Beyond climate: adopting a wider environmental approach

Views are my own

Climate and natural capital are front of mind for investors as never before. The long-term climate goal to limit the global temperature increase to 1.5oC was re-affirmed at the United Nations COP 26 Climate Change summit and since then, calls to make significant emissions reductions to meet this target have become more urgent. In turn, the COP 15 Biodiversity summit held last December resulted in the historic Kunming-Montreal Global Biodiversity Framework aiming to halt and reverse biodiversity loss by the end of the decade.

Increasingly referenced by scientists and policy makers are the two-way drivers and processes at play between climate change and biodiversity loss. Termed the “Twin Crises,” the interconnected nature of climate change with biodiversity loss is clear. Accordingly, adopting a holistic approach to tackling both issues can contribute more effectively towards meeting the global goals.  

Against a context of fast-evolving biodiversity metrics and reporting standards, investors are looking to integrate natural capital considerations within climate-focused portfolios as they look to effectively align portfolios with the sustainable transition.

Adopting a wider environmental approach in a ‘Century of Decarbonisation’

Climate has become a key area of focus for institutional investors who seek to mitigate climate transition and physical risk or to invest in green solutions that may contribute to the transition to a low carbon economy. Meeting this demand, there has been a significant rise in investment funds with a climate-related mandate, encompassing a variety of approaches including carbon reduced strategies, thematic investing (e.g. clean energy / technology), and green bonds.1

Europe is by far the most significant climate funds market, with almost 80% of these global assets, set within developing sustainable financial regulation including the 2020 Taxonomy Regulation and 2021 Sustainable Finance Disclosure Regulation (SFDR), aiming to provide increased transparency and reporting, and the 2019 EU Climate Benchmarks Regulation aiming to support the reallocation of capital towards a low carbon economy.

The 2020 Delegated Regulation specified minimum requirements for climate benchmarks methodologies, with the EU Climate Transition Benchmark (EU CTB) defining a benchmark portfolio decarbonisation trajectory, and the EU Paris-Aligned Benchmark (EU PAB) portfolio’s climate parameters requirements including the initial reduction in carbon intensity of 50% and a year-on-year self-decarbonisation of at least 7%, aiming to be aligned with the Paris Climate Agreement goal to limit the global temperature rise to 1.5oC above pre-industrial levels by 2050. EU PAB (and extended ‘PAB +’) strategies provide climate-conscious investors with a means to align with an established temperature pathway and to mitigate climate-related financial risks that may not otherwise be explicitly considered within a broad market universe.

These may include transition risks to companies associated with the move towards a low carbon economy including changing policy and regulations, as well as acute and chronic physical risks caused by extreme weather events and longer-term changes in climate patterns. To illustrate these risks, S&P Global Trucost cite that major global companies face up to USD 283 billion carbon pricing costs and 13% earnings at risk by 2025, under a high carbon price scenario. They estimate that 66% of major global companies have at least one asset at high risk of physical risk under the high impact climate change scenario in 2050, with the greatest risks coming from water stress and wildfire.2

However, with physical risks being all-too evident after the past year or so of extreme weather events including multiple heatwaves across the Northern hemisphere, and extensive flooding in South Asia and elsewhere, there is concern that current climate pledges are not enough to ensure Paris Agreement targets are achieved.

The World Meteorological Organisation’s latest global climate report3 makes for stark reading. The last eight years are the warmest on record and the ten year global mean temperature for the period 2013-2022 is estimated to be 1.14 oC higher than pre-industrial levels. This compares with 1.09 oC from 2011 to 2020, as estimated by the Intergovernmental Panel on Climate Change (IPCC)4.

The UN Environment Programme (UNEP) states that, with current levels of Nationally Determined Contributions (NDCs), global temperatures may reach 2.8oC by 21005.  Given the scale of the emissions gap, they state that urgent, and wide-ranging transformation is now needed to achieve net zero.

The UNEP call for the protection of remaining natural ecosystems as one domain of transformation. They highlight the impacts of deforestation on climate change, biodiversity loss and ecosystem services, with deforestation being the main source of emissions from land use and land use change, and reducing natural climate sink capacity.

More sustainably managing forests is also cited as a nature based action that can help mitigate climate change in a report by UNEP and IUCN6; nature-based solutions can deliver emission reductions and removals of at least 5 gigatons of CO2 per year by 2030, playing a significant role towards reaching the Paris Agreement global warming objective.

This brings us to the concept of environmental feedback loops, where wider environmental issues such as ecosystem loss impact climate change. Equally, climate change significantly impacts and accelerates the depletion of biodiversity. It is one of five direct drivers of biodiversity loss identified by the IPBES, who refer to indications that as many as one in six species may be threatened by temperature increases7.

Climate change and biodiversity loss are identified as two of the Planetary Boundaries that appear to have been crossed, in the framework which sets out that deterioration in thresholds beyond tipping points in these areas could increase the risk of highly uncertain impacts to the Earth’s essential ecosystem services that we rely upon, such as clean water and air. Natural capital focused solutions, including halting deforestation, are valuable tools towards reducing such systemic risk.  

Natural capital considerations

Reflecting the recognition of climate and biodiversity being inter-related Twin Crises, natural capital considerations including biodiversity, are a matter of increasing importance for investors. This may be especially so now in a more challenging market context, recognising the associated material risks.

Water is a good example. Water scarcity impacts almost two-thirds of the world’s population who experience severe water scarcity for at least one month each year, and as many as half the world’s population could be living in areas facing water scarcity by as early as 20258. The issue is compounded by the effects of climate change including drought. Investors may need to evaluate water scarcity risks including production issues and price volatility, regulatory and policy risks, and not least the impact that companies may have in terms of contributing to this or to other related issues such as water pollution, which brings reputational risks into play too.

The delays and modifications to planned production expansion at Tesla’s Berlin Gigafactory last year due to environmental and civic concerns about associated water shortages, illustrates the significance of water scarcity as a business risk, even in developed markets where water resource infrastructure may ordinarily be assumed as adequate.  

Indeed, in 2019, the Dutch regulator De Nederlandsche Bank (DNB) highlighted the aggregate exposure to EUR 97bn of companies at risk of ‘extreme water scarcity’ held by Dutch pension funds and other institutional investors9.

Increasingly, investors are looking to hedge such climate and natural capital risks. MSCI ESG Research point to this being a driver in the emergence of carbon credits funds which allow investors a way to price carbon risks in their portfolios and to protect against losses in the event that global climate targets are not met10.

New opportunities are emerging too. Established mechanisms to integrate climate and natural capital considerations as contributors to return, providing exposure to companies that make a positive environmental impact, are broadened by the development of relevant metrics such as those which quantify the green revenues a company may derive from alternative or renewable energy, sustainable water or agriculture; green patents development; or high management scores for key natural capital issues including biodiversity and land use, toxic emissions and waste, to mention just a few.

Notably, Clean Energy (including clean energy production or the provision of clean tech solutions including innovative climate adaptation technologies), is now the key ESG impact theme in the European ETF market in terms of AUM and net new assets, and ETFs aligned to SDG 15 – Life on Land, are working their way up the rankings11.

Incorporating natural capital considerations within portfolios can prove to be less than straightforward, with data points, tools and reporting in this space still being relatively nascent. However, we can see the development of some highly relevant environmental datasets to assess biodiversity impact, both negative and positive.

This has been enhanced by the increase in related financial regulation. The six environmental objectives of the EU Taxonomy include three related to natural capital, being the sustainable use and protection of water and marine resources; pollution prevention and control; and protection and restoration of biodiversity and ecosystems. The EU SFDR includes impact on biodiversity sensitive areas as a mandatory Principle Adverse Indicator (PAI).

Arguably more significant developments are the Sustainability Accounting Standards Board (SASB) framework, and the advent of the Taskforce on Nature-related Financial Disclosures (TNFD).

The fourth and final iteration of the TNFD beta framework was released in March, looking towards a comprehensive framework for nature-related risk management and disclosures later this year. The TNFD announced that their outlined approach to disclosure metrics, with a tiered approach of leading indicators, draws from existing standards, and aims for comparability across and within sectors, whilst acknowledging the differences in nature-related issuers across sectors and business models. The approach allows companies to signal alignment to global policy goals, such as the Global Biodiversity Framework, similar to climate reporting and alignment with the Paris goals. They also highlight how they have adapted climate reporting Scopes to the context of nature, as ‘direct’ operations, ‘upstream’, ‘downstream’, and ‘financed’.

Assessment of climate strategies is arguably easier than for natural capital-related investing, based on the commonly used measurement of reduction in GHG emissions. Nature-aware investing is more complex, involving many diverse considerations and being distinctively location-specific. However, the TNFD approach has been able to leverage that of the Taskforce on Climate-related Financial Disclosures (TCFD), for instance incorporating all 11 of the TCFD recommended disclosures into the TNFD final draft. With this type of alignment we might accordingly expect faster development for nature-based investing.

The Partnership for Biodiversity Accounting Financials (PBAF) sits alongside the climate equivalent, the Partnership for Carbon Accounting Financials (PCAF), having been developed by a coalition of financial institutions aiming to develop biodiversity, and GHG accounting methodologies, respectively, and thus enabling institutional investors to assess, manage and disclose impacts and dependencies on biodiversity and climate on their investments in a transparent way.

ENCORE (Exploring Natural Capital Opportunities, Risks and Exposure), a tool developed by the Natural Capital Finance Alliance (NCFA) in partnership with UNEP-WCMC, provides an extensive dataset mapping dependencies and impacts of production processes on ecosystem services and natural capital assets, covering all sectors of the economy. It includes essential natural processes such as pollination, with the tool enabling exploration of natural capital risks and helping investors to understand how businesses may be exposed to environmental change.

Incorporating the ENCORE database, and aligning with the approach of the TNFD, is the Nature Risk Profile methodology, announced earlier this year by the UNEP and S&P Global, a new methodology aimed at enabling the financial sector to analyse companies’ impacts and dependencies on nature. It’s positive to see such convergence in standards and alignment with best practice approaches as development of such methodologies advances. 

Iceberg Data Lab’s Corporate Biodiversity Footprint assessment tool assesses the biodiversity impacts of corporates, financial institutions, and sovereign issuers throughout their value chain, with the stated aim of supporting investment strategies in terms of portfolio or index development, exclusions and risk management, reporting requirements, stewardship and engagement policies. This is also aligned with regulatory frameworks and principles including the Organisation Environmental Footprint Guide of the European Commission; the Corporate Sustainability Reporting Directive (CSRD); and with SFDR.

Data metrics such as the MSCI SDG Alignment Tool may be more generally widely applied but encompass biodiversity considerations, assessing a company’s net contribution, both positive and negative, to the UN SDGs including SDG 13 (Climate Action), SDG 14 (Life Below Water) and SDG 15 (Life on Land).

It’s perhaps not surprising that goals including SDG 7 (Clean Energy) and 13 (Climate Action) have been found to be amongst those with the highest percentage of companies (8-9%) misaligned with the goals12. 

Such discrete considerations illustrate the diverse datasets that are now available to investors to suit a wide range of environmental objectives and preferences, and represent an opportunity to tailor climate-focused and natural capital-related investment accordingly. This data space is yet to mature and there is plenty of scope for refinement, but it is possible to use what is currently available in a meaningful way to assess nature-related impact.  

The TNFD carried out a landscape assessment and found more than 3,000 different nature-related metrics in use already today13. They highlight the need for standardisation to enable improved measurement, management and reporting of nature-related risks and opportunities, particularly for providing comparability across and within sectors.

As the sustainability transition progresses, natural capital data and methodological approaches will continue to evolve, become more standardised, and will be more comprehensively integrated within portfolio construction. This will help advance the significant opportunity that investing in nature-positive solutions represents for investors, both in terms of mitigating the risks of biodiversity loss and identifying the opportunities associated with advancing nature-positive outcomes.

________________________________________________________________

1 Refer to Investing in Times of Climate Change, Morningstar, April 2022, for more on the global landscape of climate funds

2 www.spglobal.com/esg/education/essential-sustainability/climate/physical-risks, January 2023

3 Provisional State of the Global Climate in 2022, World Meteorological Organisation, November 2022

4 Intergovernmental Panel on Climate Change (IPCC) Sixth Assessment Report, 2021

5 Emissions Gap Report 2022: The Closing Window - Climate crisis calls for rapid transformation of societies, UNEP, October 2022

6 Nature-based solutions for climate change mitigation, United Nations Environment Programme (UNEP), and International Union for Conservation of Nature (IUCN), November 2021

7 The Global Assessment Report on Biodiversity and Ecosystem Services, The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Sciences (IPBES), 2019:

8 Water scarcity, Addressing the growing lack of available water to meet children’s needs: Water scarcity | UNICEF

9 Dutch regulator warns of EUR 97bn ‘water scarcity’ risk, IPE, 23 January 2019: Dutch regulator warns of €97bn ‘water scarcity’ risk | News | IPE

10 ESG and Climate Trends to Watch for 2023, MSCI ESG Research LLC, December 2022

11 FlexShares research (# ETFs, AUM and NNA 1 and 3 years, according to theme), Bloomberg, January 2023

12 MSCI launches tool to help investors align portfolios with UN SDGs, ESG Clarity, September 2020: MSCI launches tool to help investors align portfolios with UN SDGs - ESG Clarity

13 The TNFD Nature-Related Risk and Opportunity Management and Disclosure Framework, Beta v0.2, June 2022