Ignoring or paying lip service to natural capital could be disastrous for banks writes Keith Rovers, partner at Minter Ellison, in the second of a two-part series. For the first part, click here.
On top of quantifying the impacts of climate risk on loan books, assets portfolios and insurances lines, banks will also need to assess ‘natural capital’ impacts of its own footprint and that of its customer base.
Basically, this means putting an asset value on nature or the natural capital used in the supply chain – and thus a monetary value on a business’s impact on the ecosystem, which will likely mean taking a hit to corporate earnings.
Last year, National Australia Bank chair Ken Henry identified the role of clean air and water, energy, soil health and biodiversity to the healthy ecosystems, which underpin prosperous economies and argued that these 'services' are not traded in a market or captured in any system-wide accounting framework and, as such, are invisible.
To compound matters, in some instances our ignorance of ecological processes has sometimes led us to label natural capital assets as liabilities. Accordingly, we needed to design accounting frameworks which make these 'services' or assets visible and properly price and account for them.
Take the example of PUMA, the sporting goods group. In 2011, PUMA, published the world's first environmental profit and loss – which assessed water and land-use, greenhouse gas and air emissions, as well as waste production across its business and supply chain. They published a profit and loss account that put specific numbers on the environmental damage caused by the sportwear operations as well as its supply chain partners.
That report determined the 'cost' to PUMA of the natural capital used in its value chain at €145 million, a sum which would have wiped out a staggering 70 per cent of its 2010 profit.
In short, by giving the environment a financial value, the company discovered that the everyday actions of manufacturing sports gear and shoes meant PUMA faced enough charges to decimate earnings ... if it had to pay up.
Water, biodiversity, land
At its heart, a natural capital focus enables better pricing decisions and resource allocation - and a transition towards truly sustainable practices and companies and financing. Those company's which adopt best sustainable practice will be rewarded and those which don't will be starved of capital.
Possibly because NAB started out as an agri-bank, in 2011 it was one of the first signatories to the Natural Capital Declaration, a global agreement that recognises natural capital in supply value chains and the development of appropriate risk and accounting frameworks.
Consequently, the bank is currently involved in a multi-year project to recognise that natural capital is a core asset on its customer's balance sheet and to develop robust national accounting principles, which assign value to assets like water, biodiversity and land.
The adoption of the Natural Capital Protocol (NCP) and its industry sector guides launched by the Natural Capital Coalition (NCC), a global think tank in July 2016, is a key plank in this process.
These protocols seek to establish a broad framework and sector-specific guidance for measuring the direct and indirect impacts and dependencies on natural capital for particular industries. In 2013, the NCC valued the unpriced natural capital consumed by primary production and some primary processing sectors at US$7.3 trillion.
One environmental consultancy concluded that none of the top 20 industries would be profitable if environmental externalities were properly priced and accounted for.
The critical point to note, however, is that whilst the numbers are mind-boggling, ignoring the conclusions and failing to adapt is not a sustainable option. Like the whole climate change debate, the quicker we start to adapt the better.
Inevitably, sustainable companies and practices will grow and spread - they will be rewarded and the unsustainable fall by the way. They will be penalised by having capital denied to them and customers will shy away.
First mover advantage
For banks as lenders, investors and insurers, there is a first mover advantage in identifying those businesses which are ahead of the curve - those which are utilising global best practice in sustainable farming practices - who's skills and business models are scalable and profitable.
Similarly, identifying those industries/businesses ripe for disruption or destruction - where unsustainable practice can be replaced or selling out of those. Understanding the cash flow and balance sheet implications of natural capital usage for each of the underlying businesses is vital.
A draft finance paper released by the NCC in May will help banks to incorporate consideration of natural capital impacts and dependencies, and to better assess risks and opportunities, into their lending, investment and insurance practices and processes.
As such, banks should add another line item to their stress testing models and practices, as well as revise internal decision-making frameworks to factor natural capital into business decisions.
Natural capital asset management now needs to be considered alongside financial capital and climate change risk. So, for the banks, there is a major portfolio analysis and reshaping to be done across industries to identify the winners and losers - a similar exercise as with climate change risk.
They must also get up to speed with the protocol and the supply chain analysis of natural capital and how this feeds into loan books (to understand issues in the banking business), and review or create new financial products (or re-pricing products) which incentivises better natural capital usage by the borrower base.