While the rationale to account for biodiversity in a company's business operations has only been made clear for extractive industries (although it remains unquantified at present) the business case for biodiversity from a financial sector perspective is underdeveloped17.This chapter aims to contribute to a better understanding of it from a risk perspectiveq. Section 3.1 draws attention to the relationship between financial institutions and ecosystems and how impacts relate to direct and indirect risks for financial institutions. Section 3.2 provides results of an interview survey that assess the business case for biodiversity from a financial sector's perspective. Section 3.3 assesses what evidence is available to back up the business case for biodiversity. Section 3.4 outlines how drivers for BBRs add up.
Porter and Kramer (2006)33 argue that sustainability issues are so disconnected from a company's business strategy and operations that they offer insufficient guidance for companies to start incorporating them into a company's business operations. Other than simply stating that there are moral and sustainability arguments for companies to start addressing for environmental and social issues, it is important to understand the interconnectivity or relationship between companies and society. This can be done by analyzing the corporate value chain, which are all the activities a company engages in while doing business, and by analyzing how society impacts on a company, in terms of the specialized inputs available to a company (e.g., natural resources) and the availability of highly qualified and enthusiastic employees among others.
Applying their concept to financial institutions and ecosystems, the question can be posed: How impacts on ecosystems relate to biodiversity business risks (BBRs) that financial institutions are exposed to? First, it should be understood that all businesses have an impact on biodiversity through their operations. However, there is a great difference between sectors in terms of their impact on biodiversity. Some sectors have a high impact on biodiversity, such as the oil & gas sector or the mining & metals sector, while other sectors have substantially less impact, such as the telecommunications sector. FIs have a twofold impact on biodiversity as part of their operations:
Direct impacts: These constitute primarily use of land (i.e. buildings), energy consumption, paper use and waste.
Indirect impacts: By providing financial services (loans, bonds, equity, etc) to companies that have a direct or even an indirect (high) impact on biodiversity.
While the direct impacts of FIs are generally limited, the indirect impacts can be very considerable, depending on the type of financial institution, service and portfolios.A report by F&C Investments (2004)34 revealed that 80% of the respondents during a workshop believed that banks, insurance and investment companies have a medium to high impact on biodiversity. These assumptions were based on 1) the proportion of companies likely exposed to biodiversity risk; and 2) the significance of risks faced by individual companies. For purposes of clarification, this project focuses primarily on the indirect impacts that FIs have on biodiversity. Although the direct impacts cannot always be neglected these have been put outside the scope of this project.
While business may have an impact on ecosystems, the same holds true vice versa.This impact can be positive, in the form of opportunities. For example when a company adequately recognizes and manages its impact on biodiversity it might circumvent future regulation, build capacity with key stakeholders and safeguard its reputation. On the other hand biodiversity can turn into a risk when biodiversity issues are at stake, but are not recognized and managed by a company. In this case, it might turn into a liability, damage a company's reputation or lead to regulatory constraints. Financial institutions can be indirectly affected by these ecosystem constraints, particularly from two types of client companies:
Clients having (high) impacts on ecosystems. These include companies with direct footprints on ecosystems, such as the oil & gas sector and utilities, or sectors that have a significant impact through their supply chains, such as the food retail sector.
Clients depending on ecosystem goods and services. These include for example the tourism sector, agriculture, forestry or the fisheries sector.
FIs that provide financial services to these types of sectors can be exposed to BBRs, both directly and indirectly (Figure 7). Directly, FIs can be exposed to liability risks or reputational risks when a project that comes under heavy biodiversity-related scrutiny attracts major NGO attention. Indirectly, FIs can be exposed to biodiversity risks for loans to and investment portfolios in the above-mentioned types of companies.As biodiversity will likely increase in relevance for these types of companies in the coming years, some of them may increasingly come under biodiversity-related scrutiny. FIs that are not positioned to identify which companies are most at risk can be exposed to lower ROIs, increased risk for default or an increase in insurance claims.
Figure 7. The dual link between biodiversity and the financial sector: The corporate value chain (impacts on ecosystems) and influences on competitiveness (risks and opportunities)
Source: Adapted after Porter and Kramer.33
Although many businesses have been addressing environmental issues for decades, until recently, FIs had been indifferent to environmental issues19,35,36 because:
General confusion exists about the importance of environmental issues, together with uncertainty how their effects should be measured;
Difficulty in reconciling and communicating short-term private gains vs. long-term social (and private) impacts;
Prices of natural resources do not reflect possible future shortages or their unsustainable use;
The financial sector did not see environmental issues as a separate moral issue, but just as another pressure.
However, these attitudes are changing.19,37 The financial sector increasingly understands that environmental issues have an impact on business and therefore need to be properly addressed. Weber et al. (in press)4 outlined a number of environmental risks that banks for example face in their lending activities that may impact on credit risk:4,38,39
Sites used as collateral that are contaminated. Contamination of a site affects the value of the collateral in a significant way, because remediation is costly.
Regulatory driven investments. When a bank is obliged to invest in environmental-related activities (e.g., environmental technological development) and it does not have the capacity to assess this, it might run into costs.
Market changes. Attitudes by consumers and investors can change.
Reputation risk. When banks engage with companies that have bad environmental records, it can harm the reputation of the bank.
While concerns have so far mainly focused on a company's energy efficiency, the corporate CO2 footprint and use of waste, biodiversity is an issue that is just starting to be addressed by financial institutions.The literature that is available outlines drivers for the private sector in general to engage actively in reducing the impact on ecosystems by incorporating biodiversity into its 2 business operations:2,5,10,19,40
Disruption of the supply chain/increase in costs of inputs;
Increased vulnerability of assets to floods and other natural disasters;
Conflict and corruption in areas scarce in ecosystem services;
Lower ratings in financial markets/shareholder value;
Poor staff morale and reduced productivity;
Regulatory constraints/legal license to operate;
Since the business case for biodiversity has only to a minor extent been addressed for the financial sector specifically, an interview survey was conducted with 12 financial institutions, especially banks, and 13 NGOs and multilateral institutions. Due to the global significance of this issue a number of NGOs, multilateral organizations and other private sector companies, which were familiar with the issue, were consulted as well (see Annex I for an overview of the respondents, and Annex III for the questionnaire). The question that was posed to all respondents concerned: Do you believe there is a business case for biodiversity from a financial sector's perspective?r The results of this survey are shown in Figure 8. The percentages in Figure 8 indicate how many of the respondents in the group “financial sector” or “other stakeholders” found a certain motivation to be a convincing biodiversity business case for FIs.
As it turns out, the available body of literature, but even more the interview results clearly reveal that reputational risk is the most prominent type of biodiversity risk for the financial sector. Nineteen out of 26s (>70%) of the respondents believe there is a business case for biodiversity because of reputational damage the financial sector can face. In addition respondents from the financial sector indicated liability risk, social license to operate, credit risk and reduced shareholder value as additional types of risk, although they were regarded as less important (at present). Regulatory constraints from policy makers and access to capital (for emerging market FIs) were only stated by ‘other stakeholders’. Other types of risks, such as poor staff morale, were hardly regarded as being a risk issue for the financial sector.
Figure 8. The business case for biodiversity from a financial institution's perspective – information gathered during interview surveyst
In order to understand if there is indeed a business case to address biodiversity from a financial sector's point of view, this section provides an overview of cases that sheds some light on how tangible the business case for FIs is.
Due to the indirect relation between the financial sector and biodiversity and due to data limitations it is difficult at present to measure the financial implications of BBRs in terms of market capitalization or asset values (standard financial metrics). “Evidence” has therefore been sought anecdotally, in terms of examples, case studies and trends. Some of the cases are directly targeted at FIs (i.e. direct BBRs), while in other cases the business case is expressed indirectly (i.e. indirect BBRs).This can for example be by providing evidence how insufficient accounting for biodiversity risks can lead to reduced shareholder value for construction companies or oil & gas companies, which can directly impact on both private and institutional investors.
The information in this section has been gathered through literature reviews and consultations with experts.
The last years have seen a growing number of initiatives (especially in developed countries) to hold companies directly responsible for environmental damage. Investors and banks can be impacted twofold. Indirectly, they are impacted when a project they have invested in or provided a loan to is subject to unforeseen costs, such as liabilities resulting from failures to recognize and manage the impacts on the environment and biodiversity.This may eventually result in lower returns on investment or increased risk for default. Second, they are directly impacted when they are being held liable themselves for environmental damage from companies they have invested in or provided loans to. Other than for investors, liabilities are foremost connected to the insurance and re(insurance) business, as they have a sharp eye fixed on newly developing liability legislation.This is especially so in Europe where from April 2007 operators will be held legally liable for damage to the environment (Directive 2004/35/EC).41 Since the Fleet Factors case (see Box II) this is already the case for contaminated sites in the US for both operators and lenders of the capital (e.g., banks).
The directives and treaties that are listed in Table 1 provide an indication of the gradual increase in liability risk for companies although it should be stressed that this list is by no means complete.The fact that most of these developments emerged within the last few years shows that both operators of sensitive environmental sites as well as the insurance and (to a lesser extent) the banking sector have increasingly to take account of biodiversity-related liability issues.
Table 1. Directives and treaties that affect corporate environmental and biodiversity liability risk
|CBD Article 14(2)42||In progress||International||The Conference of the Parties is examining, on the basis of studies to be carried out, the issue of liability and redress, including restoration and compensation, for damage to biological diversity, except where such liability is a purely internal matter (in progress).|
|Directive 2004/35/ECu,41||2004||EU member states||The directive aims at preventing environmental damage to water resources, soil, fauna, flora and natural habitats and at making the polluters pay whenever damage cannot be avoided. It introduces a liability scheme which will not only compensate for damage to the environment, in accordance with the ‘polluter pays’ principle, but also prevent such damage. When the directive will come into force as of 30 April 2007 operators of risky or potentially risky activities could be held liable for the costs of preventing or remedying environmental damage. The future directive also requires Member States to promote the development of financial security products and encourage operators to take out financial security cover.v|
|Cartagena Protocol on Biosafety43||2003||International||The objective of this Protocol is to contribute to ensuring an adequate level of protection in the field of the safe transfer, handling and use of living modified organisms resulting from modern biotechnology that may have adverse effects on the conservation and sustainable use of biological diversity, also taking into account risks to human health, and specifically focusing on transboundary movements.|
|Protocol on transboundary environmental liabilityw,44||2003||International||Although attempts to develop an international convention on transboundary environmental liability did not prove to be successful, a protocol was established and signed by 22 countries that will hold companies liable for accidents at industrial installations, including tailing dams, as well as during transport via pipelines. The Protocol will give individuals affected by the transboundary impact of industrial accidents on international watercourses (e.g., fishermen or operators of downstream waterworks) a legal claim for adequate and prompt compensation. Physical damage, damage to property, loss of income, the cost of reinstatement and response measures will be covered by the Protocol. The Protocol is implemented in the Convention on the Protection and Use of Transboundary Watercourses and International Lakes.|
|OECD Global Forum on International Investment45||2000||International||As a result of four major mining accidents (two in Romania and two in Spain) between 1998 and 2000 recommendations were suggested both for mining companies as well as public and private financial institutions. A suggestion was made to develop an international convention on environmental liability which made not just the operator liable for compensation for damage caused, but also the provider of the capital. This would imply:
|Pensions Act46||1995||UK||This legislation, which came into effect in July 2000, has proved very powerful in focusing minds in the financial sector and among companies on the growing importance of ethical investment. It requires pension funds to 1) disclose the extent to which they take social, environmental and ethical issues into account when investing money; and 2) their policy (if any) in relation to the exercising of rights (including voting rights) attached to investments. It has been regarded a good example of ‘light touch’ legislation internationally, with similar approaches being adopted elsewhere in Europe.|
|Fleet Factors Case||1990||USA||In the Fleet Factors Corporation case, the court decided that “a secured lender could be considered liable for the environmental damage on a borrower's property if the lender as much as held the capacity to influence the borrower's waste management decisions, even if it actually did not do so”. It was the first case, in a series of cases, also to hold banks liable for environmental damage (see Box II).|
|Wildlife and Countryside Act (amended by the CROW act, 2000)x||1981||UK||Owners/occupiers of “Sites of Special Scientific Interest” (SSSIs) convicted of damaging sites via specified operations, and third parties convicted of reckless or intentional damage, can be ordered by Court to restore to the former condition where this is possible.|
|Superfund||1980||USA||The Comprehensive Environmental Response Compensation and Liability Act (CERCLA) also known as “Superfund” reinforced the Environmental Protection Agency (EPA) in the United States in their effort to clean up contaminated sites. The act made owners of contaminated sites liable for the clean-ups. Although lenders (i.e. FIs) were exempted, due to the complexity of the issue, some banks were forced to enter into the court procedure (see Box II).|
|Clean Water Act and Endangered Species Act47||1970s||USA||In order to control water quality and protect endangered species throughout the United States, two acts were developed: the Clean Water Acty and the Endangered Species Actz. These acts, however, can hinder economic development, such as road building or other constructional activities. Certain US states, most notably California, therefore proposed a more market-based approach whereby companies are allowed to encroach on wetlands and land, containing species listed on the Endangered Species List, if the damage this has caused is being offset. The two types of markets that were created in this way, and really took off in the last couple of years are Wetland Mitigation Banking and Conservation Bankingaa. Currently, these markets comprise a market volume of $290 million and $40 million.|
As biological diversity is continuing to decrease around the world, governments are putting ever stricter regulations such as laws and limitations on the use, trade and conservation of biodiversity. This may affect the financial sector in two ways. Indirectly, it may affect financial institutions when companies in which they hold shares or which have debt face stricter regulations. This may consequently lead to increased costs or even lower investment returns. Directly, it may affect FIs when they are forced themselves to screen, manage and report on biodiversity-related issues.
The recently launched “Potsdam Initiative – Biological Diversity 2010”1 is such an example of legal license to opeate. The environment ministers of the G8 countries and the five major newly industrializing countries outline in this initiative that they will “approach the financial sector to effectively integrate biodiversity into its decision making”. Also, Portugal, which will hold the next EU presidency (second half of 2007), indicated their appetite for management systems to mainstream biodiversity in the private sector.48
On another note, an article on the Forbes website 3 May 200749 announced that Credit Suisse has been urged by indigenous groups from Guyana, Cambodia, Malaysia, and Papua New Guinea to pay them US$10 million in compensation, because of their link to the Malaysian timber company Samling. This company retained Credit Suisse as an adviser during its stock market flotation in February, along with HSBC and Australian bank Macquarie. The indigenous peoples claim that Samling's operations have damaged their communities by cutting down forests and in some cases, polluting sources of drinking water. This highlights the importance for FIs such as banks to also take into account their social license when doing business.
Without identifying a clear link between environmental improvement and the financial bottom line, the financial sector itself will remain sceptical and reluctant to encourage companies to improve their environmental performance. Over the last few years this link, however, is becoming clearer and is increasingly recognized by key players in the financial sector. Nowadays, the shareholder value of a company is also determined by extra-financial issues, such as governance and environmental issues.
An increasing number of institutional investors are becoming interested in approaches to asset management that explicitly include environmental criteria. Although clearly not always the case this means that reputational risk, liabilities, concerns by policy makers, etc. may have an effect on how shareholders value a company and therefore have an effect on a company's stock. Since share prices in financial markets are core to any major business that is present at a stock exchange, lower ratings may therefore very well be the most direct and significant risk investors face with respect to environmental and biodiversity issues. Vice versa, better stock ratings provide clear evidence that proper accounting of environmental issues by a company can also impact shareholder value for the better.
A few cases and trends are shown below to highlight how they can lead to positive or negative performances by a company's shareholder value. It uses the hypothesis that attention for sustainability issues lead to better performance. However, when turning around that hypothesis one could say that companies that outperform are more professional companies, which automatically pay more attention to sustainability issues including environmental and biodiversity considerations.
Note: The cases that are presented below are divided in “positive performance” and “negative performance” and do not always link specifically to a company's biodiversity performance. Rather, words like “environment” (which includes biodiversity),“CSR” or “sustainability” (of which environment and biodiversity are part) are used.
On an aggregated scale, the Dow Jones Sustainability Group Index shows that proper accounting of sustainability issues does not necessarily mean less financial performance as it has out-competed its elder brother, the Dow Jones Group Index, in the past few years (see Box III).
A study by Innovest focused on the performance history of over 300 “Fortune 500” companies and found similar evidence. This study showed that highest-rated companies outperformed their competitors by as much as 5% and often in the range of 2–3%. This, Innovest claims, is because there is a strong correlation between environmental management and overall performance: A company that pays attention to the former is more likely to be well-managed overall.50
Another study by UK's Environmental Agency, together with Innovest, tried to find evidence on the link between environmental governance and financial performance of companies.51 A detailed literature review of 60 studies (from business, academia, NGOs and government) revealed a positive correlation between environmental governance and financial performance in 85% of the studies. The sectors reviewed comprised: oil & gas, EU and US electric utilities, paper & forest products and water products.
In line with this, a World Bank study Capital market responses to environmental performance in developing countries, focusing on Argentina, Chile, Mexico and the Philippines, assessed whether stock markets in these countries react to the announcement of firm-specific environmental news. They found that stock markets react positively (increase share prices) to the announcement of rewards and explicit recognition of superior environmental performance. However, the authors also show that capital markets react negatively (lower share prices) to citizens' complaints.52
The cases shown below are all related to non-FI companies. They are nevertheless interesting for investors and asset managers:
Associated British Ports was immediately penalized by its shareholders for not appropriately taking into account biodiversity issues in its management plans to develop a new port in Dibden Bay, near Southampton (see Box IV).
A study by WRI investigated how constraints on two major environmental issues for the oil & gas sector have impacted on their respective sales, operating costs, asset values and shareholder value. The two environmental issues concern 1) climate change; and 2) restricted access to oil & gas reserves. A previous study by the WRI stated that “three quarters of active mines and exploratory sites overlap with areas of high conservation value and areas of high watershed stress”.53 The likely loss in shareholder value that 16 major oil & gas companies face because of presence in pristine or protected areas lies in the range of 2–6%.54
Gupta and Goldar (2005)55 found evidence from India where capital markets generally penalize environmentally unfriendly behaviour in that announcement of weak environmental performance by firms leads to negative abnormal returns. 17 pulp and paper companies, 15 companies in the automotive sector and 18 companies in the chlor-alkali sector were given a green rating by India's leading NGO, the Delhi-based Centre for Science and Environment (CSE).This rating was consequently announced after which the impact of this announcement on the company shareholder was measured at the popular Bombay Stock Exchange. Although not all companies received the same rating in this study, it can generally be concluded that companies that received a bad “green” rating (i.e. negative environmental performance) encountered negative abnormal returns in the pulp & paper sector of up to 30% and in the chlor-alkali sector of up to 11%. No relation was found for companies in the automotive sector.
Reputation is one of the most highly prized assets of a company. It is also an intangible asset, difficult to capture and quantify. A survey by the Economist Intelligence Unit56 among 269 senior executives (CEOs, CFOs and chief risk officers) revealed that reputational risks was regarded as the most important type of risk (even more important than regulatory risk, human capital risk, market risk or credit risk). 37% of the companies in the survey were financial institutions.
Non-compliance with regulatory obligations was seen as the biggest source of reputational risk that a company faces. However, “poor crises management” (e.g., as a result of NGO campaigning), “exposure to unethical practices”, “failure to address matters of public concern” (e.g., climate change or biodiversity conservation), and “environmental breaches” (i.e. liability) can all be attributed to environmental concerns depending on the subject. These were regarded important as well (Figure 9).
Figure 9. The extent to which these actions a source of reputational risk for companies
Source: Economist Intelligence Unit.56
Although this survey did not specifically focus on biodiversity, it does provide an indication that environmental issues (or actions that have an environmental cause) are being recognized by the senior management.
Though difficult to quantify the reputational risk for FIs these following cases provide evidence that outside influences may have an effect on FIs:
In April 2005, for example, demonstrations held in front of the offices of JPMorgan Chase, the second largest bank in the US, led to the introduction of policies promoting sustainable forestry and indigenous people's rights, as well as the allocation of funding to fight illegal logging. The protests related to the bank's underwriting of forestry practices in Indonesia and alleged human-rights abuses tied to a JPMorgan Chase-funded mining operation in Peru.
One of the reasons why Citigroup backtracked on funding for an oil pipeline planned to go through old-growth forests in Ecuador may be the fact that an NGO ran an advertisement in the International Herald Tribune labelling the CEO of Citigroup an ‘environmental villain’.
ING Group has withdrawn support from an investment project by the Finnish company Botnia to build pulp mills in Uruguay. The project has been under scrutiny, among others from local communities. Although it remains speculation, a lack of social license to operate and potential reputational scrutiny could have contributed to ING's decision to withdraw from this project (Box V).
Barclays, one of the banks that participated in the initial development of the Equator Principles, came under scrutiny in the end of 2003 for providing a $400 million loan to the $1 billion project to build a series of dams in the east of lceland.57,58,59
In addition, evidence from the oil & gas sector suggests that insufficient accounting for environmental and biodiversity issues by companies and its investors can lead to reputational damage and impacts on financial return for investors and commercial banks (Box VI).
It is difficult to estimate, let alone calculate, the aggregated risks related to biodiversity that financial institutions are exposed to, based on the anecdotes, scientific papers, trends and other examples stated in this chapter.
However, the cases and trends provided in this chapter point out that biodiversity cannot be ignored either. Given the fact that global biodiversity resources are expected to decline further in the near future, increased pressure for tighter regulations from governments, consumers (especially in industrialized countries) and NGOs can be expected towards companies impacting on ecosystems.
In addition an interview survey among 25 FIs and other stakeholders also attempted to understand the FI's willingness to be better equipped to identify, address and mitigate biodiversity risks through their risk management procedures or other business operations. Though a few FIs appeared neutral, most of them clearly expressed their interest in having a tool developed that would enable them to take better account of biodiversity considerations within their business operations. However, such an instrument should carry broad consensus, be easy to implement in existing (environmental) risk structures, be quick to use (a client's presumed biodiversity impact should be quickly assessable) and the information, used as input for the instrument, should be readily available.
q Chapter 6 subsequently focuses on biodiversity business opportunities.
r While FI respondents naturally answered the question from their company perspective, the non-FI respondents were asked to imagine what types of risks they believed the financial sector can be exposed to.
s Though HSBC did not take part in the interview survey, the company clearly states in their Environmental Risk standard (published in June 2003) what types of BBRs it can be exposed to. For this reason they were included in the graph in Figure 8.
t “No trade-off with ROI” was mentioned by one (alternative) bank, which believes that incorporating sustainability and biodiversity considerations into equity investment and lending activities does not affect profits.
u See http://europa.eu/bulletin/en/200403/p104056.htm (consulted October 2006).
v This directive was approved by the European Parliament and Council on 31 March 2004. Information can be found here: http://europa.eu/bulletin/en/200403/p104056.htm
w It concerns a protocol to the Convention on the Protection and Use of Transboundary Watercourses and International Lakes and the Convention on the Transboundary Effects of Industrial Accidents.
x From the overview of existing environmental liability schemes in the UK: http://www.defra.gov.uk/environment/liability/index.htm
y The Wetland Mitigation Banking phenomenon was made possible because of the Clean Water Act 1972 Chapter 404(b)(1), giving it a legal basis and the US Army Corps of Engineers regulations (33 CFR 320.4(r).
z Conservation banking could be developed because of the Endangered Species Act 1973. Furthermore, see the Guidance on Establishment, Use and Operations of Conservation Banks (http://endangered.fws.gov/policies/conservationbanking.pdf).
aa Other legal requirements include: Habitats and Birds Directives in the EU, 1992; offsets in Brazil under the Forest Regulation and National System of Conservation Units, 2000; Federal law for the protection of nature and landscape in Switzerland; offsets in Australia; no net loss of fisheries habitat in Canada under the Fisheries Act, 1986.
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