06/08/2023 | Press release | Distributed by Public on 06/08/2023 01:08
8 June 2023
Why is the ECB concerned about the risks of biodiversity loss?
To pursue price stability, we need to understand the economy. We need to understand how economic trends and shocks affect the effectiveness of our monetary policy transmission. This is nothing new. We look at trends like demographics, globalisation, innovation and digitalisation. We've always done this and now we understand that climate change and crucially also biodiversity belong in that list of things that affect the economy. In my view, if we did not take climate, environment, biodiversity and nature-related aspects into account, we would be failing to deliver on our mandate.
Is there a particular reason to be looking at this now?
We should avoid doing too little, too late. With climate, we now understand that higher temperatures can lead to higher prices, ultimately feeding into higher inflation. But the same is likely true for biodiversity. Take farmers - they need pollination. Without pollination, there are lower crop yields, and possibly higher prices. Farmers need healthy soils. Without healthy soils, it's the same thing; there will be lower crop yields, which may have an impact on prices and inflation.
Now all this happens against the backdrop of a trend that is worrisome. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services states clearly that in terms of nature and biodiversity, we are on a downward trend. To give you some examples: of the species they assessed, 25% of the animal and plant groups are threatened. This means that 1 million species face a risk of extinction, many of those within decades; 85% of wetlands have already been lost; 66% of the oceanic area is experiencing cumulative impacts; and 75% of the land surface is significantly altered.
Look at the River Po in Italy. Just a month ago it was already at a level where it would normally be in August. In August last year, it was empty. You could walk to the other side. This matters a lot if you depend on it. The economy relies on nature. Destroy nature, and you destroy the economy. Analytically, we can use the widely accepted framework that we have for climate-related risks: we can look at physical risks and transition risks facing the economy that are related to biodiversity loss.
Give me an example of a physical risk in biodiversity.
The agricultural sector's dependence on pollination by insects is an example of a physical risk. We see insect populations dwindling and this will negatively affect crop yields. Another example is that large parts of the tourism sector rely on the beauty and diversity of nature to attract tourists as customers. If the forest they want to visit is burnt down or logged, they may no longer visit that area. These physical risks affect supply and therefore they could also affect prices. And this is where it could get into the realm of monetary policy, of price stability and of inflation. But also think of the firms that are active in these sectors. The farm producers, the tourism companies but also the construction companies that rely on timber or sand. They will potentially suffer from a diminishing or a degradation of the nature-related services they rely on, which might hamper or negatively impact their profitability. Protection against flooding provided by mangrove forests is another example. And there are many more. The economy relies on the services of nature. This is also why we have to dig deeper.
But we're not going to run out of trees or sand, are we?
They become scarcer and then prices might go up. These things are happening. In the Netherlands, there is a huge nitrogen problem. This is not climate-related at all, but it is something that affects production. This will hamper profitability. And that might have an impact on banks, which of course have exposures to these firms, and this might affect credit risk.
What about transition risk, how does that work?
Governments are not sitting on their hands; they are taking actions against biodiversity loss. We already have the Montreal Convention on Biological Diversity, which might increase existing natural reserves. There is a transition risk if your firm's activities take place on the land that is adjacent to existing reserves that are going to be expanded. Think about nitrogen. There are already limits on how much nitrogen deposits are being allowed. This directly affects production by the farmers involved.
Another example is if governments want to do something to prevent the loss of insect populations. One day there will be legislation on pesticides. That is a transition risk. If you are the pesticide manufacturer, maybe your product is going to be phased out or prohibited.
Transition risk can also be caused by changing consumer preferences. Consumers could start saying "I don't want to buy products from firms that are known to be actively involved in deforestation" or "I don't want to buy products or services from firms that have not signed up to certain voluntary associations or protocols". This risk can materialise suddenly. The same might happen with investors, because a number of environmental, social and governance (ESG) investment policies extend beyond climate.
All of this can also affect the banks that lend to the companies affected, because those firms might no longer be able to service their debt. I'm not predicting the extent to which this will happen, but it is how causal chains can play out. This is why we are analysing these exposures and why we will be publishing a report on them in the autumn.
What will be in this report you plan to publish on biodiversity loss?
We looked at 4.2 million euro area firms to determine their exposure to nature-related services. What we found is that 72% of firms - about 3 million firms - depend on at least one of these nature-related services, sometimes more. So the things we talked about earlier: timber, clean water, pollination, sand, healthy soils. That's quite a lot.
And we looked at more than just these firms. We also looked at bank loans. We found that 75% of bank loans are to firms that depend on ecosystem services. So banks are clearly exposed.
It is a landmark analysis because it's the first time that someone has looked at the exposure to biodiversity loss in the financial system of the euro area as a whole.
What else have you found?
Now the research that we are doing goes further than that because just looking at who is exposed doesn't give you all the answers yet. You also want to see what the sensitivity to shocks is. You need to go one step further and ask what happens if there are certain degradations in some of these nature-related services. How will that affect the firms that depend on them, and how will that dependence then affect the exposures that the banks have?
It's a little early to say much more. We will be very happy to explain in more detail when we publish the full report. It will be more granular and deeper. We will also assess transition risk aspects by looking at how firms' activities have an impact on biodiversity. This angle serves as a kind of proxy for what might happen to these firms if regulation of the kind I mentioned before is introduced.
What about banking supervision?
When we published our guide on climate-related and environmental risks at the end of 2020, that broader scope was new because so far most other supervisory authorities had just focused on climate. After that, we asked banks to provide their self-assessments in 2021 and to come up with action plans. Then in 2022, we conducted what we call a thematic review, in which we looked at all the banks under our direct supervision. One of the findings was that banks have made less progress on environmental risks than on climate-related risks. While 25% of the banks had not yet conducted a materiality assessment of climate risks, 40% hadn't yet done so for environmental issues. So the glass is not yet half full.
Have you seen signs of progress since then?
There is progress now on biodiversity. Very concretely, we have seen the first banks that actually, in their internal capital calculations, earmark capital for environmental risks. That is an interesting development. But we want full compliance by all banks with all our expectations. We try to help the banks by publishing examples of good practices. At the same time, I've been making it very clear that, if needed, we will also enforce them. It's carrots and sticks.
What's your objective here? Are you trying to save the planet and the natural world? Or are you just focused on the financial and economic risks?
Let me try to be super specific here. Even if I couldn't care less about the planet, even if I couldn't care less about biodiversity, I would say the exact same things. The fact that as a private citizen I may have certain concerns is not relevant for anything that I say here. What I'm trying to explain is that this is a risk that banks need to manage. What I'm saying is that biodiversity and nature-related services generally are relevant for the economy. This is not some kind of a flower power, tree-hugging exercise. This is core economics. This is core financial stability, core macroprudential, core price stability. It would be nice if we had more data, if we had more certainty, more clarity. But sometimes you have to deal with the knowledge that you have. On the basis of the knowledge we have, we certainly see that there are more pages in this chapter. But it's not about saving the planet. It's about our mandate. It's about safeguarding price stability. It's about financial stability. It's about a resilient banking system.
But how do you measure this? With climate change, you look at carbon emissions. What is the yardstick for biodiversity?
There are similarities between climate and biodiversity that make both difficult. What they have in common is uncertainty, and the non-linearity of these risks. You cannot just extrapolate from what you're seeing today. There might be tipping points and these might lead to irreversible effects, in which case there's no going back, even if we change our ways of living. And there's all this uncertainty on the likelihood of certain things happening and the timing of it all, and the magnitude. But it's true what you say, there's not just one easy carbon dioxide-kind of measurement for biodiversity. But things are happening. We have the EU Corporate Sustainability Reporting Directive, which contains disclosure requirements that go beyond climate. They also cover biodiversity and ecosystems, as well as water and marine resources and pollution.
Could we see more concrete action to address these risks by the ECB, not just on banking supervision, but also in your asset portfolio or collateral rules?
When we published our measures to include climate change in our monetary policy operations in July last year, the statement had a review clause stating that the ECB Governing Council stands ready to revisit all of its climate-related policies if more is needed, with a specific reference to also look at environmental issues. I'm not predicting anything specific here. Our actions will follow where the science, analysis and research take us.
The ECB looks like a bit of an outlier here, doesn't it? Why aren't other big central banks doing this too?
We are not the only ones. Before us, similar work was done by De Nederlandsche Bank and then by the Banque de France, but also by Malaysia, Brazil, Singapore and the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), which has 125 members who all signed up to its statement that "nature-related risks, including those associated with biodiversity loss, could have significant macroeconomic implications, and that failure to account for, mitigate, and adapt to these implications is a source of risks relevant for financial stability". I think this worldwide recognition of the significance of nature-related risks is important.
You say we are somewhat of an outlier. Well, maybe some people speak up more openly. When I believe in something, I say it. But I am not the only one. The NGFS statement is a strong one. That all flows from work that has been done together with many others, including the US Federal Reserve. Look at the Basel Committee, where I co-chair a task force on climate-related risks. There, the scope is climate-related risk. But everything I've said in terms of the analytical framework distinguishing transition risks and physical risks, it's all in there. And this analytical framework is subscribed to by the entire Basel Committee.