges faced by financial services firms, more specifically their risk assessment boards, in order to consider the best paths available to mitigate their exposer to future losses from Natural Capital Risks.

Diving into a scenario on climatic water deficit, the moderator explained that while historically wildfire events have been tied to human incidents, the reality from data available (to this fictional board) in fact shows a pattern of this climatic water deficit. The board was asked to consider whether it would act on this data to manage and monitor the situation more closely, or, to wait and see.

Immediately, the panellists were prompted to address the challenge of reputational risk, with institutions having to weigh up the pros and cons of acting early verses waiting to see if acting on the risk is worth saving both the financial and reputational cost.

On this, Katie Henry, senior manager, EY commented that “reputational risk is becoming a really important aspect for all institutions in the modern world, where information travels more quickly and can also be misconstrued reputation impact. We're increasingly seeing organisations consider natural capital risks and how they interconnect with their reputation and are therefore turning down investment opportunities and potential loans to different organisations as a result.”

The idea was echoed by global sustainability partner at Ashurst, Anna-Marie Slot, who noted that one of the core challenges of sitting on a board is trying to make strategic decisions with less than perfect information. This in the real world tends to lead to people “guesstimating their true impact.”

Having accurate data for the board to use for this decision making allows them to see the potential costs of different routes. Slot furthered that “cost is the hardest thing for boards to assess - ‘what am I avoiding by doing what I’m’ doing right now?’”

She explained that this is happening in climate right now, as people have realised the cost involved, and seeing this cost alongside data is where it affects boards directly. Not acting on this kind of information is where the reputational impact and potential ramifications come into play.

On the ability to make effective decisions, Alex Money, managing director at OXFORDEO qualified that the idea of data is somewhat fetishised in these conversations. He commented that “what we need is the ability to made good decisions, that’s what the board is there to do. You may get an influx of environmental risk data or governance data - some of which is inherently contradictory or at least suggesting that organisations could follow a range of different paths.”

“That piece of taking data to the decision-level insight remains a poorly developed part of the puzzle and I think that the infrastructure need to be in place for people to make better decisions,” Money continued.

Organisational friction was raised as a core hurdle toward improving decision making, particularly given the challenge that those with the relevant data and information tend to sit many levels below the board in institutional hierarchies. Additionally, each level or individual within the hierarchy layers may not be motivated to push through certain information that does not impact or benefit their personal compensation structure or KPIs.

This ability to make informed decisions at the board level demonstrates a need to reset this structure. David Cox, sustainability lead within Microsoft, noted that “across the whole ESG spectrum there is a tendency to look at things in silos rather than to focus on the risk implications of the interrelationships between them. The consequence of that is that we often end up missing the whole story.”

Further, Cox argues this results in situations where we are presented with binary choices, whereas in reality, the world is far more complex, “we therefore tend to miss out on some of the options and strategies that we can possibly pursue…It’s really important to look across the whole ESG stack, not analyse data in terms of individual silos or approach these opportunities in terms of individual projects, but to think about the risk implications of the interrelationships between them.”

What is tangibly helping from a board perspective? Slot believes it’s important to that sit down with good information and having an awareness that the past is not indicative of the future. This allows them to challenge their current approach and think critically about how processes are responding to the information being received.

As Christophe Christaen, sustainable finance lead, Satellite Applications Catapult pertinently observed, even the process of attempting to translate data into insightful information represents a challenge, as the process tends to simplify things down by removing certain inherent complexities. This can have the added detriment of creating binary options when in fact there are many more options that are not explored.

Translation of data into more insightful piece of information is essential for boards to make effective decisions, but in addition, it is also time to upskill senior members of the relevant risk teams and boards to be about to understand the complexities of the situation.

Rounding out the session, Money added that “Specificity is everything, and the challenge and real opportunity for service providers, is to figure out how to take from the specific, the value of the general. This is the level where boards and so forth operate.”

“There's this huge incipient opportunity to move from these really granular, highly spatially resolved models, to something that is then decision ready at the scale of the asset and the skill of the entity… Until and unless there is much greater granularity available about what the assets in these companies are, where they are located, and what are the risks that they are exposed to in the context of the push to specificity. A lot of this other stuff becomes quite difficult.”