Biodiversity loss has long concerned scientists and conservationists, but new research shows it has now started to become a material financial risk for listed companies and their investors.
Several studies published this year have found that biodiversity-related risks are beginning to affect company valuations.
One study published by the Swiss Finance Institute showed that the risk premium investors have demanded on stocks of companies with larger biodiversity footprints has risen in the past two years.Garel, A. et al, Do Investors Care About Biodiversity? (May 26, 2023). Swiss Finance Institute Research Paper No. 23-24, European Corporate Governance Institute – Finance Working Paper No. 905/2023 https://ssrn.com/abstract=4398110
Based on an analysis of the returns of shares in more than 2,000 firms from 32 countries, researchers found that stocks experienced an additional monthly rise in risk premium of 23 basis points, or an annualised increase of 2.8 per cent, for a one-standard deviation increase in the value of their corporate biodiversity footprint.The biodiversity footprint was calculated using a metric based on a species-based indicator of biodiversity intactness
Companies with the largest average biodiversity footprints along the value chain were those operating in industries such as retail and wholesale, paper and forestry, and food.
Among the sectors with the smallest footprints were leisure, services and education.
Tellingly, the increase in the premium occurred around the time of the Kunming Biodiversity Summit in October 2021, which was the initial part of the COP15. While the final agreement on a Global Biodiversity Framework (GBF) was reached later in Montreal in December 2022, the Kunming meeting is considered to have laid the groundwork and contributed to increasing both investor awareness about the loss of biodiversity and the prospect of future intervention by authorities.
“Our findings suggest that investors anticipate that new regulations will target business activities whose biodiversity footprint is large. As a result of the associated policy uncertainty, a biodiversity footprint premium starts to emerge,” the study reads.
“We confirm (previous research papers) that ESG risks are increasingly getting priced, and demonstrate this for what is now, next to climate change, the focal ESG topic among institutional investors.”
The GBF includes a target which requires large companies and financial institutions to monitor and disclose their impact on biodiversity, as well as the risks they face from biodiversity loss.https://www.cbd.int/article/cop15-cbd-press-release-final-19dec2022
These requirements will apply across the entirety of a business’s value chain. For financial institutions, the provisions will extend to portfolio investments.
The Europe-based researchers also found that companies with large biodiversity footprints experienced a cumulative stock price decline of 1.18 per cent relative to small footprint stocks in the three days following the Kunming meeting, compared with the three days before.
Impact of carbon and biodiversity-based risk factors on expected returns on companies with large biodiversity footprint
Source: Coqueret and Giroux. Detailed methodology is available here
Emergence of a risk premium
Other research suggests the biodiversity risk premium may have existed as far back as 2010.
A working paper published by the National Bureau of Economic Research analysed financial statements and corporate annual reports from 2010 to 2020. It found that companies which were more exposed to biodiversity risk saw their stock prices underperform compared with others when biodiversity risk increased.Giglio, S. et al, Biodiversity Risk (April 4, 2023). https://www.nber.org/papers/w31137To determine the extent to which biodiversity risks were being incorporated into equity prices, researchers performed a two-part study.
To determine the extent to which biodiversity risks were being incorporated into equity prices, researchers performed a two-part study.
First, they constructed a news-based measure of biodiversity risk using a natural language processing model.
They then built model equity portfolios along sector lines, grouping them according to what the researchers judged as their exposure to biodiversity risk.
The portfolios held long positions in industries with low biodiversity risk exposure – such as semiconductor, software and communication services – and short positions in industries with high biodiversity risk exposures – including energy, utilities and real estate.
Researchers assumed that if biodiversity risk is priced, the return on these biodiversity-risk-sorted portfolios should move together with their aggregate biodiversity news index, effectively behaving like a hedging portfolio for biodiversity risk.
The correlations between the return of this hedging portfolio and their biodiversity risk index were positive at up to 0.2 -- a pattern researchers said was large and comparable to those obtained by climate hedging portfolios when evaluated against aggregate climate news. This reflects the fact that biodiversity is becoming as important a risk factor as climate change.
Negative return expectations
A separate group of researchers examined companies in industries that have a large biodiversity footprint – those which depend more on ecosystem services and natural capital such as agriculture. They found that investors require higher compensation for holding biodiversity-impacting firms.
These researchers from Emlyon Business School and the Center for Research in Economics and Statistics found a "negative and significant" impact on their expected stock returns, or the expected average return from stocks computed from options prices.Coqueret, G. and Giroux, T. A Closer Look at the Biodiversity Premium (July 21, 2023). https://ssrn.com/abstract=4489550.
"These results demonstrate that, similarly to carbon risk, markets anticipate that biodiversity will become a major risk factor in the years to come, in particular for companies that rely the most on nature-based exploitation," reads the working paper.
Premium in bond markets
Another study showed the emergence of biodiversity risk in fixed income markets.
Researchers from Ireland, France and Switzerland compared the Credit Default Swaps (CDS), or the cost of insuring debt against default, for a term between one and 10 years.Hoepner, A. et al, Beyond Climate: The Impact of Biodiversity, Water, and Pollution on the CDS Term Structure (February 8, 2023). Swiss Finance Institute Research Paper No. 23-10, Michael J. Brennan Irish Finance Working Paper Series Research Paper No. 23-4 https://ssrn.com/abstract=4351633
They focused on the infrastructure industry, a sector that is crucial in the tackling of the triple planetary crisis of climate, biodiversity loss and pollution and also responsible for nearly 90 per cent of all climate adaptation costs.https://www.unep.org/resources/report/infrastructure-climate-action
They found that companies with better biodiversity risk management had up to 93 basis points better relative long-term financing conditions than the worst ones (see Fig. 2).
What is more, the results show the difference was greater over longer lending periods – or the slope showing one to 10 years – than that of one to five years. This flattening of the CDS curve, the researchers concluded, indicates that investors perceive those risks as long-term issues.
Scale of negative effects on CDS slopes from three environmental variables
Based on monthly regression results from a sample period between December 2007 to January 2018. Source: Hoepner, A. et al
“To protect endangered species or preserve natural habitats, laws that, e.g., forbid building roads or rails in protected areas, could lead to high additional costs for firms operating in this business,” the study reads.
Researchers said legislation that already internalises clean-up costs for companies when they pollute on- or off-site, such as the US Clean Air Act, could be one of the reasons for this phenomenon.
Biodiversity: not business as usual
The biodiversity risk pricing mechanism is a complex phenomenon that will evolve over time.
But this does not mean businesses and investors can afford to disregard biodiversity loss as a risk factor. Research suggests that it has already started to become a material financial variable. It is likely to increasingly affect the way companies conduct their business and how investors allocate their capital.
The Taskforce for Nature-Related Financial Disclosures (TNFD), an industry body representing financial institutions and companies with assets of over USD20 trillion, has just launched a set of 14 disclosure recommendations that are aligned with the GBF. More regulatory changes are sure to follow.
All of which means biodiversity risks will become a major topic for debate across corporate boardrooms worldwide.
Appendix: Rapidly developing policy scene
International agreements that took decades in the making are now all falling into place, reflecting how policymakers consider halting the degradation of nature an urgent environmental issue.
This comes eight years after nearly 200 countries agreed to limit global warming in Paris in a sweeping deal that has aligned finance flows and investment portfolios with climate objectives. The Paris agreement has also raised risk premium for companies for both climate transition and physical risks from global warming.https://www.bis.org/publ/bppdf/bispap130.pdf
The Montreal Agreement of December 2022 could have the same transformative effect, encouraging businesses to accelerate efforts to protect biodiversity, and investors to incorporate biodiversity risks when allocating their capital.
