Banking on Nature | From Climate to Nature Risk Scenario Analysis
Written by Sourajit Aiyer, Insight Contributor and author of the Banking on Nature series at In|Flow
Climate scenario analysis is fast becoming a key component of risk measurement and capital planning in the global financial sector. Financial institutions are re-defining analytical boundaries, selecting reference scenarios, assessing macroeconomic transmission, applying “what-if” logic to gauge the impact on the business-drivers of counterparties, and translate these impacts into credit risk metrics such as interest coverage ratio, risk ratings, probability of default, and ultimately the implications on capital charge.
The question that forward-looking financial institutions now face is to extend the same analytical approach to assess nature and biodiversity risk. Research by PwC shows over 50% of global GDP is moderately or highly dependent on nature, underlying its materiality.
The conceptual foundation for nature risk scenario analysis leans on the transmission logic used in climate scenario analysis. Variables such as risk in temperature, climate policy shocks, etc., transmits to macroeconomic variables such as GDP, inflation, prices, etc. This, in turn, transmits to counterparty-level variables such as revenues, operating costs, capex, etc., which finally transmits to financial risk elements like probability of default and ratings. Nature risk scenario analysis builds on this logic, but by replacing carbon emissions with ecosystem dependency and impact as the core risk variable.
Ecosystem dependency and impact imply the core variables in nature risk are more multidimensional. The Taskforce on Nature-related Financial Disclosures (TNFD), a market-led initiative to develop a disclosure framework for nature-related risks, and opportunities, categorises this under its LEAP approach (Locate, Evaluate, Assess, Prepare). In short, this asks reporting institutions to locate their exposures relative to sensitive ecosystems, evaluate their dependencies and impacts on nature, assess financial risks and opportunities, and prepare responses, using variables such as water withdrawal, land-use, deforestation, biodiversity destruction including habitats, pollution, soil degradation, ecosystem services like pollination, flood resilience with mangroves, amongst others. This makes nature risk extremely specific to the location and ecosystem-specific, and the use of geospatial data becomes a key enabler.
For financial institutions looking to extend climate scenario methodology to nature, they would need to:
1. Define the analytical scope and boundaries, whether it would cover the portfolio or specific exposures
2. Identify the materially exposed sectors that are highly dependent on ecosystem services, and business activities that have the most impact on nature
3. Select nature-related scenario pathways based on biodiversity regulations, water reforms, ecosystem degradation that disrupt supply chains, growing consumer preference for deforestation-free products, liability risk related to nature loss, etc.
4. Apply “what-if” analysis to counterparties, and assess how water pricing may impact operating costs, how a ban on deforestation-linked products may impact revenue or export, how soil degradation may impact long-term yield, etc., which translates into impacts on the borrowers’ revenue, capex, operating cost, hedging and insurance cost, and asset write-downs.
5. Adjust borrowers’ projected financials to reflect these impacts, thereby revising the cash-flows, interest coverage ratio, leverage, and risk rating. Since probability of default needs historical default data, nascent areas like this may use proxies like environment compliance failures, water disruption events, etc.
6. Stress-test for impact on capital charge, by applying worst-case shock scenarios to estimate potential provisions and erosion of capital buffer
Applying nature risk scenario analysis at the transaction-level could lead to appropriate adjustments in financial instrument design, including adjustments to exposure limits, tenors, moratorium, covenants, phased drawdowns, risk-pooling lending, or enhanced technical due diligence, to safeguard asset quality.
Aggregating these approaches at the portfolio-level could lead to the implementation of sector or location exposure concentration limits, improved capital planning for ecosystem-related shocks, higher relative pricing for nature risk-exposed exposures, and reallocation of capital flows to nature-positive sectors.
First-mover financial institutions may be better positioned to identify and capitalize nature-positive funding opportunities before markets start to fully price in ecosystem risk. Rather than wait for the perfect data, the initial efforts could start with work on sector prioritisation, geospatial mapping and qualitative-based stress pathways. These could always be progressively fine-tuned over time.
While some institutions have conducted exploratory biodiversity risk assessments, it is still in early stages.
For example, in 2020, the De Nederlandsche Bank conducted a systemic biodiversity risk assessment for the financial sector. This mapped the exposures of Dutch financial institutions to sectors highly dependent on ecosystem services and then assessed transition and physical risks arising from ecosystem degradation. It found a significant share of portfolio exposure to high biodiversity risk. The same year, Triodos Bank quantified the biodiversity footprint and sector-level exposure to nature-related transition risks to gauge the impact on its financed activities. This covered land-use, agricultural, and deforestation-linked activities, and led to outputs like portfolio-level biodiversity impact metrics and exclusion criteria.
In 2024, Barclays conducted a TNFD pilot on nature risk scenario analysis for its food and agriculture portfolio in Europe. It analysed physical and transition nature risk pathways, focusing on how ecological stressors, geographic dependencies and biodiversity impacts cash flows of counterparties, and financial impacts from physical ecosystem degradation and regulatory shifts due to biodiversity loss. It used the results to enhance its internal Client Transition Tool for farmers, which led to better identification of clients that needed support, and to update its Forestry and Agriculture Statement to tighten restrictions on clients exposed to significant deforestation risk, thereby reshaping its credit policy and underwriting.
That said, while the base analytical logic might be similar to climate scenario analysis, nature risk scenario analysis is far more complex. The granularity and quality of spatial data is key since risk depends on the specific location, multi-dimensional nature of risk variables instead of a singular carbon emission variable, and a greater degree of stochastic uncertainty in ecosystem degradation shocks.
In conclusion, the developments around integrating climate risk in financial systems demonstrates forward-looking analysis in these evolving areas of risk can be embedded into credit underwriting, portfolio targets, and capital planning. Nature risk extends that to the broader dependencies on natural ecosystems.
References:
BIS. (2022). Principles for the effective management and supervision of climate-related financial risks. Bank for International Settlements. https://www.bis.org/bcbs/publ/d532.htm
De Nederlandsche Bank. (2020). Indebted to nature: Exploring biodiversity risks for the Dutch financial sector. De Nederlandsche Bank. https://www.dnb.nl/media/4c3kz5bo/indebted-to-nature.pdf
Financial Conduct Authority. (2024). Nature-related Risk: Handbook for Financial Institutions. Climate Financial Risk Forum. https://www.fca.org.uk/publication/corporate/cfrf-nature-related-risk-handbook-financial-institutions-2024.pdf
Network for Greening the Financial System. (2019). A call for action: Climate change as a source of financial risk. NGFS. https://www.ngfs.net/en/publications/call-action-climate-change-source-financial-risk
Network for Greening the Financial System. (2023). NGFS climate scenarios for central banks and supervisors. NGFS. https://www.ngfs.net/ngfs-scenarios-portal/
PwC. (2023) PWC boosts global nature and biodiversity capabilities with New Centre for Nature Positive Business, as new research finds 55% of the world’s GDP - equivalent to $58 trillion - is exposed to material nature risk without immediate action. PwC. https://www.pwc.com/gx/en/news-room/press-releases/2023/pwcboosts-global-nature-and-biodiversity-capabilities.html
Taskforce on Nature-related Financial Disclosures. (2023). Recommendations of the Taskforce on Nature-related Financial Disclosures. TNFD. https://tnfd.global/publication/recommendations-of-the-taskforce-on-nature-related-financial-disclosures/
Taskforce on Nature-related Financial Disclosures. (2023). Guidance on scenario analysis. TNFD. https://tnfd.global/publication/guidance-on-scenario-analysis/
Triodos Bank. (2020). Biodiversity in focus: A strategy for the financial sector. Triodos Bank. https://www.triodos.com/articles/biodiversity-in-focus
WWF. (2020). Nature is too big to fail: Biodiversity – the next frontier in financial risk management. WWF. https://wwfint.awsassets.panda.org/downloads/nature_is_too_big_to_fail_en_web.pdf
