The research paper identifies nature-related financial risks as both endogenous and exogenous to the financial system. It draws attention to the physical and transition risks, highlighting radical uncertainty,multi-dimensionality, and the complexity of the environmental threat.
The paper argues that a market-based approach to sustainable finance has not been successful in curbing economic activities that have damaging consequences for the environment. Instead, we need a precautionary approach to financial supervision that fosters preventative action to build financial resilience against environmental risk. By focusing on the wider impact of environmental threats, a precautionary approach can re-shape market behaviour and reduce environmental risks.
The paper recommends that central banks and supervisors focus on managing environmental risks by implementing regulations at the micro- and macro-prudential levels. The goal is to focus the analysis on systemic risks. It proposes that nature-related risks be included in supervisory exercises to allow the identification of systemically risky and vulnerable activities.
The precautionary policy approach asks central banks and supervisors to determine the materiality of nature-related risks based on the systemic implications of its outcomes. The recommendations should be integrated into other areas of policy to promote financial resilience and reduce financial instability.
The paper highlights the need for the transition to non-extractive business processes to provide finance for innovation and capital investment. The opportunities arising from the transition (i.e. new sectors and technologies) as a solution to climate change are well understood by investors. However, questions remain as to how nature can become a new sector of opportunities. Monetising ecosystem services is difficult due to the public good aspect. Additionally, environmental protection often requires minimising human claims upon nature, which implies a reduction of economic activity.
The research paper concludes that central banks and supervisors should adopt a precautionary policy approach to manage nature-related financial risks. Specifically, it endorses three principles for the integration of environmental risks into prudential supervision for the financial system: the approach should be integrated and holistic, it should be proactive and take systemic effects into consideration, and it should be precautionary and focus on prevention rather than cure.
