Nature-related risks and their relevance for central banks

Nature is currently undergoing a rapid decline due to factors such as land-use changes, climate change, and pollution, which may lead to the earth’s sixth mass species extinction. The current extinction rate is estimated to be between 1,000 and 10,000 times the natural rate. Since 1970, monitored wildlife populations have declined by 69 per cent, while freshwater populations have seen an 84 per cent decrease. This decline directly threatens ecosystem services—such as the provision of food, building materials, and clean air—that underpin the global economy.

More than half of the world’s yearly economic output is moderately to highly dependent on nature, indicating that the global economy is embedded within natural systems rather than being external to them. The collapse of major ecosystems, such as the Amazon rainforest, could significantly alter global weather patterns, affecting economic growth, commodity prices, exchange rates, and debt sustainability. It is therefore imperative for central banks to acknowledge and assess how their operations and the broader financial system depend on nature to ensure price stability and sustainable development.

How nature-related risks lead to financial risks

The Taskforce on Nature-related Financial Disclosures (TNFD) identifies three transmission channels through which nature-related linkages translate into financial risks: physical risks, transition risks, and systemic risks. Physical risks arise from the tangible consequences of nature loss, such as the degradation of pollination services. Research estimates that 36 per cent of Dutch financial sector investments and 42 per cent of securities held by French financial institutions are highly or very highly dependent on at least one ecosystem service. In Brazil, approximately 50 per cent of bank lending is concentrated in sectors with high nature dependency.

Transition risks emerge from shifts in policy, legislation, technology, and consumer preferences as the global economy moves towards sustainability. Systemic risks occur when nature tipping points trigger widespread failures with cascading interactions between physical and transition risks. These risks ultimately affect central banks through their impact on commercial banks and the value of assets held in monetary and non-monetary portfolios.

Pricing of nature-related risks in financial markets

The extent to which financial markets price nature-related risks is a critical question for resource allocation and risk management. While some evidence suggests equity prices may reflect biodiversity risks—notably following the Kunming Declaration in 2021—empirical findings remain mixed. Market participants are increasingly considering these factors, but data gaps and lack of measurable targets often hinder accurate pricing.

A case study: Biodiversity risks pricing in the bond market

This paper presents a case study on the existence of a biodiversity premium, or ‘biomium’, in Eurozone corporate bonds. Using MSCI ESG indicators, the study analysed the ‘Biodiversity & Land Use Key Issue Score’ and the ‘Exposure Score’. The results show that firms with better scores have significantly narrower bond yield spreads. Specifically, a one-point improvement in the Key Issue Score reduces the average bond spread by 7.7 basis points, while a one-point increase in the Exposure Score (representing higher risk) increases the spread by 10.2 basis points. This evidence suggests that nature-related risks are being viewed as financial risks in asset classes relevant to central banks.

Implications for central bank financial risk management

Central banks themselves are exposed to these risks. For instance, 40 per cent of the European Central Bank’s corporate bond portfolio is exposed to firms highly dependent on ecosystem services, and 70 per cent is exposed to firms that potentially contribute to biodiversity loss. Risk managers must explicitly integrate these considerations into their frameworks to safeguard balance sheets.

Material risks for central banks’ balance sheets

Nature-related risks manifest through interest rate, credit, and market risks. Nature loss can disrupt supply chains and increase production costs, creating inflationary effects that may lead to higher interest rates. Credit risk increases as the degradation of ecosystem services leads to stranded assets and higher default probabilities for nature-dependent firms. Furthermore, asset price declines resulting from nature-related shocks expose central bank portfolios to market risks.

Nature loss and fundamental uncertainty

Incorporating nature risks into risk frameworks is challenged by fundamental uncertainty and non-linear dynamics, such as feedback loops and tipping points. These complexities make it difficult to predict the timing and magnitude of nature loss impacts, necessitating a precautionary approach and the development of innovative assessment models.

The integration of nature-related risks in a central bank’s risk management framework

The report proposes a four-step cycle for managing these risks. Identification involves recognising firm dependencies on nature using tools like the ENCORE database. Assessment employs scenario analysis and stress tests to quantify potential financial impacts in a forward-looking manner. Mitigation strategies include setting dependency risk limits, selecting nature-aware benchmarks, adjusting haircuts on collateral, and tilting asset purchases towards firms with smaller nature footprints. Finally, Disclosure promotes transparency and accountability, utilizing frameworks like the TNFD to redirect capital flows towards nature-positive outcomes.

Conclusion

The relentless degradation of the natural world poses a serious threat to financial stability. Central bank risk managers play a vital role in ensuring balance sheet resilience by integrating nature-related risks into their management frameworks. By gathering and disclosing relevant data, central banks can also help resolve current issues regarding data quality and coverage in the financial sector.