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Is it time to change how investors analyse ESG issues in their investment practices and processes?

Natural capital input could radically shift the way environmental resources are looked at.

In October 2016, the Natural Capital Coalition, the Natural Capital Finance Alliance and VBDO announced that they would jointly produce a Finance Sector Supplement to the Natural Capital Protocol. Link to website to download
The Supplement will provide financial institutions (asset owners, asset managers, banks, insurance companies) with guidance on how to incorporate natural capital – that is, the stock of renewable and non-renewable natural resources (e.g. plants, animals, air, water, soils, minerals) that combine to yield a flow of benefits to people – into their lending, investment and insurance practices and processes.
In some ways this sounds like a relatively straightforward tidying-up exercise, given that environmental issues are already integrated into the investment analysis conducted by many large institutional investors. However, the briefing paper that sets out the likely scope and approach of the Supplement suggests that the Supplement may well challenge current practice in a number of quite radical ways. For example, it suggests that:

1. The Supplement will encourage financial institutions to report on their wider business activities (lending, investment, insurance) rather than on their own operations. While it is widely recognised that, for the majority of financial institutions, their most significant social and environmental impacts relate to their lending, investment, insurance and other activities, it is striking how many of these institutions focus much of their reporting on their operational impacts (e.g. the carbon footprint of their offices and transport) rather than on the wider social and environmental impacts of their business activities.

2. Financial institutions should consider both their impacts and their dependencies on natural capital, where ‘impacts’ refers to the negative and positive effects of their activities on natural capital, and ‘dependencies’ refers to their reliance on natural capital. In current ESG practices, dependencies are often not taken into account. The requirement to pay attention to dependencies requires natural capital to not only be seen as an externality but as an important resource, in a similar manner to financial capital and human resources.3. The Supplement will encourage and help financial institutions to take a more holistic and systems approach to their decision-making and KPIs. There are signs that this is starting to happen in other areas. For example, the Portfolio Decarbonization Coalition (PDC) encourages investors to systematically align their investment portfolios with the goals of a low-carbon economy. This requires investors to assess and manage impacts and risks across all of their portfolios, geographies and asset classes. The most recent PDC progress report shows that investors are starting to adopt this logic by analysing carbon risks in different asset classes and, although this is at a relatively early stage, looking at how carbon risks and greenhouse gas emissions can be managed across asset classes.

4. Financial institutions should treat natural capital as an integrated agenda rather than as a series of stand-alone issues (water, ecosystem services, forestry, etc) as is often done in current investment practices. Of course, this is both complex (as many of the measurement tools and metrics do not yet exist) and controversial (as the basis on which decisions and trade-offs are to be made is not clear or agreed). It is, however, important as financial institutions might find that they have significant exposure to water or biodiversity-related risks because of their aggregate exposure to specific geographies, sectors or markets. These are the sorts of risks that ‘conventional’ stock analysis is unlikely to identify.

These are complex questions and we encourage investors to use the process of developing the Financial Sector Supplement (see Note 2 below) as an opportunity to explore potential answers.

Notes:

1. Frank Wagemans is Senior Project Manager, Responsible Investment at VBDO. Dr Rory Sullivan is an independent consultant and is the Technical Editor of the Finance Sector Supplement.
2. For further information on the Finance Sector Supplement, Click to link
3. The development of the Finance Sector Supplement has been made possible by generous funding and support from The Rockefeller Foundation, International Finance Corporation (IFC) with the support of the Swiss State Secretariat for Economic Affairs (SECO) and the Ministry of Foreign Affairs of the Government of the Netherlands, United Nations Environment Program (UNEP), and the Dutch Ministry of Economic Affairs.