ESG Focus: Biodiversity Risks And Losers

ESG Focus | Oct 10 2022

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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

ESG Focus: Biodiversity risks and losers

Moody’s has estimated US$1.9trn in rated global debt is at risk from biodiversity loss, and it appears those responsible for the losses are expected to foot the bill.

-Moody’s lists sectors with high exposure to natural capital
-Vulnerable sectors and supply chains
-Dwindling tax subsidies a massive risk 
-Here comes the capital expenditure bill
-Quality of governance critical
-Global legislation and politics

By Sarah Mills

As FNArena outlined in Part 1 of its Biodiversity series, big capital is preparing to roll out biodiversity investment incentives and structures, which are expected to lay the foundations for a multi-trillion dollar investment opportunity. 

But with opportunity comes risk. And with winners come losers. 

In part 2 of this series, FNArena identifies the potential losers, the rising risks and the growing disclosure, taxation and regulatory nets that will be used to propel the market forward.

A Quick Recap

Biodiversity is being positioned as an overarching class of “natural capital” with strong overlaps with emissions and circularity (with climate change logically falling under the biodiversity banner given it affects ecosystems such as reefs and forests).

Natural capital refers to the fundamental “assets” of the natural world such as air, land and water that protect food production (from drought and pollinator loss for example) and ameliorate natural disasters such as floods. They include habitats such as wetlands, coastlands and forests.

Biodiversity has a broad remit, which encompasses emissions projects, water resources, oceans, forests, development, agriculture, recycling and so much more.

According to the World Economic Forum, US$44trn of economic value generation moderately or highly depends on nature, and big capital is moving to protect the asset base.

The Global Biodiversity Forum has identified a minimum annual funding gap of US$700bn going forward, and private and public sectors are expected to plug the gap, although this likely to refers to many opportunities that are only part or indirect biodiversity plays.

The Paulson Institute estimates the market for more pure biodiversity investment may hit US$93bn by 2030.

The kick-off date is mooted as late 2023 after the Task Force for Nature-Related Disclosures (TNFD) publishes its final draft on the matter, but major companies, such as Fortescue Metals ((FMG)) are already jockeying for position.

Vulnerable Sectors

Last week, Moody’s warned that nature-related financial risk for some industries is growing at an alarming rate.

The rating agency has identified nine sectors carrying US$1.9trn in debt with high or very high exposures to natural capital, and which face serious material financial risks.

These sectors are expected to face greater regulatory and investor scrutiny over the next few years.

Moody’s says another 24 industries holding US$9.6trn in debt have a “moderate exposure” to natural-capital risks.

Among the first category, Moody’s identifies coal mining, oil and gas, metals and mining industries; and companies dependent on “ecosystem services”, such as agriculture, protein, forestry, fishing and tourism; and chemicals.

Other analysts identify Real Estate; Mining and Markets; Chemicals and Materials; Supply Chain and Transport; Retail, Consumer Staples and Lifestyle; and Aviation Travel and Tourism.

The Financial Services sector also has a strong exposure to these sectors.

The five environmental categories Moody’s considers most material to credit include:

-carbon transition;
-physical climate risks;
-water management;
-waste and pollution; and
-natural capital.

Not even renewables are immuneAmongst  the various renewable technologies, offshore wind and hydro energy pose the biggest risks to biodiversity. Solar has the lowest footprint, again pointing to a solid future for the latter.

Finance sector tallying its exposures

Central banks around the world are already measuring the biodiversity exposure of their banking sectors.

The United Nations and TNFD have advised that the business and financial sectors “have a central role to play in shifting global financial flows from negative to positive outcomes for nature”.

Nederlansche Bank found in 2020 that 36% of its financial institutions were “highly or very highly” dependent on “at least one ecosystem service”. Banque de France had a comparable estimate of 42%.

One can only imagine that Australia’s score, with its economy weighted heavily to resources, real estate and agriculture, will be even higher.

Ratings Agencies Scope Out Risks

Last June, Moody’s outlined its raison d’etre in the biodiversity market: the dual facts that investor focus on biodiversity is growing and that biodiversity and natural capital credit considerations involve environmental and social risks.

Moody’s says there are two methods it uses to weigh natural capital risk: the impact companies, government and other entities have natural systems that can lead to direct and indirect loss of revenue; and the level of dependence these groups have on ecosystem services such as goods and materials derived from natural capital.

As of July, the agency’s controversies risk assessment screening had 540 active biodiversity-related cases.

It finds the top three-related ESG topics affected by biodiversity controversy include indigenous rights, social impact on local communities and fundamental human rights. (No. 4 is climate change).

Direct and indirect risks

Biodiversity risks include physical risks from lack of biodiversity (which can degrade land and affect water flows); litigation risk; transition risk; regulatory risk (see Westpac’s $1.3bn fine below); certification and contract risk; and systemic risk.

Last year, Citi proposed an Investor Framework For Biodiversity Loss and outlined credentials companies use to disclose risks and opportunities surrounding biodiversity loss.

“Biodiversity loss poses a financially material risk across asset classes, sectors and geographies and should be considered in parallel to climate risk in our view.”

The analysts finds that publicly listed companies with weak supply-chain management have below average ecological scores (no big surprise there), and that “monitoring supply-chain management can be a proxy indicator to identify ecological mismanagement”

“Similar to climate change, incidences of ecological impact are buried deep in supply chains. This highlights the need for traceable supply chains with transparent disclosures to help investors better evaluate company oversight and ownership but equally future opportunity”.

Sectors such as Consumer Staples and Materials have been identified for their impact on biodiversity, so Citi says companies that screen well now on biodiversity are likely to fare better from a risk standpoint given future regulation, reputational risk and litigation risk.

As an example of certification risk and direct risk facing agricultural services, the Roundtable on Sustainable Palm Oil suspended IOI Group’s certification in 2016 after receiving complaints of illegal deforestation. 

The body warned markets that this could disrupt supply of certified palm oil.

IOI Group’s share price dropped -18%, 26 customers suspended contracts and Moody’s placed the company on negative watch.

In May, 2021, 98% of shareholders in the global commodities-trading giant Bunge (one of the Big 4) approved a proposal from investment funds to implement biodiversity sanctions. It planned to undertake a “suspend then engage” approach to suppliers that contribute to deforestation.

It was also considering adopting 2020 cut-off date for soybeans grown in the Brazilian Cerrado region that is struggling with deforestation in a bid to discourage further deforestation. Such cut-offs are one tactic that could rein in the southern hemisphere clearing mentioned elsewhere in this article as a COP15 sticking point.

Subsidies Being Targeted

One of the first incentives off the rank is likely to be the reduction and eventual removal of subsidies that are harmful to biodiversity. 

The Global Biodiversity Foundation (GBF) has called for the redirecting, re-purposing, reforming or elimination of all incentive schemes linked with biodiversity harm reduction of at least $500bn a year.

Certain agricultural subsidies are worth 5x more than the capital that is currently deployed to save nature, reports Morgan Stanley in an April research paper.

It is broadly acknowledged that the fossil fuel industry relies almost entirely on public funding for its profits.

Transition risks

The biodiversity transition will come at a cost and these costs will need to be managed astutely to gain the best outcome for shareholders.

For reefs alone, investment will be needed for digital management, reduction in transportation and installation, and the use of sensors and acoustic technology to monitor fish populations, pollution and viruses in otherwise inaccessible marine locations.

Capital expenditure for exposed industries will be a key focus for investors going forward.

Post-2020, GBF identified a minimum annual funding gap of US$700bn and both public and private finance will advance this.

Some of this will represent upside, some of it downside.

Industries and biodiversity capital expenditure

Oil and gas midstream companies are expected to manage areas with conservation status, endangered species habitat, or other ecologically sensitive areas to identify and mitigate associated risks. 

Failure to do so could incur heavy fines and loss of shareholder capital.

Similarly, oil and gas services will be expected to manage land disturbances.

Engineering and construction services will be expected to report on water use, air emissions and biodiversity loss.

Renewable energy companies with solar and wind assets will be expected to develop quieter turbines and demonstrate a strong biodiversity strategy.

For agriculture, investors will expect companies to demonstrate strategies to reduce water use, improve habitat, and increase carbon content in soils.

In the meat, poultry and dairy industries, companies will be expected to: develop strategies aligned with conservation criteria; demonstrate an environmentally responsible approach to managing manure and litter; and address pollution problems posed by concentrated animal feeding operations (and calculate the percentage of protein from such operations). Innovation is likely to attract incentives.

The tourism industry will be expected to encourage sustainable tourism and demonstrate preservation of nearby ecosystem with the cruise-liner industry having a particular focus on marine protected areas.

Retailers and Consumer Staples producers will be expected to rein in single-use plastic and ensure products are sourced from sustainable supply chains.

Deforestation and Single-Use Plastic

Any industry with an exposure to deforestation, including in their supply chain, is likely to be particularly at risk. 

These industries include soybean, meat, palm oil, rubber, coffee, infrastructure expansion and mining; and their downstream markets such as Consumer Staples and Construction.

This is partly due to forest’s intimate connection with climate priorities. 

The permanent clearing of forests for non-forest use is estimated at 20% of greenhouse gas emissions.

Many countries have been burning forests (most of the world’s fires are not due to climate change as mainstream media would have people believe, but human activity) and are clearing land at an alarming rate in anticipation of the introduction of biodiversity measures.

Single use plastics are also expected to be targeted, but this is likely to be prioritized below emissions. 

When ithe time comes, industries at risk include Petrochemicals, Consumer Staples, Retailers, Building and Waste Management (an opportunity). Most Consumer Staples and Retailers are already preparing.

Biodiversity Key Governance Issue

Biodiversity is set to become a key governance issue.

Moody’s says that companies without credible management strategies and governance to deal with the challenge face serious financial repercussions.

Experts now recommend that boards add a Chief Environmental Officer role to the C-Suite with executive oversight of an environmental team.

Citi finds the proportion of ASX100 companies with biodiversity policies was 43% in 2020.

The Sustainability Accounting Standards Boards, which develops reporting standards for US companies, has developed a Sector Specific Materiality Map for Engagement on Ecological Impacts.

Boards, and their Chief Environmental Officers, will be expect to monitor and improve these metrics within their organisations.

This will require adequate disclosure, the identification, tracing and mapping of risks, the development of a strategy and processes for implementation, spheres of influence, and company commitments and targets.

Westpac’s ((WBC)) failure to maintain adequate internal money-laundering controls linked back to child sex trafficking cost shareholders billions and stands as an example of the potential costs that could arise for major corporations that fail to maintain proper internal processes.

Disclosure nets tighten reporting

Biodiversity reporting is built on similar models to climate modeling.

Climate Disclosure Standards Board’s Biodiversity Guidance was launched late last year. 

It aims to extend the Task Force for Climate Disclosure’s recommendations and its core elements to nature for adoption by the Task Force for Nature Disclosure next year.

At present, less than half of European companies refer to nature in reports.

In Australia, Citi notes that 144 Australian companies with revenue over US$1bn have signed up for Business for Nature.

The broker reports more than half of 76 such large companies without a biodiversity policy do not attract a Buy or Neutral Citi rating.

Legislation

Governments are regulating on biodiversity globally.

In June, the European Commission proposed a new nature restoration law with binding targets on pollinators, wetlands, rivers, forests, marine ecosystem, urban areas and peatlands.

The EC established a target to restore 20% of the bloc’s sea area by 2030 and all ecosystems in need of restoration by 2050. Roughly 25,000km of rivers are to be restored and the decline of pollinator populations is set to be reversed by 2030.

France requires all financial institutions to disclose biodiversity-related risks and climate-related risks. Europe also requires mandatory reporting from companies on biodiversity in sensitive areas under its SFDR.

Other EU legislation has targeted pesticides, setting a target to halve pesticide use by 2030, and a proposed laws to repair 80% of European habitats in poor condition by 2050, and to tackle deforestation and forest degradation globally.

This year, in the United States, the Federal District Court restored the Endangered Species Act regulatory protection to many species after an Earthjustice lawsuit succeeded in the vacation of former President Donald Trump’s 2019 ESA regulations.

In Britain, the Environment Act of 2021 determined all planning permissions granted in England (minus a handful of exemptions) will have to deliver at least a 10% biodiversity net gain, most likely starting in November 2023. 

And the green King Charles has ascended to the throne.

One of the first jobs of the Australian Labor government was to establish biodiversity certificate trading.

Political landscape

While late 2023 is mooted as the kick-off date for standardised reporting, much still depends on the political landscape.

The Ukraine conflict, the unseating of power broker Elizabeth Cheney in the US by Donald Trump partisans, China’s party elections, and latent covid discontent are all proving solid distractions.

And then there is Green grass-root politics.

Critics of the approach are quick to point out that one of capitalism’s strategies is to create problems so as to create a market for solutions. (As consistently evidenced, the world under the aegis of big capital has allowed problems such as single-use plastics and land clearing to spiral out of control.) They argue that there are more environmentally friendly methods to deal with these problems.

While these voices could influence a growing contingent of independent politicians globally, it is unlikely that the groundswell will hold sway.

Global and grass-roots politics may yet delay the biodiversity rollout but these projects have been decades in the making and big capital is committed.

The final article in the biodiversity series checks out the political context, the upcoming Conference of Parties on Biodiversity (COP15), standards, and existing and impending legislation.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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