Natural Capital: The Finance Sector & Financial Reporting – Catalysing Action?
This Insight is an extract from an article by Kurt Ramin and Cornelis Reiman featured in ‘Trust Meltdown II’ launched at the recent World Economic Forum in Davos. The full article is available for download from the AccountAbility website.
Sustainability and the Financial Sector
Given the widespread impact of the recent global financial crisis, increasingly, the finance sector is now in line to be affected by factors of sustainability, as well as intensifying social and environmental risks and impacts. As a direct consequence, more attention must be paid by financial institutions to sustainability programs that are shaped and driven by factors such as corporate strategies, policies, goals and initiatives. In turn, these are based on drivers of economic, social and environmental risk, as well as, in addition to reputation, financial return and natural resources. Sustainability programs ensure that, amid environmental, social and economic uncertainty, an organization is able to adapt and, thereby, remain viable for the long-term interest of its owners.
Financial reporting systems will play a major part in watching the sector‘s progress towards sustainable policy adoption. This will include IT system integrations, making financial flows more transparent and increasing pressure for implementing a less speculative global currency model. Appropriate accounting and reporting systems are needed urgently. Additionally, these must have a global reach in tracking and valuing financial products if the financial sector is to play a critical role as a catalyst and integrator in moving other global financial reporting initiatives forward.
A changing agenda for financial institutions
We now understand the intellectual argument that natural capital (land, air, water, and living organisms in particular) provides significant value to society and the economy. But, it is not recognised or accounted for accordingly. What does this mean for the finance sector? Let‘s explore the type of risks that financial institutions should begin to think about when it comes to natural capital; these are:
Credit risks: The default of investments can be caused by risks associated with natural capital, and this can also prompt inaccurate information affecting counterparts. Collateral risk is central to this, as banks don’t have the means of recognising the loss of natural capital and what this means in relation to their investments.
Operational risks: These are most serious when it comes to an acceleration of natural disasters or the effects of ecological degradation on business outputs, such as agriculture. Losses are a probable outcome.
Reputation risks: being associated with financing an entity that is involved in major ecological liabilities bears increased risk. Once a financial institution loses its reputation in this manner, it is very difficult to build that back up.
These risks, and others, are recognised inherently by the 2010 Unsponsored study on “The Economics of Ecosystems and Biodiversity” (also referred to as the TEEB initiative - see www.teebweb.org), Even so, the finance sector must pioneer fundamental changes in how it estimates and analyzes risks. It is more than likely that some within the finance sector will be hit harder than others. The insurance sector represents a particular case in point where exposure to natural capital risk is more pronounced, especially due to accelerating climate and environmental risks.
It must be said that the lack of agreement on valuation mechanisms and metrics are a barrier. Yet, banks today use a wide range of instruments. These must be brought together in a systematic way, such as in a financial sector tool kit that addresses natural capital. This would also identify good examples of the financial instruments, the institutional processes, and the valuation mechanisms that are already implemented.