Climate change and carbon emissions have recently received a lot of attention from governments, non-governmental organizations (NGOs), businesses and the general public, and rightly so. But we must be wary of carbon emissions tunnel vision and instead take a more holistic view of the planetary challenges that will affect the stability of our economy, society and earth’s systems. We believe natural capital could be the next ESG-related point of focus for pension plans. Those who thoughtfully engage with it now potentially stand to benefit by understanding the risks and opportunities before the wider market. But what is it, and how can plan committees assess its impact?

Natural capital is the world’s stock of natural assets, including soil, air, water, grasslands, forests, wetlands, rocks, minerals and all living things. Collectively, these provide vital ecosystem services such as water for agriculture, natural filtration for clean drinking water, crop pollination, carbon sequestration and flood and storm protection. In monetary terms, these services are valued at US$44 trillion a year and form the basis of half the world’s GDP.[i]

Why focus on natural capital now?

Natural capital is worth considering in its own right, and its link to climate change makes it all the more important right now. Meeting the goals of the Paris Agreement will require halting and reversing the loss of natural resources. Land use and forestry changes amount to just under a quarter of human-caused greenhouse gas emissions.[ii] Forests and oceans absorb vast amounts of carbon dioxide, but this capability is diminishing due to acidification, biodiversity loss and plastic pollution. As we approach various tipping points, the impact of the damage to natural capital becomes more important.

The growing appreciation of natural capital could significantly impact the economics of many companies and, as investors, it is our job to price the risks and opportunities in the future and then turn those into an investment thesis today. 

How to assess the impact of natural capital?

Our investment team formulated a three-step framework to analyse the risks and opportunities for companies in relation to natural capital. 

The team’s initial focus has been the food industry, given its high dependency on natural capital compared to other industries. The food industry also has the largest impact on natural resources, driven primarily by intensive and industrialised processes. Moves toward more sustainable food production are also likely to impact profit margins. If no such transition is made, the food sector’s reliance on natural capital and ecosystem services makes it particularly vulnerable to deteriorating value derived from nature. This has implications for food sector companies and investors alike.

Step 1 – Identify high risk commodities in supply chains and understand their impacts on nature

The impact a commodity has on nature depends on how much of the commodity is produced, the level of demand and the range and extent of the negative outcomes that it creates.

We began by mapping the size of material natural capital impacts of food groups such as beef, rice, corn and palm oil, against the type of impact in play (soil degradation, pollution, water scarcity and salinisation, biodiversity loss and emissions from land use). 

We then identify the companies we invest in that have significant direct exposure to the biggest impacts and the supply chains in which they appear.

Step 2 – Map the supply chain, local consumption and local resource stress

Natural capital impacts are often highly localized and driven by a variety of geographic factors including scarcity of resources, biodiversity, government policies and farming practices. This makes it hard to assess the impacts of global supply chains. 

In addition to location, how much of a commodity is locally consumed and how resource intensive it is to produce also affects its natural capital cost. For example, although it takes much more water to produce meat than to grow wheat, the water stress of wheat in India is much higher than in the US because wheat is a staple of the Indian diet and because of the severe water stress in the regions where Indian wheat is grown. Global supply chains therefore require us to map resource use, local scarcity and contribution to local diet.

We then map company-specific exposure before moving to the final step.

Step 3 – Assess areas to focus our stewardship efforts (high risk and high impact commodities)

This framework can guide us on where to focus our further analysis and engagement efforts. For example, higher water scores might be more meaningful than lower forestry scores because water stress might be a more material risk for a particular company than deforestation. 

Other ESG factors outside the scope of this framework will also influence our engagement efforts as we track both the progress made by companies and our own ongoing engagements in a dedicated engagement tool.

Next steps for plan committees? The “E” of ESG should not only be about climate change.

We believe plan committees should consider discussing natural capital with their advisors, including their investment managers as they may potentially benefit from more accurately pricing relevant opportunities and risks before the wider market is able to do so. That said, we appreciate committee members have a lot on their plate in terms of regulatory requirements, and many advisors themselves are at an early stage of the learning curve.

We think natural capital, along with the ecosystem services it provides, poses a material systemic risk, but also presents opportunities in several key sectors. Assessing these risks is harder than assessing those associated with climate change, but we are encouraged to see more conversations starting to happen. While the data are still largely unavailable or remain poor-quality, organizations such as The Science Based Targets Network (SBTN) and the Taskforce on Nature-related Financial Disclosures (TNFD) are beginning to gather momentum, providing a more structured framework for assessing natural capital. 

We hope to be able to share with you more insights on this topic as we continue along this journey. Visit mfs.com/sustainability for more on this topic and other ESG related insights.

References