Emerging Market Banks Are Highly Vulnerable To Nature Risk

A working paper by World Bank researchers has investigated the link between natural capital and bank loans across 20 emerging & developing countries and found that half of the loans were dependent on ecosystem services and thus vulnerable to degradation of these services. Moreover, the dependence from non-financial company customers of banks was higher in lower-income than in middle- and higher-income countries, and there exists a linkage between nature and climate vulnerability for these financial systems.

Here's why that is so important for the financial sector. The global economy post-Covid has been marked by a startling rise of debt sustainability risks for emerging & developing countries in particular. The Chief Economist at the World Bank recently highlighted challenges to the system for resolving debt crises in emerging & developing countries because existing mechanisms don’t include most private creditors. Evidence that not only climate change but also nature-related risks present a vulnerability that is more acute for lower-income countries presents an urgent issue for financial sector stakeholders to tackle.

Although there has been some progress in moving the current trajectory of climate pledges in the direction of aligning with the Paris Agreement, the latest IPCC report indicates they are still misaligned with the 1.5° C target. Meanwhile, there has been progress on both marine and terrestrial biodiversity with the Convention on Biodiversity at COP15 agreeing to protect 30% of coastal & marine areas and terrestrial land by 2030 (30 by 30).

The combination of financial risk facing many emerging & developing countries and the escalating need for more dramatic action to address climate and natural capital risks heightens the need for finance to play a role. On the climate finance front relating to financial flows from developed to emerging & developing countries, this has often seemed to be ‘too little, too late’.

Despite shortfalls in action to increase financial flows to support climate change mitigation and adaptation, and other flows to mitigate nature loss, there remains an urgency for all financial institutions to find ways to respond. The World Bank working paper makes a rough ‘order of magnitude’ estimate of the significance of the ecosystem services that financial institutions rely on. They do this by combining estimates about the varied types of ecosystem services – from surface & ground water and regulation of a stable climate to protection from storms, floods & erosion – with a range of economic activities. Each activity has been ranked by the degree to which it relies upon a range of ecosystem services.

The data on economic activity reliance on different ecosystem services are combined to create a vulnerability metric for each non-financial corporate sector to be financed across the sample. This allows the authors to sum up the total banking sector financing that is vulnerable to loss of ecosystem services.

The logic is that a loss or degradation of the provision of an ecosystem service to which a particular type of company is highly vulnerable would be expressed in a reduction of revenue or increase in costs, which would affect its creditworthiness. In total, the analysis found credit exposure of between 45% and 55% for banks across the 20 countries. That means that in high-income emerging markets, about 45% of the credit exposure of banks is vulnerable to loss of an ecosystem service, and 55% of credit exposure is similarly at risk in lower-income emerging markets.

The authors are sufficiently circumspect in putting too much weight on the point estimates they arrive at. They are working with top-down data estimates, and rough metrics of vulnerability to loss of ecosystem services. However, it is reasonable to suspect that the degree of vulnerability is more likely to be higher than their estimations rather than lower.

For starters, they look only at situations of high direct vulnerability. For example, rain-fed agriculture is highly vulnerable to availability of groundwater. It is also vulnerable to a range of other risks such as availability of surface water, pollination, and climate regulation (the presence of a stable climate), and these risks are more likely to occur all at once rather than having only one type of risk materialize.

The impact of an ecosystem risk materializing for agriculture (an upstream sector) in one country will result in spillover down the line in that country and in countries that are dependent on that production. The loss of groundwater supplies also won’t impact only one sector in isolation, and the response to mitigate the impact to one ecosystem service loss will be likely to accentuate impacts in other areas.

For example, loss of groundwater supplies will affect agriculture, but will also impact other users of fresh water such as urban water systems. In response to more limited or uncertain access to freshwater, they may start to rely more on other sources such as desalination. This in turn can increase energy demand, leading to a more challenging decarbonization process, as well as increasing the salinity of oceans, which would harm the fisheries that provide important sources of protein.

The financial element for emerging & developing countries of the risk to ecosystem services should be one of awareness that risks are rising. Financial institutions will not be able to mitigate the risks on their own – but they can start to measure their exposures and also develop ways to support their customers in limiting their impacts on critical ecosystem services.

Risks beyond climate are quickly rising up the agenda and many emerging & developing countries will be important sources of mitigation. By gaining understanding about the degree to which climate and nature risks are present in their customers’ activities, financial institutions and their customers can understand how those risks will travel through supply chains beyond their borders.

As supply chain due diligence requirements strengthen, this will increase the flow of financing to limit disruptions caused by nature loss, which could become an important channel of financing from developed to emerging & developing countries in years to come. Because the link between ecosystem services and nature is more widely distributed through supply chains and within financing portfolios of banks than is direct climate risk, it may end up attracting more international flows than climate change has to date. That’s good for nature, and for increasing flows of finance to countries that are currently facing challenges around debt sustainability.