Global Finance and Economy Group of the Environmental Change Institute, University of Oxford                                                        RNC0009

Written evidence submitted by Global Finance and Economy Group of the Environmental Change Institute, University of Oxford

Environmental Audit Committee

Inquiry: The role of natural capital in the green economy

The following submission represents the collated views of two academic experts from the Global Finance and Economy Group, Environmental Change Institute (University of Oxford). We have extensive expertise on understanding the critical role of natural capital and the economy through both greening finance and financing green with a special focus on the importance of an integrated approach to avoid locking in systemic risks including impacts on financial stability.

Aligning investment with environmental benefits – Area 2 of Terms of Reference

Natural capital underpins our economy, financial system and society. In the past 50 years, at the expense of an increase in materials and food, there has been a decline in 14 out of 18 nature contributions to people (a term analogous to ecosystem services). There is a misalignment of financial flows which further contribute to nature degradation with 7 trillion per year of harmful subsidies (oil and gas, coal, intensive agriculture) vs 200 Bill. a year investment in nature-based solutions (a third of what is needed by 2030 to meet the targets in Kunming-Montreal Global Biodiversity Framework.

Our written evidence under Area 2 of the Terms of Reference acts to both demonstrate the financial criticality of natural capital to the UK economy, and the need for intervention by the Bank of England to manage these systemic risks, and provides insights on the role of played by financial policy in aligning investment with environmental benefits.

Firstly, traditional measures of the value of natural capital to the UK economy often fail to fully capture the economic and financial dimensions. Recently, academics and practitioners such as us have spearheaded work to calculate the financial risks related to the erosion of natural capital, specifically through the degradation of ecosystem services. Such risks are not captured, for example, through the National Ecosystem Assessment or the National Risk Register and are not considered within natural capital accounting methods. This means that we are underestimating the macro-criticality of natural capital for the economy and finance.

The Central Banks and Supervisors Network for Greening the Financial System (NGFS), a group of 144 members and 21 observers in five continents, has spearheaded the understanding of nature-related risks to financial stability. Dr Nicola Ranger and Dr Jimena Alvarez worked as experts on the NGFS nature Task Force contributing to the NGFS Recommendations toward the development of scenarios for assessing nature-related economic and financial risks paper as well as our The Green Scorpion: The Macro-Criticality of Nature for Finance report, which was published as an NGFS Occasional Paper. This report focusses on the foundations for scenario-based analysis of complex and cascading physical nature-related financial risks including, for example: principles for analytics and scenario development, a conceptual framework for integrated nature-climate scenario development, transmission channels framework, typology of nature-climate shocks based on the analyses of historical analogues, building block database for narrative scenario development as well as a risk screening and assessment approach to identify key material risks to a country.

Our report on Assessing the materiality of nature-related financial risks for the UK (Ranger and Oliver 2024) introduced six innovations: the first nature-related risk inventory for the UK, a dependency and transition exposure analysis, sectoral nature value at risk scores, three scenarios for nature-related risk assessment, macroeconomic modelling of scenarios and results (GDP, inflation and others), first nature ‘stress test’ for the UK. The report was led by Dr Ranger and Prof Tom Oliver (University of Reading) and developed with several other partners, including Dr Jimena Alvarez as an author in five of its six chapters.

The report included three nature scenarios and found that these could result in losses to of 6% UK GDP vs baseline by 2030 in two scenarios (one driven by local environmental degradation and another one on international environmental degradation) and above 12% UK GDP vs baseline under an anti-microbial resistance/ pandemic scenario. These results are larger the impacts on UK GDP 6% decrease in GDP after the 2008 financial crisis and 6% decrease in GDP after the 2008 financial crisis.

An important conclusion from our report is that nature doubles climate losses, with impacts from nature being of at least a similar scale to those climate-related risks. This conclusion strengthens the need for an integrated approach of nature and climate-related risks as a siloed approach drives systemic risk. Financial institutions face both nature-related physical —through ecosystem services degradation, and transition —regulation, litigation and market sentiments changes— risks. The risks outlined above are currently missing from financial regulatory and supervisory frameworks in the UK. This means that our financial institutions are missing these critical risks and consequently our financial system is exposed to potential systemic risks from nature loss. The same is true for government – fiscal risks exist that are not being managed. It also means that the impacts of investment on nature are currently being underpriced in financial decision making.

Secondly - on the alignment of investment with environmental benefits - risk pricing has a critical role to play in remediating the misalignment of financial flows. Currently nature-related risks are not priced into financial decision-making. In addition, the lack of disclosure on nature-related risks further leads to an opacity in the understanding of the double materiality of nature and finance (how a firm depends on and impacts nature). Both mean that finance continues to flow to activities that damage nature, and investments aligned with environmental benefits are vastly insufficient.

The recently published thematic assessment of the interlinkages among biodiversity, water, food, health and climate change (Nexus assessment) by the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem services (IPBES) (on which Dr Alvarez is a contributing author) identifies ‘align finance’ as one of ten categories of response options.

Our report, Ranger and Oliver 2024, provided a series of recommendations for government, financial institutions and the Bank of England:

• Given the evidence and the unique characteristics of nature-related risks, there is an urgent need to assess if and where these nature-related risks may ‘fall through the cracks’ of current supervisory, regulatory and policy frameworks and where this would necessitate actions. Based on such an assessment, actions may include:
• Advancing disclosures of nature-related risks and impacts in the UK. The high exposure of UK firms to nature-related risks shown in the analysis coupled with other studies that demonstrate the information asymmetries that are holding back risk management (e.g. GARP 2024, TNFD 2023) suggests that corporate regulations to increase disclosures at the firm level would lead to meaningful improvements in financial resilience. Taking forward the recommendations of the TNFD therefore, as outlined in the UK’s Green Finance Strategy, could be an important step therefore in terms of building financial resilience to nature-related risks.
• Broadening supervisory statements on climate to explicitly include environmental risks, and incorporating aspects of environmental degradation into exploratory scenario exercises. The benchmark scenarios developed here could create a foundation to build one or more exploratory scenarios for firms.

• There are also several low-regrets measures that can also be win-wins with climate risk management. For example:
• An immediate priority is to encourage financial firms to begin to build capability in assessing and managing nature-related financial risks. Existing fora such as the Climate Financial Risk Forum can support capability building across the financial sector and enable the development of best practice.
• Advancing disclosures of asset-level information and supply chains. Nature-related risk assessment suffers from data gaps common to climate risk management. For example, enhanced disclosures of the asset locations and supply chains would enable significant improvements in both nature and climate risk assessment and management. Regulators should also assess if steps should be taken to enhance transparency around the largest financial sector exposures of banks, where it is currently impossible to assess nature- (or climate) related risks.
• Take timely opportunities to incorporate nature, as appropriate, fully within emerging regulatory frameworks and standards, for example the ISSB, new green taxonomies and transition plans. This will reduce the burden on firms.

• There is a clear and urgent case for investment in enhancing the underpinning data, analytics and modelling of nature-climate-economy interactions as a global public good. One of the most significant constraints in this exercise, has been the availability of granular data on the state of ecosystem services in the UK and modelling of future risks. Data availability and accessibility is substantially poorer than for climate, for example. While large amount of data exist these are not necessarily those needed for economic and financial risk assessment. Further work is needed by government with the scientific community to identify the priority gaps and put in place a funded-roadmap to fill them. Given the materiality of nature- related risks for the UK economy and financial sector, there is a strong strategic case for government, philanthropies and financial institutions to invest in advancing climate-nature-economy modelling, analytics and scenarios as a public good. The NGFS (2023) similarly identified the priority need to advance modelling. An action for government could be to work with the new UKRI Integrating Finance and Biodiversity programme (IFB) as a platform for collaboration, drawing upon its substantial multidisciplinary nature expertise and links to seventeen universities across the UK.

• The exposure of the UK economy to global nature-related risks provides a clear rationale to collaborate internationally to ensure material nature-related risks are addressed. Given the global nature of risks, the Financial Stability Board, the NGFS and IMF could play a key role, alongside other bodies (including the IFRS, ISSB and the G20). This is a particularly important priority for the UK given the result that more than half of the risk faced by the UK economy originates overseas and is transmitted through global supply chains. For government, the findings highlight the material importance of protecting and restoring nature both domestically and globally, including through meeting the goals of the Kunming-Montreal Global Biodiversity Framework (GBF). The UK is already a signatory to the GBF, yet the materiality of nature-related risks to the UK demonstrated in this study adds additional urgency to put in place the mechanisms, domestically and globally, to meet these goals and targets. This includes making progress on Target 14 to align financial flows with the GBF, as well as strengthening disclosures and risk assessment. For supervisors and regulators, this means engaging internationally to ensure that sustainable finance frameworks incorporate nature risks and impacts. There is also a clear role for Government in working to align public financial flows and working with partners across the international financial architecture to upscale nature finance and fully integrate nature. While our analysis is focused on financial risks, there are potential fiscal and wider implications for the UK that require further consideration. For government, there is a rationale for similarly exploring where nature risks may be falling through gaps within current fiscal policy and risk management frameworks and acting accordingly. Also, considering if and how to more fully integrate nature-related risks within the UK National Risk Register and the UK Climate Change Risk Assessment.

How can the proposed UK Green Taxonomy support high-quality investments which deliver genuine benefits to nature? What financial disclosures should the taxonomy require? – Area 5

The UK Green Taxonomy can play a vital role in supporting high-quality investments that deliver genuine benefits to nature. Dr Nicola Ranger was a member of the UK Green Technical Advisory Group and the subsequent LNAS Group that provided independent advice on the rationale for and design of the UK Green Taxonomy. Such a taxonomy can play several important roles:

• The ‘Do No Significant Harm’ (DNSH) criteria of the Taxonomy can ensure that investments made against the taxonomy meet minimum criteria that protect biodiversity and nature.
• From experience, a significant barrier to investment in high-quality nature positive projects as a lack of awareness and information amongst investors of what that actually means. The taxonomy plays an important role in signposting investments that do deliver genuine benefits and so provides an important guide to investors.
• Similarly, a nature-inclusive Taxonomy can be used by investors to hold investees to account and to guide strategic asset allocation.
• A UK taxonomy that includes nature can also guide bond issuance, leading to a new asset class for financial products with genuine benefits for nature. It can similarly promote the issuance of related instruments, such as high-quality sustainability-linked finance.

Without a UK taxonomy that includes nature, these benefits would be forfeit, but it could also lead to investments that continue to be damaging to nature.

Firms reporting against the UK taxonomy should be required to disclose where investments do and do not meet criteria on ‘Do No Significant Harm’ to nature, and where they make a significant contribution to biodiversity and environmental benefits, thus helping to guide investments.

What role can the UK’s financial markets play in developing the flow of international capital into the development of the UK’s natural capital? – Area 6

The UK is well positioned to be globally leading financial hub for international investment into natural capital, both in the UK and globally. The Transition Finance Market Review identified a similar opportunity for transition finance, but the definition of transition finance can be broadened to be inclusive of natural capital. The UK already has unique strengths relevant to nature finance, including through its world-leading insurance sector and strength in climate and environmental science and analytics. The London Market is the largest commercial insurance and reinsurance hub globally. With $121bn of gross written premiums in 2020, the London Market is considerably larger than other competing centres, such as the US and Singapore. And the London Market’s capital is increasingly global in source: 89% of London Market premium is written by companies domiciled outside the UK. The financial strength of the London Market is also coupled by significant expertise in risk, resilience and analytics that can be deployed to support the financial system to align with environmental goals and mobilise investment in natural capital in the UK and globally. The UK is also a global leader in environmental science, including through centres like the UK Centre for Ecology and Hydrology and its research institutions and also commercial data providers and professional services businesses. This leadership, coupled with the wider strengths of the UK financial sector, including across international banking and borrowing, asset management, international debt issuance, financial services and foreign exchange trading mean the UK has unmatched potential to lead globally as a resilience, net zero and nature positive financial sector to the world, as well as support domestic nature finance needs. For UK nature to benefit, this must be coupled by policy and regulation from government to set the enabling environment for finance to flow into natural capital, including through blended finance (e.g. the UK Infrastructure Bank), the adoption of mandatory nature-related disclosures aligned with TNFD, clear national nature investment plans and targets, and credible nature markets.

What role does the UK have in establishing international standards for natural capital investments, alongside other jurisdictions and financial centres? – Area 7

The UK was a leader in establishing international standards for climate and carbon, and this resulted not just from its active support and leadership on international initiatives such as TCFD and the Transition Plan Taskforce, but also importantly through leading by example in implementing frameworks domestically. For example, the leadership of the Bank of England in conducting the first bottom-up financial stress tests for climate risks and through the early mandatory adoption of TCFD. UK champions such as Mark Carney, former Governor of the Bank of England, and major international leadership e.g. on COP26, similarly cemented our leading role. The UK has benefitted through being widely seen as one of (or the) Green Finance Capital of the world. On nature, the UK has fallen behind, with the European jurisdictions demonstrating more leadership and therefore setting the international standards, which the UK will need to comply with. It is not too late. The UK has an opportunity to now take the same leadership role on natural capital investments, shaping international markets and cementing the role of the UK financial sector. This will similarly require leading by example at home, through for example the UK conducting the first nature stress tests of the financial system and introducing mandatory nature-related disclosures. Such international leadership is essential to ensure that international standards most benefit UK firms.

Acknowledgments

This response has been prepared by Global Finance and Economy Group (GFG) with contributions from:

• Dr Jimena Alvarez, Greening Finance for Nature Lead, GFG, Environmental Change Institute, University of Oxford
• Dr Nicola Ranger, Director, GFG & Resilient Planet Finance Lab, Environmental Change Institute, University of Oxford

We would be pleased to speak further about our response.

December 2024