How can we embed nature risks in investment decisions?

Nature-related risks are rising up the agenda, driven by regulatory developments such as the Corporate Sustainability Reporting Directive (CSRD), European Union Deforestation Regulation (EUDR) and Corporate Sustainability Due Diligence Directive (CS3D), and voluntary initiatives like the Taskforce on Nature-related Financial Disclosures (TNFD) and Science Based Targets Network (SBTN). At the same time, there is growing debate over the availability and usability of company-level nature data and metrics, and whether they are fit for capital allocation decisions.

For example, data at the individual asset level may not always provide the necessary granularity on factors such as location or associated supply chains. In some cases, the data needed to make investment decisions may need to be sourced from multiple data providers and stitched together. And with limited time and resource, how should investors decide what financial material risk to focus on?

“The roundtable discussion focused on whether the current data and tools for portfolio assessment can meaningfully inform financial materiality estimates and investment decisions. And if not, what is needed to close the remaining gaps.”
 

Against this backdrop, the roundtable discussion focused on whether the current data and tools for portfolio assessment can meaningfully inform financial materiality estimates and investment decisions. And if not, what is needed to close the remaining gaps. The discussion was centred around three key points: institutional investor needs; accelerate collaboration; and financial materiality.

Institutional investor needs

An emerging trend within institutional investors, especially asset owners and pension funds, is the need to consider nature risks alongside climate risks, and the inextricable link between the two. The protection of nature is necessary to achieving climate resilience, and there is a requirement for tools and data sources that encompass both. Indeed, climate change scenarios don’t currently embed nature-related factors and assumptions.

Furthermore, institutional investors face the challenge of balancing the short-term with the long-term, as they do with any other investment risks. For example, what steps can be taken to mitigate short-term risks, such as droughts, with the knowledge that large changes (and the associated risks) are also on the horizon. A holistic consideration of the risks over both timescales requires sufficient data. 

Accelerate collaboration

There is a need for better collaboration across the industry, in order to accelerate the journey towards investment-grade nature metrics, that can be used to inform capital allocation decisions, leveraging from the learnings the industry gained with climate. Not only within financial services businesses, but also in partnership scientific researchers and regulators. 

Research into the effects and impacts of nature degradation are continuing apace, in what is still a relatively nascent area of science. Collaboration with the scientific community will be key to staying abreast of these developments, and working towards a place where investment decisions can better integrate nature-related risks. Regulation also acts as a powerful level for demonstrating the financial materiality of nature risks. However, it is notable that the state of nature is currently poor because, although regulations are moving in the right direction, they simply aren’t moving fast enough.

There is also the need for internal collaboration within the investment industry, in order to improve awareness of nature-related risks outside of nature ‘bubbles’. Investment approaches that are run without a sustainability or ESG lens are less likely to consider the financial materiality of nature risks. In such instances, it is prudent to ‘speak the language’ of the investment decision-makers, translating nature risks into the likes of operational, regulatory or credit risks, in order to demonstrate the potential impact on the bottom line. Of course, doing so requires access to the correct tools and data. 

However, we must also consider how best to balance the simplicity of the data chosen, with the complexity of the science itself – especially as it is still evolving. The world needs consistency, but complexity can’t be the enemy of good.

Financial materiality

It is important to consider the financial materiality of nature risk over both the short and long-term. While it is not difficult to construct a compelling narrative about why nature risks will be financially material in many circumstances, these insights must be quantifiable and data-driven to gain the attention of investment decision-makers. 

This can present difficulties, as making the link between nature risks and cashflows isn’t currently common. However, plenty of examples can be found – for example, generating alpha from divesting high risk companies prior to a negative nature-related impact occurring. We must also acknowledge that the financial impacts of nature risks may often be small. The risks can also be very specific, relating to a particular geographical region or nature-related dependency. The concept of net impact was discussed, where gross calculated materiality is ‘netted’ by nature-relevant mitigation plans put in place, such as access to desalinated water in areas of high water stress. 

Embedding nature-related risks into investment decisions will require a concerted effort across the financial ecosystem, from investors, data providers, scientists, and regulators alike. While challenges remain around data quality, granularity, and usability, progress can be made by aligning tools, language, and collaboration with investment colleagues to explore the investment alpha that lies in investments that are impacted – or dependent by ecosystem processes.