EU Nature Value at Risk Facing the Banki

EU Nature Value at Risk Facing the Banking Sector

Source: European Central Bank: Occasional Paper Series No 380, Chart 3

As biodiversity loss and shocks to ecosystems increase due to climate change, there are more impacts than just what meets the eye. Nature Value at Risk (NVaR) evaluates shocks within ecosystem services and how these issues impact production, supply chains, and credit exposure.

NVaR dives into endogenous risk and displays the negative impacts of economic activity financed by banks, and how this financing contributes to ecosystem issues that make losses worse. NVaR evaluates the risks associated with natural disasters, ecosystem decline, and biodiversity loss and displays how these issues impact businesses and finance.

Thank you to ECB Occasional Paper Series No 380 for the data provided used in this analysis.

Why Nature Value-at-Risk Matters

Water Scarcity: Water risks, such as water scarcity, has the potential to completely disrupt approximately a quarter of the euro area’s economic activity.
Agriculture: Agriculture is significantly at risk, with output losses facing up to 40% in response to the severity of a drought.
Supply Chains: As half off nature related risks are created outside of the EU, demonstrating the EUs reliance on global supply chains and worldwide ecosystem health.
Banking exposure: Banks lose money when ecosystem issues impact lending, and water scarcity is a significant risk within real estate and construction.
Endogenous risks: Bank portfolios depend on ecosystem services while simultaneously harming those services, thus, long term systemic credit risk increases.

Nature Value-at-Risk: Introduction

The application of the NVaR framework to the EU banking system demonstrates an organized and detailed approach to quantifying shocks to ecosystem services. The goal of the NVaR framework is to implement nature-related risk through the linkage of biophysical shocks and ecosystem services as inputs for production models within a specific sector. NVaR provides a consistent assessment of financial issues that stem from the risks of biodiversity loss.

Additionally, the NVaR framework acts as a mechanism to aid both businesses and banks in understanding the impacts of the environment on finance. Nature risks impact economic outcomes which allow companies, financial institutions, and other organizations to practice resilience by protecting themselves against future financial losses.

Nature Value-at-Risk: Three Pillars

The three pillars of the NVaR are:

Capturing direct/indirect physical nature risks.
Modeling financial impacts regarding regulatory and market shifts.
Applying probabilities and financial values to risks associated with nature over a forecast time horizon.

The NVaR is extremely relevant to policy makers and financial decision makers.

Both of those roles intertwine. The NVaR is important for all corporations, banks, shareholders, lenders, and other stakeholders to understand.

Nature Value-at-Risk: Calculation

Source: ECB Occasional Paper Series No 380, pp. 11-12

The metric for the NVaR shown above addresses three main measurements:

Hazards: Location c and ecosystem-service specific e demonstrated hazard score HSe,c, which effectively merges the probability of ecosystem service degradation.
Exposure: monetary number of sectors and production systems s exposed in countries along with spatial dispersal of assets/exposures ESs,c.
Vulnerability: Production systems and their output and services vulnerability to loss of biodiversity and degradation of ecosystems. This is shown within countries and also among supply chains within these countries as the vulnerability score VSc,e,s.

Nature Value-at-Risk: EU Economic Risks

Nature and the economy are never ending businesses partners. Global ecosystems are tied to the economy and the humans within that economy.

Nature risks create economic obstacles, but the strongest are water-related issues that stem from degraded ecosystems.

The European Central Bank published a nuanced monetary policy response to climate change and nature degradation concluding that half of the global GDP relies on biodiversity, demonstrating the urgent need to think ahead of the looming financial impacts of ecosystem degradation.

Unsustainable production has increasingly put pressure on the EU, as issues like resource exploitation and pollution contribute directly to biodiversity destruction. In terms of land use, forests and mountain ranges are subject to increased pressure as a response to unsustainable land-use practice.

Monocultures, pests, and fires are all examples of ways land can be negatively impacted by unsustainable practices.

Nature Value-at-Risk: Water

NVaR can be used to partially address water risks. To start off, 38% of surface-water bodies demonstrated proficient ecological status, with only 30% having proficient chemical status. Chemical status within a body of water is affected by pollutants, specifically mercury.

The EU economy depends the ecosystem services supported by healthy, functioning hydrological systems. Water services, like surface water/groundwater provision and flood protection, rank at the top for NVaR.

The image below displays two side by side analyses on euro area dependencies on services from ecosystems and euro area nature value-at-risk. The data shows that a large portion of the risks stem from water-related ecosystem services.

12% of the EU economic output is at risk as a response to degraded flood protection. Many flood plains in Europe have demonstrated gradual environmental degradation over the previous two centuries as a response to increasing urbanization and use of land.

Source: European Central Bank: Occasional Paper Series No 380, Chart 1

As a response, financial implication becomes present as over 60% of loans from banks are granted to businesses within these unprotected areas, leaving asset values exposed to the risk of floods.

Nature Value-at-Risk: Endogenous Risks

Banks contribute to endogenous risks, despite already being exposed to nature-related risks. Endogenous risks, or double materiality, occur when a bank’s decision to lend or make an investment contributes to biophysical pressures. These pressures circle back into financial risks that will impact the future. A bank’s lending often contributes to their nature and ecosystem-related financial risks.

By analyzing this idea, banks and financial institutions can gain a better understanding of how to participate in lending that does not enhance nature-related risks. Data from biodiversity studies show that bank loans often are intertwined with sectors that carry out changes in land-use and release greenhouse gasses.

Source: Assessing the Materiality of Nature-Related Financial Risks for the UK, pp. 33

Nature Value-at-Risk: Planetary Boundaries and Global Tipping Points – Tying It All Together

The NVaR framework and nature risks in general have a clear connection to planetary boundaries , as many of these issues directly correspond to the declining ecological ceilings. Climate change, biodiversity loss, water, and land conversion all demonstrate common issues between both nature and finance risks as well as global tipping points and planetary boundaries. If we can more effectively identify and measure biodiversity and ecosystem thresholds, we may be able to alleviate future nature risks. Analyzing these issues together could result in a large comprehensive framework addressing both social and financial problems tied to biodiversity loss and nature degradation.

Take Action

Banks: Use NVaR to calculate nature related risks within loan books, and subsequently, update pricing models.
EU Policy Makers: Engage banks and businesses to deploy NVaR to calculate nature related risks, and as a result, address related systemic risks.
Urban Planners: Incorporate NVaRt into forecasting tools to mitigate nature related risks.

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