Biodiversity finance

COP 15

Following COP15, and the adoption of the Kunming-Montreal Global Biodiversity Framework on the last day of the conference, markets have started to pay attention. The framework aims to address biodiversity loss, restore ecosystems and protect indigenous rights. The need for such actions is widely documented: the World Economic Forum estimates over half of global GDP depends on high-functioning, healthy biodiversity. There is no doubt the financial markets are required to accelerate and scale the necessary investment in nature-positive assets to reverse the trends of declining biodiversity.

Measuring biodiversity

Biodiversity has emerged as the measurement of choice when assessing the health of a natural environment. Biodiversity looks at the variety of life forms within an ecosystem, which makes it an appropriate measurement of an ecosystem’s health as such variety is essential to the viability and resilience of ecosystems. It is equally fundamental economically as the health of an ecosystem is directly linked to its output and the continued ability for people to benefit from and harvest its resources.

For example, take forestation and the timber industry. The ability to create wood products depends on consistent supply of high-quality timber, which itself is generated from a healthy forest, therefore dependent on the biodiversity provided by forestation. Measuring biodiversity can help attribute economic value to ecosystems but without the pitfalls of using a natural capital measurement which solely measures monetary value without considering the issue of sustaining the ecosystem.

Reliance on nature/biodiversity

The health and maintenance of nature and its biodiversity should be a key consideration for all stakeholders. Markets depend on healthy nature: food and consumer goods supply chains have suffered because of biodiversity loss as homogenised crops become more vulnerable to changes in their surroundings; fashion relies on a consistent clean water supply to produce its materials; and regenerated soil is required to prevent widespread flooding. Alongside ensuring the provision of food, clean air and water necessary for human survival, the products of healthy biodiversity (or lack thereof) affect the probability and predictability of cashflows. Low output from natural resources (such as failed crops or depleted herds) because of ecological destruction can have a noticeably negative effect on GDP and could result in deterioration of sovereign credit ratings.

Diligence and similarities

Lenders are already familiar with identifying and assessing nature-based risks and opportunities as such aspects will fall within lenders’ pre-transaction diligence and credit-analysis processes. Diligence processes focus heavily on an entity’s operations, the purpose of the financing and the transaction funds flow to allow lenders to structure repayment and model profitability. The effect of biodiversity loss on the borrower needs to be considered as part of this process and priced into any value or forecast. Likewise, the macro-economic concerns caused by any biodiversity loss will have been similarly accounted for. By switching the focus of diligence from effects on a borrower, asset, or service to the effect of the borrower, asset, or service, such diligence can identify and assess the impact on biodiversity and the natural environment. Where the repayment profile of an investment is linked to successful biodiversity performance, such assessment will most likely have been undertaken and the scrutiny of the ecological effects of the project or operation will be even higher. With their existing experience and streamlined, adaptable diligence processes, lenders are well placed to identify and amplify nature positive opportunities.

Further lender considerations

Notwithstanding the existing head-start lenders get from their diligence processes, there are further ways for lenders to accelerate nature-financing whilst protecting themselves from the related transaction risks. In use of proceeds financings (where all loans must be applied to projects with a primary purpose of mitigating or counteracting biodiversity loss), ongoing reporting on key biodiversity metrics should be required as part of regular information reporting to keep lenders appraised of the project’s progress and notified of any increase in biodiversity risk. Additionally, the parties must adhere to a strict, controlled funds flow to ensure all monies are applied to the specified biodiversity project. Where multiple or future projects will be financed, parties should agree a framework to sit parallel with the loan documentation which will determine the criteria for selecting eligible biodiversity-related activities which can be funded using the proceeds of the loan. Appropriate representations and confirmations in respect of the framework should also be included as a condition of advancing funds. Each of these aspects are recommended as part of the LMA’s Green Loan Principles and are further built on in the International Finance Corporation’s Biodiversity Finance Reference Guide.

Biodiversity risk can also be addressed in sustainability-linked loans, where parties agree to work towards ambitious targets on prescribed key performance indicators in exchange for a pricing benefit. As any such targets under these loans should be material and relevant to the borrower and their business, biodiversity targets can provide tailored risk prevention and detection functions. The targets themselves encourage biodiversity-positive operations and act as a deterrent to any behaviour harmful to nature, both of which are supported by a financial incentive or disincentive accordingly.

Reporting resources

Outside of green or sustainability linked loans, lenders can still identify and protect themselves against risks from the natural environment using regular biodiversity reporting. In the same way that financial covenants act as early warnings for financial distress, robust and regular reporting against nature focussed values will provide the equivalent signals in nature-sensitive investments. Increasingly accessible reporting frameworks facilitate transparent, nature-specific records and open communication on biodiversity in standard lending transactions. Following the success of the Taskforce for Climate Related Financial Disclosure, the Taskforce for Nature Related Financial Disclosure has developed and published a set of disclosure recommendations and guidance which request and present a business’ ecological information in a similar way to financial reporting. This approach enables stakeholders to identify nature-related dependencies, impacts, risks and opportunities in a familiar manner. The Principles for Responsible Investment also has comprehensive guidance on incorporating biodiversity and nature risks into lender assessments.

By incorporating new tools and perspectives into existing processes, lenders can leverage their extensive experience to channel more financing into reversing biodiversity decline and avoiding the related environmental risks. Such capital allocations are not only desperately needed to help drive global investment into nature preservation but have the potential to support other sustainable finance initiatives such as carbon offset projects. Considering how fundamental a healthy natural environment is to society and the economy, it is now more urgent than ever that market participants take account of the intrinsic and material value that nature holds in all transactions.

This article was first published in Butterworth's Journal of International Banking & Financial Law.