Building capacity to identify and assess nature-related financial risks
This report examines nature-related financial risks in the Indonesian and Malaysian palm oil sectors. Using scenario analysis, it evaluates how an intensified El Niño and ecosystem degradation affect production, costs, and credit risk. Findings highlight the vulnerability of upstream producers and the necessity for banks to assess nature-based dependencies.
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OVERVIEW
Preface
This research, conducted by the University of Cambridge Institute for Sustainability Leadership (CISL) in collaboration with DBS, OCBC, and UOB, and supported by the Monetary Authority of Singapore (MAS), aims to build internal capabilities within banks to identify and assess nature-related financial risks. The project focuses on recognising and evaluating nature-related dependencies in wholesale lending portfolios through a high-level mapping exercise. It develops a sector-specific scenario use case for the palm oil industry in Indonesia and Malaysia, intended to serve as an archetype for broader financial sector assessments of business impacts linked to nature-related risks.
Industry context
The palm oil industry is a significant global sector, with Indonesia and Malaysia accounting for over 85 per cent of global production. Crude Palm Oil (CPO) production is highly dependent on critical ecosystem services, including soil quality regulation and pollination services. The industry is valued at approximately US$60 billion and directly employs six million people. Research using the ENCORE tool indicates that 89 per cent of ecosystem services required for agricultural products have a medium or high level of materiality. For instance, pollinators directly affect the yield or quality of 75 per cent of globally important crops, contributing between US$235 billion and US$577 billion annually. Annual production is projected to grow to between 93 and 156 million metric tonnes by 2050, provided environmental conditions allow for this trajectory. Millions of smallholder farmers have transitioned to palm oil, which yields significantly more per hectare than soybeans, sunflowers, or canola.
Probable nature loss events scenario
The report develops hypothetical climate–nature loss scenarios triggered by an intensified El Niño event. These scenarios examine the physical risks associated with compromised ecosystem services. El Niño typically results in drier, hotter conditions in Southeast Asia, with severe events causing average temperature increases of 2 degrees Celsius or more. Two primary scenarios were analysed: a mild nature loss scenario involving a 20 per cent reduction in production volume, and a severe scenario involving a 40 per cent reduction. These projections are grounded in historical data; for example, 33 per cent of the world’s soils are already moderately to highly degraded, reducing their capacity to provide nutrients and sustain expected crop growth. Furthermore, climate change and habitat loss increasingly compromise pollination, which is crucial for fruit development in palm oil production.
Business impacts
The analysis examines four key dynamic variables: sales volume, average selling price, fertiliser costs, and labour costs. In a mild scenario, sales volumes decrease by 20 per cent while average selling prices rise by 31 per cent, leading to a 5 per cent increase in revenue. Conversely, a severe scenario sees a 40 per cent volume drop and a 62 per cent price increase, resulting in a 3 per cent decrease in revenue. Production costs are expected to rise significantly, with fertiliser utilisation costs projected to increase by 40 per cent due to a challenged environment. Conversely, labour costs for harvesting are expected to decrease by 12 per cent to 24 per cent as the volume of fresh fruit bunches harvested declines. The report assumes a median price increase of 1.55 per cent for every 1 per cent reduction in production volume, acknowledging that market dynamics and demand responsiveness may cap price increases in severe scenarios.
Potential credit risk impacts
An assessment of 16 corporate companies showed that upstream producers, such as planters and millers, are more sensitive to nature-related risk impacts than integrated players. Integrated companies benefit from greater financial strength and diversified operations, making them more resilient to short-term acute stress. In the mild scenario, the credit impact was limited, with the average notch change ranging from -0.33 to -0.63. However, in the severe scenario, the impact was elevated, with average notch changes for Malaysian planters reaching -1.60. Specifically, five out of thirteen planters and millers faced a credit rating downgrade of more than one notch in the severe scenario. Companies with better baseline financial strength demonstrated greater resilience to these acute nature-related risks.
Limitations and assumptions
The study is subject to several constraints due to its exploratory nature. It focuses on a limited sample of 16 companies and assumes a one-year short-term acute impact during which strategic management mitigation actions are not initiated. The analysis assumes that demand volume equates to production yield and does not account for second or third-order effects on costs for refiners. Furthermore, the report relies on country-level empirical data, acknowledging that company-specific and site-specific data granularity remains a challenge. The complex interaction between climate and nature risks, such as the emergence of pathogens due to temperature changes, was not fully incorporated into the modelling.
Reflections
The exploratory approach provides an early indication of nature-related risks but highlights significant knowledge gaps that must be addressed before such assessments can be integrated into routine risk analyses. Future research should transition from assessing nature dependencies to evaluating the nature impacts, or footprint, of companies. The learnings from this project could be extended to other sectors, including mining, renewables, and real estate. The findings underscore the importance of collective action from financial institutions, real economy players, and policymakers to advance understanding and create positive change in the management of nature-related risks.