Climate change and biodiversity loss: to manage the financial risk, central banks and financial regulators need to treat them as interconnected
The world’s financial authorities — central banks, financial regulators and supervisors — now recognize both climate change and declining biodiversity — the loss of animal and plant species, as well as the degradation of ecosystem diversity and genetic biodiversity within species — as a significant source of systemic financial risks, and they’re developing policies to mitigate their effects. But to make real progress, they need to see the connection between the two problems, and take a more proactive approach.
01/09/2024
4 min
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Based upon an interview with Hugues CHENET, an associate professor of sustainability, and his paper “Biodiversity loss and climate change interactions: financial stability implications for central banks and financial supervisors,” co-written with Katie KEDWARD and Josh RYAN-COLLINS of University College London, first published online in the journal Climate Policy in August 2022.
Climate change and its numerous effects—from soaring summer temperatures and changes in precipitation to increasingly violent storms and rising sea levels—already are affecting the lives of people across the world, and more drastic change is likely ahead. Awareness of that danger is evident in a recent World Economic Forum survey of 1,200 risk management experts, who put failure to mitigate climate change at the top of the list of the 10 most severe global risks over the next decade.
In recent years, central banks and financial supervisors have begun working on how to mitigate the risk caused by a changing climate, which one forecast estimates could threaten the value of up to 10 percent of global financial assets by 2100. A study published in Financial Stability Review in 2021 estimated that “Around 30% of euro area banking system credit exposures to NFCs (non-financial corporations) are to firms subject to high or increasing risk due to at least one physical risk driver.”
That’s not the only potentially ruinous environmental woe that we face. In that same WEF survey, the experts ranked another problem — biodiversity loss and ecosystem collapse — as the fourth-biggest global risk, and central banks and financial supervisors are increasingly concerned about the effects that the decline of animal and plant species will have upon the world’s financial and economic stability as well.
But financial authorities may be making a costly mistake, by treating climate change and biodiversity loss as separate policy concerns, according to IÉSEG Associate Professor Hugues CHENET. He and his colleagues argue that the two environmental problems are closely connected, and interact in a way that makes it essential to take them both in consideration when crafting solutions.
“The environment must be seen as a system,” Professor CHENET explains. In his view, so do the solutions for protecting against financial risk.
How Climate Change and Biodiversity Loss are Linked as Financial Risks
The financial risk from climate change’s most destructive events — such as increasingly severe storms that endanger valuable coastal real estate — might be easier for financial authorities to assess. Biodiversity loss, in contrast, tends to be a more complex dilemma, with cascading effects as a decrease in one species affects others that depend upon it in some way. From a financial and economic standpoint, Professor CHENET describes ecosystems as providing services to companies, such as pollination to grow crops, timber for building, or clean water for manufacturing beverages.
“If ecosystems don’t work as well and don’t provide services such as clean water and pollination, companies’ metrics are impacted,” Professor CHENET explains. “That beverage company might have a bank loan, and the risk to the bank is affected because the company has different costs and revenues than planned. So, biodiversity loss is transmitted to the financial level.”
But biodiversity loss can’t be separated from climate change, in part because the latter often is a factor in causing biodiversity loss. As an article on the United Nations’ website notes, higher temperatures can force plants and animals to move to higher elevations to survive, disrupting the delicate balance in ecosystems.
Similarly, Professor CHENET notes, devising a solution for one problem without taking the other into consideration can actually be counter-productive. He uses the analogy of planting more trees to capture and store carbon in their biomass (trunks, branches, leaves, pines, roots).
While industrial scale mono-specie plantations (e.g. with fast growing eucalyptus) may help with climate change mitigation, it might actually harm the biodiversity of a particular area, by affecting animals and other plants in that ecosystem, which can become less resilient and finally release instead of storing carbon. “If you focus on just one problem, you may cause collateral effects,” he says.
The Challenges of Acting to Prevent Both Problems
Additionally, Professor CHENET and his coauthors argue that environmental problems can’t just be managed at financial system level as they occur and become material. Instead, they demand a proactive strategy, in which financial authorities scrutinize the financial system to see how it might be actively facilitating the direct drivers of environmental damage, and aim to reduce — or stop — the flow of financing to harmful activities that could push the world over ecological tipping points.
Professor CHENET cautions that dealing with both climate change and biodiversity loss together is a complex matter. “Climate change can be a relatively slow process, with lots of inertia,” he explains. “Biodiversity, in comparison, can be very quick — you can destroy a species very quickly.” Unlike climate change, which has some effects that are irreversible, ecosystems can regenerate, if a threat such as pesticides is eliminated before extinctions thresholds are crossed. That, in turn, requires financial authorities to be more creative and ingenious in crafting policies. They must take a closer look at the activities and projects that are receiving loans or being capitalized by investment, with an eye to their environmental impact.
Practical Applications
Central banks and financial regulators/supervisors can draw upon the ideas in the paper to craft risk-reduction policies that are broader in scope and more proactive, by using a precautionary approach that would lead them to rather decrease the sources of the problem upstream (climate and biodiversity risk), instead of trying to only diminish its consequences downstream (financial effects).
Methodology
The authors reviewed a wide range of studies from academic researchers, as well as institutions such as Banque de France, and synthesized the data and insights to develop their own findings.
