Evidence increasingly tells us that environmental challenges like weather extremes, water scarcity and ecosystem degradation can financially affect compa­nies in different sectors. The development and testing of analytical tools that assess how environmental risks affect standard financial metrics, such as EBITDA, could allow credit analysts, rating specialists and portfolio managers to factor excess envi­ronmental risk into the cost of capital for firms borrowing money.

This is important, as our dependency and impact on the Earth’s natural capital are becoming increasingly material. Wa­ter, for example, can be a vital element of a company’s production processes. The Brazilian water firm Sabesp saw the out­look on its rating changed by both Moody’s and S&P due to drought in Brazil. S&P has stated that the environmental costs of wa­ter use and infrastructure will increasingly be included in water pricing in the United Kingdom.

A 2010 study from the World Resources Institute showed that 79 per cent of the planned electrical generation capacity in India – amounting to 60 gigawatts, much of it relying on water for generation and cool­ing – will be built in areas that are already water scarce or stressed.

And it’s not just companies that are vul­nerable; countries are equally impacted. A study out of The Economics of Ecosystems and Biodiversity (TEEB) initiative calculat­ed that welfare loss due to ecosystem degra­dation through ‘cost of policy inaction’ will equate to about $50 billion (U.S.) by 2050.

The Environmental Risk in Sovereign Credits (E-RISC) project has taken that analysis a step further. It is looking at the potential materiality of natural resource and environmental risks in the context of sovereign credit risk analysis. The results of the project’s first phase found that a 10 per cent variation in commodity prices leads to changes in a country’s trade balance equiv­alent to between 0.2 and 0.5 per cent of a nation’s GDP.

These studies are helpful to raise aware­ness, but banks, investors and rating agen­cies need a way to systematically factor these issues into the way bonds are priced and rated.

Analytical tools, the missing link

Missing in the marketplace have been analytical tools that can factor environmen­tal risks into a company’s future financial performance. Historically, the lack of com­parable ESG (environmental, social and governance) data across and within indus­tries on a temporal and spatial scale, and the inability to link it with financial data provided by Bloomberg, Thomson Reuters and others, have proven a major barrier.

The good news is that organizations like CDP and the Global Reporting Initiative, which seek increased disclosure of ESG data, have helped bring richer databases to banks and investors. This has given mo­mentum to the Natural Capital Declaration (NCD), a CEO-endorsed and finance-led initiative launched in 2012.

The initiative, which is aimed at main­streaming the integration of natural capital considerations with bonds, equities, loans and other financial products, has embarked on a number of pilot projects that focus on developing practical analytical tools for fi­nancial institutions.

The tools are being designed to quantify how specific changes to natural capital ele­ments, such as water availability and defor­estation risk, can affect the financial perfor­mance of companies that either depend on these resources or have significant impacts on them.

Two NCD pilots aim specifically to de­velop and test tools for corporate and sov­ereign bonds. The first is a “Corporate Bond Water Risk Tool,” which investors can use to assess how water scarcity in certain sectors affect the credit quality of corporate bonds. The second builds on the E-RISC project by modelling a forward-looking range of potential economic impacts that countries are likely to face due to the changing avail­ability of and demand for renewable natural resources. It will also estimate the potential effect on a country’s sovereign credit rating.

How does this empower bondholders? A company that is increasingly facing water stress – that is, there is a growing gap be­tween demand and supply of water – could be faced with higher operating costs or ad­ditional capital expenditure, such as the need to build a desalination plant.

A higher debt-to-EBITDA ratio can undercut a firm’s ability to make timely payments to bondholders. Using the new analytical tools, the potential effect of water scarcity on default risk could be modelled and – if applied – could affect the credit rating of companies and, subsequently, the coupon on interest that needs to be paid to cover any additional risk for newly issued bonds.

Water risk is just one example. Analysts and rating specialists would have a way to model how a range of environmental risks might affect the value of a bond. If such tools are mainstreamed, bondholders could become principal drivers of sustainability by pricing unsustainable (or more sustain­able) corporate and governmental practices into the cost of capital.

Given that the bonds market is about twice as big as the combined value of the world’s stock exchanges, the importance of such tools in the context of sustainability cannot be overstated.

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The NCD was borne from the fact that, unlike climate change, natural capital is largely unaccounted for by banks, investors or insurance firms in their products and services. Nature underpins global wealth creation. The renewable flow of goods and services provided by the earth’s ecosystems buttress our economy and yield benefits for business. But this stock of ecosystems – also known as “natural capital” – is largely invisible in financial decision-making. As a result, natural capital does not appear on the balance sheets of businesses and is largely unaccounted for in financial products.

Take, for instance, an investor in London, Shanghai or New York who finances a palm-oil development scheme in Indonesia or Africa, resulting in clearance of a large area of natural tropical rainforest. The dependency on and impacts of this investment on climate, food, energy, water and livelihood security are unlikely to be included in the cost of capital or debt, credit ratings on fixed income products, investment analysis or insurance premiums. Most finance institutions still do not believe that natural capital is material to their bottom line. In addition, for many types of financial products there are (at present) no metrics available to incorporate it into credit risk.

The aim of the NCD is to mainstream the systematic integration of natural capital considerations in loans, fixed income, equities and insurance products, as well as work towards embedding natural capital in corporate accounting and reporting frameworks.

The UN Environment Programme Finance Initiative (UNEP FI) and Global Canopy Programme (GCP), who jointly manage the NCD, will soon launch the NCD Roadmap and Business Plan to kickstart Phase II of the project. The project is seeking US$2 million over a three year period from the private sector, governments and foundations for full implementation.

What are our objectives in the next three years? First of all, we aim for the NCD to be an operational initiative that develops practical tools, frameworks and metrics that finance institutions can use to integrate natural capital – alongside other material ESG factors – into their own organisations.

The Environmental Risk Integration in Sovereign Credit analysis (E-RISC) project that UNEP FI and Global Footprint Network initiated in association with fifteen banks, investors and information providers is a good example of natural capital applied to a specific asset class: sovereign fixed income. It showed, for the first time, that natural resource and environmental risks are financially material to sovereign credit risk analysis. This topic was also the focus of the Corporate Knights ‘Global 100 – Executive Roundtable Dinner’ in Davos earlier this year. The NCD implementation phase aims to start similar types of projects focused on developing metrics for other asset classes such as corporate fixed income, various insurance lines and private equity, among others.

The second objective of the NCD is to increase the number of endorsements by financial institutions to build an even greater commitment in the sector towards taking action based upon the material importance of this topic.

Four working groups have been formed to design methodologies to implement the four core commitments of the NCD that endorsing CEOs sign up to. These are:

• Understanding: Build an understanding of the dependencies and impacts of natural capital within a financial institution’s operations, risk profile, etc.;
• Embedding: Integrate natural capital considerations into financial products and services – including loans, investments and insurance policies;
• Accounting: Work towards building a global consensus for the integration of Natural Capital into private sector accounting and decision-making; and
• Disclosing/reporting: Work towards a global consensus around the development of integrated reporting, which, includes natural capital.

A number of challenges still remain. Given that a considerable part of economic growth is likely to come from emerging markets, it will be especially important to convince finance institutions based in emerging markets to sign up to the NCD. Second, it is crucial to show how systematically embedding natural capital factors into financial products can go hand in hand with having successful business models. Even though there is an obvious need to better account for the value of ecosystems in our global economy, the current economic climate makes this particularly challenging. For many banks, the foremost focus is on shoring up their balance sheets, which makes it difficult to point them to the medium- and long-term horizon where environmental constraints will affect their bottom lines. The early response from endorsing financial institutions has been encouraging, but greater institutional support will be needed for this to become mainstream.

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