INSIGHT: Fixed on Natural Capital

After the first wave of research in the 90s and first few years in the new millennium focused predominantly on the economic value of nature to convince governments and businesses alike to take this issue more serious, a second large wave of research that has started to emerge over the past few years focuses on ‘hidden’ environmental and natural capital risks that companies and countries are exposed to. This type of message is more receptive for equity and bond investors.

Although the notion that nature provides valuable ecosystem goods and services that represent a certain economic, ecological and social value is true, in many cases it has not provided a sufficiently strong financial argument for many businesses – including in the financial sector - to change their business model accordingly.

As our natural capital continues to be factored out of our economic and financial models, whether in terms of pure financial accounting on corporate and country level or factored in credit risk model by financial institutions, degradation continues unabated. Economists for example estimate forest loss alone is eroding natural capital and ecosystem services valued at US$1.2 to US$4.7 trillion per year.

But there is a glitch that companies and investors alike need to be aware of. Whether or not we accept the notion of nature exhibiting an economic value, weather extremes, resource and water scarcity are starting to affect markets in a myriad of ways. It is paramount that we understand, uncover and price these hidden risks that can be potential significant for investors depending on their holdings.

A recently released report by the TEEB for Business Coalition and Trucost estimated that sectors like coal power generation in Eastern Asia, cattle ranching and farming in South America and iron and steel mills in Eastern Asia are responsible for USD 889 billion of externalized environmental costs to society. In some of these cases revenues dwarf the externalized costs, meaning that companies in these sectors in these regions make less money than they create in terms of environmental impacts. This is relevant as portfolio investors might experience a reduction in overall returns due to these externalities adversely affecting other investments in the portfolio and overall market return through taxes, insurance premiums, physical costs of disasters, etc.

A recent report by the organisation CarbonTracker compared the amount of available carbon we are able to burn to likely stay within a 2 degrees Celsius scenario (compared to pre-industrial temperatures) with the amount of listed oil, gas and coal companies reserves. The research concluded that 60 – 80% of these proven fossil fuel reserves will not be able to be used if we are to stay within the 2 degrees Celsius scenario and avoid catastrophic climate change. Eventually this need to reduce greenhouse gas emissions to secure a stable climate poses an ever increasing regulatory risk as politicians need to take decisive action to limit fossil fuel combustion, with the likely knock-on effects on the market valuations of exposed coal and oil companies in particular. The magnitude of the risk in question has been enough for some investors to divest from the most exposed companies.

Although the majority of research has focused on the materiality and relevance for equity investors, debt investors may be equally or even more exposed to these emerging risks. Equity investors are interested to know whether environmental and social factors can lead to under-performance or over-performance of a company’s revenues and profits, and therefore affect a stock negatively or positively. They are primarily looking for growth and are ready to assume a fair amount of risk. Fixed income investors are more concerned with risk reduction as opposed to return enhancement.

Sovereign bond markets are particularly interesting in this respect. Outstanding sovereign debt has ballooned in recent years as governments borrowed heavily to power their economies. Global outstanding public debt surpassed USD 40 trillion at the end of 2010. The new Basel III rules will put further pressure on investors buying highly-rated sovereign debt. At the same time a recent project by UNEP FI, Global Footprint Network and a number of investors and banks provided insight in the natural capital risks that are currently unaccounted for. The analysis of the E-RISC (Environmental Risk Integration into Sovereign Credit analysis) project concluded that changes in commodity prices and ecosystem degradation can affect trade-related GDP by up to 4% for the countries researched. This is clearly a red-flag for any investor that fails to factor this in the pricing of sovereign debt securities.

These are just a few examples of the recent explosion in research on hidden environmental risks resting on someone’s balance sheet. While environmentalists used to speak a different language than companies in the private sector or investors on Wall Street I believe the gap in language, and perception of what is at stake is closing. The World Forum on Natural Capital (Edinburgh, 21 – 22 November), the UNEP FI Global Roundtable (Beijing, 12 – 13 November) and the Responsible Business Forum on Sustainable Development (Singapore. 25-26 November) will be some of the prime forums this year which aim to bring together the key players of leading businesses and investors to discuss how this type of data and information can be factored in the way businesses make decisions and investors factor such information in credit risk models of equity and debt securities.

Ivo Mulder founded the Natural Capital Declaration and leads UNEP FI's ecosystem, water and biodiversity programme and will be speaking at the World Forum.
UNEP FI's Global Roundtable is a network partner of the World Forum.

Photo Credit: Financial District by Kole