Opinion – Pablo Acosta: The role of banks in managing financial risks related to nature

Like other countries, Brazil is being threatened by deforestation, climate change and the loss of biodiversity. This is one of the greatest threats to humanity. Considering that economies are ’embedded’ in nature, the loss of ecosystem services such as soil fertility, flood protection and erosion control can cause major losses and disruptions to economic activities.

These possible effects are usually evident initially in the negative repercussions for the financial sector. Biodiversity loss can affect the financial system in two main ways: physical risks, related to the impact of changes in natural capital; and transition risks, which derive from the process of adjustments towards a more sustainable economy.

Changes in the stock and condition of natural capital can have important consequences for companies that rely on nature’s ability to provide ecosystem services, with implications for financial institutions. At the same time, these institutions can negatively impact biodiversity and ecosystem services with their operations and investment decisions (a relationship known as “double materiality”). In this context, and while efforts to better understand the relationship between biodiversity loss and financial stability continue, it is important to build evidence of institutions’ exposure to nature-related risks.

A recent study by the World Bank examines how and to what extent banks are exposed to the risks of biodiversity loss in the Brazilian context, one of the most biologically diverse countries in the world, threatened, among other things, by deforestation and climate change. The research resembles pioneering work carried out in the Netherlands, France and Malaysia. Considering that the Brazilian financial system is bank-centric, the focus of this new report for Brazil is more on the banking sector than on the entire spectrum of financial institutions. The results, which are preliminary due to uncertainty around transmission channels and limitations of data and methodologies, suggest that the exposure of Brazilian creditors to risks related to the loss of biodiversity could be significant.

As of March 2021, the outstanding credit exposure of Brazilian banks was BRL 811 billion for non-financial companies operating in sectors with high or very high dependence on one or more ecosystem services. This amount represents 46% of the total non-financial corporate loan portfolio and 20% of the total loan portfolio.

Based on the historical sensitivity of Brazilian banks’ asset quality to macroeconomic conditions and macroeconomic modeling of ecosystem services, production losses associated with the collapse of ecosystem services could translate into a long-term cumulative increase in non-performing corporate loans of the order of nine percentage points, other factors remaining unchanged.

However, biodiversity and climate change influence each other. This means that Brazilian banks, which are already exposed to climate risks, may face the combined effects of the interaction between biodiversity loss, climate change and natural disasters.

In terms of transition risks, Brazilian banks have an outstanding loan exposure of BRL 254 billion, or 15% of their corporate portfolio, to firms potentially operating in protected areas. This exposure could increase to BRL 437 billion (25% of the corporate credit portfolio) if very high priority areas for biodiversity conservation become protected, and to BRL 664 billion (38% of the portfolio) if all areas priorities become protected.

Finally, for the 11 Brazilian companies, among the 143 listed on the stock exchange, for which there are records of environmental disputes, the banks had an outstanding loan exposure of R$109 billion (7% of the corporate loan portfolio) in December 31, 2019.

Due to the significant amount of money borrowed by Brazilian banks for potentially harmful projects and dependent on the provision of ecosystem services by nature, the prevailing practices of managing biodiversity-related risks in the banking sector present immense opportunities to prevent negative impacts on biodiversity.

The study’s findings have implications for both banks and the Central Bank of Brazil (BCB), which is the financial supervisor. Banks could begin to take steps to identify and measure their exposure to biodiversity loss with the aim of monitoring and mitigating any material risks arising from their loans and investments.

Banks could also adopt measures to disclose the impacts of their investments on biodiversity and demand the same from companies in their portfolios. In this regard, the recently launched Nature-Related Financial Disclosures Task Force could provide the appropriate framework.

The financial sector plays a key role in promoting the beneficial impacts of economic sectors on nature. The BCB, which in 2014 was among the first central banks in the world to require supervised entities to measure social and environmental risks, recently added a sustainability dimension to its institutional strategy. The sustainability pillar of its work agenda already includes initiatives that can have positive effects on the conservation and restoration of biodiversity.

Better management of nature-related financial risks would not only contribute to the safety and soundness of individual banks and the financial system as a whole, but would also help to decrease the flow of capital into economic activities that harm nature, thereby reducing the need for funding for conservation and restoration of biodiversity and ecosystem services.

Click here to access the version of this article published on the GlobalDev website. The authors are Pietro Calice, Senior Financial Sector Economist, Federico Diaz Kalan, Financial Sector Economist, and Faruk Miguel Liriano, Financial Sector Analyst, all from the World Bank.