Leading banks commit to Valuing Natural Capital Risk at Rio+20, but why, and how will this translate into action?
The CEOs of 37 major financial institutions announced that they would be integrating natural capital considerations into their products and services as a result of their commitment to the UN backed Natural Capital Declaration.
What is Natural Capital? Natural Capital is the term used to describe the value of the resources and flows of goods and services that ecosystems provide (e.g. water, climate regulation, and resources to produce food) which are essential for economic growth but have traditionally been undervalued or worse still, left unvalued.
What is the relevance to Banks? Banks signing the Natural Capital Declaration recognise the value of natural capital in underpinning wealth creation and therefore the global economy at a time when we face serious pressures on natural resources. McKinsey describe a megatrend at play in their Resource Revolution report. The world population is growing exponentially, expected to hit 8 billion people by 2030. At the same time we will have 3 billion more middle class consumers by 2030 in countries such as China, India and Brazil whose environmental footprints will grow hand in hand with their wealth. At the very least all these extra people will need feeding and WWF predicts that in the next 40 years we will need to produce as much food as we produced in the past 8,000 years...that places staggering additional demand on agricultural commodities and associated water and energy requirements. Add to this problem World Bank calculations that our current subsidization of natural resources amounts to $1.2trillion per annum, we see that this is an unsustainable situation and something has to give, and soon. Undoubtedly, there will be significant price rises and supply constraints. Trucost predicts a 450% increase in the price of wheat and McKinsey have predicted an 80% increase in demand for steel by 2030, well within the investment time horizon of pension funds and many project finance loans. The mega-trend will undoubtedly create winners and losers and companies will need to rethink their business models, product portfolios and procurement in order to adapt. Banks need to be able to identify these trends now in order to mitigate risk and optimise opportunity for themselves and their clients.
So what are the practical implications? The Natural Capital Declaration commitments focus on signatories building an understanding of their impact and dependency on natural capital, valuing that impact, embedding this understanding in their products and services and encouraging the reporting of natural capital in accounting frameworks. In order to do this, the starting point is for banks to calculate their own natural capital dependency, across their business operations, supply chains and services. To date their focus has largely been on the environmental impacts of banking operations, however this is inconsequential when compared to the magnitude of impact in their investments. A Friends of the Earth report Dirty Moneycalculated that only 1% of a typical bank's environmental impact is from their operations. It is also an area where banks face increasing pressure to improve transparency on the risk they face from their financing activities, as highlighted by the GHG Protocol move towards 'scope 3' reporting for financial institutions.
Trucost has been working for many years to help businesses understand where in their value chain their most significant risk lies through 'hot spot analysis'. We have recently extended this work to banks to help them identify key risk areas so they can focus their activities appropriately, for example it might transpire that 80% of the risk is in the corporate lending business in Asia and the domestic private equity business poses minimal risk.
Fig 1: Environmental risk analysis: a Bank
Once a high level risk assessment has been conducted, a deep dive analysis of high risk parts of the business is an obvious next step. A critical area of work is valuing the natural capital risk of the financing/investing activities. Key to our approach is that we not only quantify natural capital dependency in physical terms, we also put a price on it. By representing sustainability impacts in financial terms, we provide management teams with a robust framework to embed sustainability at the heart of business decision making and the ability to integrate that risk in financial valuations. When valued, the scale of environmental impact can be startling. A Trucost report commissioned by UNEP and UNPRI Universal Ownership found that the world's largest 3,000 companies create environmental damage valued at $2.2trillion or 11% of GDP, in line with similar studies such as that by the Chinese Academy of Social Sciences which values the total annual damage to China's economy from environment degradation is the equivalent of 9% of GDP. This of course has implications when investing in sovereign debt and other fixed income instruments as well as calculating the fair value of listed equities.
So what are the mechanisms for these costs being realised? In recent years we have seen a proliferation of environmental taxes and pricing schemes such as the European Emissions Trading scheme seeking to rectify the market failure in the pricing of natural capital and make polluters pay for the 'externalities' they create. Additionally there have been many instances recently where the price of natural capital, in terms of commodity prices, has had economic consequences for businesses. For example, a 2011 report by Ernst and Young Analysis of Profit Warnings found that 29% of profit warnings from companies in the FTSE were due to raw material prices rises. Work by Trucost on a Commodity Exposure Index has demonstrated that within an investment portfolio there will be a range in exposure to commodity price rises within sectors and regions and our analysis can therefore be used to quantify that risk and identify methods to reduce it.
Fig 2: Range in EBITDA at risk from 10% rise in commodity costs
Collaboration. Another component of the Natural Capital Declaration is collaborating with other companies to help them to value and account for natural capital in accounting frameworks so that the benefit of the learning spreads beyond the banks to their clients and the wider economy. Clearly risk reduction amongst the client base is good for banks as well as the planet and integrated reporting and full cost accounting have seen considerable support recently. A widely publicised example is Puma's world first Environmental Profit and Loss Account.
The commitment by some of world's leading banks to the Natural Capital Declaration is vital because for too long financial institutions have focused only on the relatively immaterial environmental impacts of their operations. To ensure the future health of the financial services industry it is critical that they take the type of step that Puma has. Because it is only once natural capital risks have been identified, valued and analysed that steps can be taken to mitigate risk and find business opportunities through new products and service to ensure they can remain competitive in the future.