DNB studies nature's impact on own-account equity investments

There are two types of nature-related financial risks. The first is physical. Consider a producer of tomato sauces. Its production and income depends on tomato growers. If these are affected by a loss of bee populations and can no longer supply tomatoes as a result, the sauce producer can no longer generate any income.

The second type is related to the transition to an economy that has a smaller impact on nature. This may involve compliance with government measures to protect nature or reputational damage suffered by a company that harms nature. A farmer who protects his potato crop with a pesticide that harms local biodiversity risks having that pesticide banned and, as a result, may have to adjust business processes, incurring additional costs.

In turn, a financial institution such as a pension fund that has invested assets in the sauce producer or a potato farm could face a drop in the value of its investments.

Uncharted territory

For many financial institutions, identifying nature-related financial risks is mostly terra incognita. In the public and private sectors, several methods have been developed in recent years that try to close the knowledge gap. One example is the Conceptual Framework of the Network for Greening the Financial System (NGFS), which provides central banks with a tool to examine nature-related risks in a consistent manner. One of the methods developed in the private sector is that of the Taskforce on Nature-related Financial Disclosures (TNFD). 

We opted for the TNFD’s method, because of the comparatively simple step-by-step approach it offers companies and financial institutions to identify and manage their nature-related financial risks. 

Our investments amount to roughly €8 billion, just over half of which consist of bonds issued by countries and government-related institutions. The remaining investments are allocated to corporate bonds and equities. In our pilot study, we screened two equity portfolios. First, we performed a high-level scan of potential nature-related risks in these portfolios on a sector-by-sector basis. We then decided to zoom in further on one sector: energy utility companies. Among the reasons why this sector is suitable for our study is the fact that it depends strongly on nature, e.g. because it needs clean water for cooling. Furthermore, this sector also has a major impact on nature through pollution, for example by discharging cooling water or emitting CO₂.

Location is crucial

Another reason for using the energy sector in our pilot study is that the locations of many power plants can be found in public databases, enabling us to measure risks for each plant location separately. This is important because the natural conditions and therefore the risks vary from one location to another.

The 'risk' to be measured is mainly the likelihood of a loss in value if a plant is forced to reduce, shut down or relocate its production due to natural events such as drought or fire, or due to regulations or in a bid to preserve the company's reputation.

Our key finding is that location is the crucial factor in any loss of value. For example, power plants in water-stressed areas, or those near nature reserves, are more at risk.

Hydropower and fossil are equally harmful

In addition, the method of energy generation is also a determinant of nature-related risks. For example, risks are lower for wind and solar power plants. Likewise, hydropower plants appear to be roughly as harmful to their environment as plants that rely on fossil or non-fossil fuels. This is a notable finding, given that hydropower plants have a lower carbon footprint. However, they do leave their mark on their environment by, for example, creating lakes or changing the course of rivers. What benefits the climate, therefore, does not always benefit nature.

What should be done?

We will discuss the results of our study with the asset managers of our corporate bond and equity portfolios and ask them how they believe they can manage the risks. But we also believe it is important to share the knowledge gained so that others can benefit. This will help others build on it, so that the wheel does not need to be reinvented when analysing nature-related financial risks.