ECB published first report on biodiversity loss risks
The ECB published its first paper about biodiversity loss risk, focused on physical risks. Following a similar methodology we have used in a previous publication, the ECB estimates that 72% of the non-financial corporations (NFCs) are highly dependent on at least one ecosystem service and that 75% of euro area banks’ loans highly depend on at least one ecosystem service. Under different emission pathway scenarios, euro area banks’ losses could be relatively high only because of its biodiversity risk.
The ECB published the first of two papers about biodiversity loss risks. This first paper focuses on physical risks, while the second will focus on transition risks
Firstly, the ECB computed the dependence of non-financial corporations (NFCs) by combining both direct and indirect dependencies (that is, from the supply chain)
Results show that 72% of NFCs are highly dependent on at least one ecosystem service. And, similarly, 75% of euro area banks’ loans highly depend on at least one ecosystem service
As exposure is not enough, the ECB also assess the magnitude and likelihood of biodiversity shocks. For this, it performed a sensitivity analysis to the banks’ loan portfolios to biodiversity changes
Were the world to follow its current emission pathway, euro area banks’ losses could be on average three times higher than under a Paris-aligned future scenario just because of its biodiversity risk
The European Central Bank (ECB) recently published the first of two papers about biodiversity loss risks (see ). This first paper focuses solely on physical risks, while the second one, which will be published in December, concerns transition risks. This paper follows a recent ESG Strategist we published in October, where we assessed the exposure of different sectors and banks across Europe to biodiversity loss risks (see ). Nevertheless, the ECB introduces a novelty in this field of study by presenting a sensitivity analysis of the change in the expected losses of banks’ credit portfolios due to possible biodiversity losses.
The first aim of the ECB’s paper was to quantify the exposure of the euro area economy and financial sector to the physical risks related to ecosystem services. In line with previous studies, physical risks are captured by the dependence of non-financial corporations (NFC) on ecosystem services, such that, the larger the dependence, the greater the exposure to ecosystem degradation. To first calculate the exposure of non-financial corporations, the ECB used two databases: the ENCORE database (similarly to what we did in our research paper) and the EXIOBASE. While the former focuses solely on first-order dependencies, the second one provides information on the dependence on other ecosystem services through the value chain. As such, the ECB sums both the direct and indirect dependencies to have a total dependency per borrower. As most economic activities rely on multiple ecosystem services, it is important to account for the multidimensionality of nature-related risks.
The second step was to link the NFCs with the financial institutions that lend to them. As biodiversity risks threaten the production and viability of a company, that will ultimately affect banks which provide credit lines to those NFCs. For that, the ECB used its AnaCredit database for December 2021. This database comprised approximately EUR 4.3 trillion in corporate loans to around 4.2 million NFCs. The loans are issued by more than 2,500 unique consolidated banks with headquarters in the euro-area. By combining the dependency score of each NFC with its share in the bank’s loan portfolio, the ECB calculated each banks’ dependency score.
75% of European banks’ corporate loans are highly dependent on biodiversity
With no surprise, results showed that the euro area NFCs have a significant dependency on several ecosystem services, both directly and indirectly through supply chain linkages. Interestingly however, was to see that the overall dependency of NFCs on ecosystem services is quite homogeneous across countries. Apart from some minor clusters in France, the Netherlands and Northern Italy, there are no clear differences across countries when looking at the dependency of NFCs.
Furthermore, the study showed that overall, approximately 72% of NFCs (around 3 million NFCs) are highly dependent on at least one ecosystem service. However, if only direct dependencies are considered, the share of NFCs directly exposed to the risk of degradation of ecosystem services falls to 52%. In line with this result, euro area banks’ loan portfolios have a significant large exposure to several ecosystem services. Overall, approximately 75% of euro area banks’ corporate loans (nearly EUR 3.24 trillion) to the 4.2 million euro area NFCs are highly dependent on at least one ecosystem service.
Interestingly, the ECB found that banks with lower Tier 1 capital ratios tend to have a slightly higher average total dependency on ecosystem services, this is, they are more exposed to physical risks. A reason for this might be related to the smaller size of these banks’ portfolio, and the fact that their loans are more concentrated in certain regions and sectors, lacking diversification. This might signal a potential problem for less capitalised banks if the risk materializes.
Sensitivity analysis: losses can be significantly high under current pathway of emissions
Besides only recognizing the exposure, the ECB also assessed the magnitude and likelihood of the shocks caused by nature degradation. Moreover, the regulator also calculated the banks’ credit portfolios sensitivity to changes in biodiversity levels. To measure the decline in biodiversity and the consequent decline in the provision of ecosystem services, the ECB computed biodiversity shocks worldwide. The computation of these shocks is based on mean species abundance (MSA) an indicator of biodiversity intactness, which is a function of multiple anthropogenic pressures such as land use and climate change. The biodiversity shocks are computed using MSA changes under three different scenarios, using the MSA level of 2015 as the baseline value. The level of change in MSA indicates the decline or gain in biodiversity intactness from the present day to 2050.
The first scenario is a sustainability scenario paired with a low level of climate change impact (which means this is a Paris-aligned scenario), and assumes low levels of both population and consumption, and less-resource intensive lifestyles. The second scenario combines regional rivalry scenario with moderate levels of climate change. This scenario assumes high population growth, resource-intensive consumption and continued deforestation. Lastly, the third scenario integrates a fossil-fuelled development with high levels of climate change. It is characterised by a consumption-oriented and energy-intensive society, and highly intensive agricultural practices. The last two scenarios are considered adverse scenarios.
The graph below depicts the maps of biodiversity loss under the three different scenarios.
Compared with the sustainability scenario, the regional rivalry scenario is characterized by a higher overall degradation level across the globe. However, there are certain regions more affected than others, like India, Turkey and Africa. In the euro area, France is particularly affected under this specific scenario. On the most adverse scenario (the fossil-fuelled development), the degradation of biodiversity is higher worldwide, but there are no regions that are more affected than others (as in the second scenario).
Regarding banks, expected losses under the sustainability scenario are substantially smaller when compared with the other two scenarios. In the second scenario, losses could be on average as much as 2.54 times those under the sustainability scenario, and, in the most adverse scenario, that number is actually 2.73 times. Moreover, countries like Germany, Lithuania, Ireland and Belgium are the hardest hit, with losses up to five times when compared with the sustainability scenario. These countries are particularly affected given the sectors that operate there.
Going forward
Results indicate that the euro area economy is highly dependent on ecosystem services. However, the progress made in measuring and understanding nature-related risks is less advanced than that regarding climate change. As such, gaps must be filled in disclosure and quantitative risk modelling frameworks. These developments are only possible by involving a number of parties, such as policymakers, researchers and civil society organisations. The knowledge and experience developed in addressing climate change should be leveraged to ensure a smooth and rapid application of an integrated climate-nature framework.