Nature-related risk in financial services: NGFS framework will ‘reframe’ understanding

Hannah Brown of Pinsent Masons was commenting after the NGFS published a ‘beta’ conceptual framework on nature-related financial risks (22-page / 1.12MB PDF), which the body said is designed to “guide action by central banks and supervisors”.

The NGFS was established in 2017. The group consists of central banks and regulators from around the world that wish to voluntarily collaborate to increase their collective understanding of environmental risk with a view to developing consistent regulation to address that risk. The body is chaired by Ravi Menon, the outgoing chief executive of the Monetary Authority of Singapore.

The NGFS said the new framework will help central banks and financial regulators “assess the interactions between nature, the macroeconomy and the financial system in a way that is intended to be comprehensive and actionable” and that it could also “prove relevant to facilitate a dialogue with the financial sector about the identification, assessment and management of nature-related financial risks”.

Many businesses globally, including in financial services, are already familiar with evolving policy and regulation – and growing investor, customer, and consumer, expectations – on climate risk. Work undertaken by the Task Force on Climate-Related Financial Disclosures (TCFD) to develop a voluntary framework for disclosure of climate-related risks and opportunities by businesses has, for example, already been adopted, and adapted, into formal regulatory regimes in some jurisdictions. However, the broader concept of nature-related risk – which encapsulates climate-related risk alongside other environmental risks, such as to biodiversity – is expected to take on greater importance as it too is reflected in policy and regulation.

A catalyst for action in this area are commitments made by 188 governments at the UN Biodiversity Conference COP15 in Montreal, Canada, late last year. They committed to meeting a series of new targets by 2030, including the preservation of at least 30% of land and water considered important for biodiversity. According to the UN, just 17% of terrestrial and 10% of marine areas are currently protected.

The commitments were dubbed by prominent figures at COP15 as a “Paris moment for biodiversity” – a reference to the landmark Paris Agreement reached by global leaders in 2015 in respect of tackling climate change.

Consequentially, similar to the work undertaken by the TCFD, a Taskforce on Nature-related Financial Disclosures (TNFD) has also been working on a new nature-related risk and opportunity management and disclosure framework for consultation.

Brown said it is in this context of a plethora of emerging nature-related regulation, that the NGFS’ work should be viewed. Its paper sets out a common understanding of nature-related risk – including how the source of that risk can be categorised as either physical risks, which stem from the degradation of nature and loss of ecosystem services, or transition risks, which stem from a misalignment of economic actors with actions aimed at protecting, restoring, and/or reducing negative impacts on nature. The paper further reflects on economic and financial risks can materialise from dependencies and impacts on nature.

Brown said: “The NGFS’ nature-related financial risk conceptional framework will entail a re-framing of how companies and institutions understand nature-related risk, as well as environmental, sustainability and climate-related risk more broadly.”

“The framework proposes an iterative and dynamic process to integrating nature-related risk into operational processes, which could be challenging to integrate and quantify. This will entail a significant cost in terms of investment, resource, and time. It does, however, offer a more comprehensive view of a range of environment and social-related risks which will significantly mitigate risk in the long term. The NGFS accounts for a broader range of climate challenges than solely climate-related risk, which will inevitably affect all companies’ operations, and which are still only at a nascent stage of being integrated in operations,” she said.

One aspect of the NGFS’ framework that will be new to financial entities already familiar with climate-risk frameworks is the concept of “endogenous risks” – risks to nature emerging from financed activities. Brown said the framework encourages firms to consider how value-chain and financed activities not only affect their exposure to nature-related risk but how they contribute to exacerbating nature-related risk.

Brown also highlighted how the “nexus” between climate- and nature-related risk is reflected in the framework. She said this points to nature-related risk becoming a more relevant concept and trigger point for action.

The framework further emphasises the importance of forward-looking scenario analysis and understanding the interconnection of different risks throughout the value-chain and across a range of ecosystems which are impacted across geographies, Brown said – though examples of scenario-analysis are yet to be developed.

Brown added: “There are also opportunities in how climate mitigation and adaptation strategies, nature restoration and natural capital can be incorporated and considered as presenting trade-offs and synergies as the role of these net-positive areas grow. Entities will have to explore how to account and measure these, in areas such as biodiversity.”

“It will be crucial to think about how risk assessment and management and reporting will overlap with other emerging nature-related global disclosure guidelines – notably the TNFD beta framework which is being released in its final version this month, with many expecting to integrate TNFD by 2026, as well as the first two new sustainability reporting standards developed by ISSB which have effect from 1 January 2024 with first reporting against it expected from January 2025,” she said.

“Companies may be able to borrow from these other reporting processes, for example, from steps being taken to implement emerging regulations, such as the Corporate Sustainable Reporting Directive (CSRD). CSRD emphasises the concept of double materiality, asking companies to consider not only financial material risks but also material risks to the market, environment, and people. Double-materiality assessments are an example which complement the more nuanced and multi-faceted approach asked by the NGFS’ and TNFD frameworks, and may offer an opportunity to reduce the resource cost of implementing voluntary nature-related risk management frameworks,” Brown said.