Economic and financial impacts of nature degradation and biodiversity loss

Prepared by Andrej Ceglar, Miles Parker, Carlo Pasqua, Simone Boldrini, Marie Gabet and Sjoerd van der Zwaag

Published as part of the ECB Economic Bulletin, Issue 6/2024.

1 Introduction

Nature is crucial to human wellbeing and provides essential ecosystem services that support economic activity. Nature encompasses all living and non-living elements on our planet, forming ecosystems such as forests, lakes and wetlands.^[1] These ecosystems provide habitats for numerous species and tangible goods like food, freshwater, timber and medicinal resources. These also maintain environmental balance, for example by regulating air quality, controlling climate and mitigating floods. Key processes facilitated by ecosystems include soil formation, nutrient cycling and pollination. Nature also offers intangible benefits such as recreation and tourism. These benefits are greatly at risk from the current unprecedented rate of nature degradation and biodiversity loss.

Businesses, the financial sector and policymakers have long underestimated, or even disregarded, the economic significance of ecosystem services, many of which are neither traded in markets nor directly assigned a monetary value. For example, wetlands act as natural water filtration systems and storm barriers, saving billions in water treatment and disaster mitigation costs. Forests absorb carbon dioxide, playing a vital role in climate regulation and reducing the economic impacts of climate change. Healthy soils and pollinators are essential for crop production. Without pollinators, crop yields would decrease, leading to higher production costs, increased consumer prices and potential food shortages. Many of the services provided by ecosystems are public goods and are either undervalued in markets or not currently priced in at all. As a result, they are often overlooked in economic decisions, which has significant consequences for the natural world. The Integrated Natural Capital Accounting (INCA) project, an integrated system of ecosystem accounts for the EU, estimated that in 2019, ten ecosystem services in the EU28 generated a total annual flow of benefits worth €234 billion.^[2] Box 2 in this issue of the Economic Bulletin sets out in more detail the challenges of incorporating ecosystem services into measures of economic activity.

Recent research has demonstrated the highly non-linear nature of biodiversity loss.^[3] While financial losses identified so far may seem limited, it is important to recognise that even seemingly minor events – such as the loss of a single species of bee – may have knock-on effects that have a substantial economic impact. Species loss can hold back economic productivity and make the provision of ecosystem services more fragile. This fragility can compromise economic resilience, lower growth opportunities and exacerbate our vulnerability to future biodiversity loss. So nature degradation can have important economic effects that central banks should be aware of to maintain price and financial stability. Indeed, negative news about biodiversity already increases financial market measures of risk, especially in countries where ecosystems are more depleted.^[4]

Central banks can only achieve their objectives for price and financial stability if they understand and forecast how economic shocks and trends affect inflation, the broader economy and the financial system. Given the potential of climate change and nature degradation to cause significant economic disruptions, these environmental crises should be integrated into policy frameworks alongside factors such as globalisation, demographics and financial innovation. They pose severe risks that can affect the business cycle and there is an urgent need for thorough analysis and decisive policy action. During Hurricane Sandy, for example, coastal wetlands in the northeastern United States prevented USD 625 million in flood damages.^[5] This illustrates how reduced capacity of ecosystems to protect against floods increases the likelihood that future extreme rainfall events will cause flooding, disrupting economic activity at the business cycle frequency. The loss of such ecosystem services can lead to greater damage, with long-lasting effects on the economy, infrastructure and financial stability of the region concerned.

This article discusses the implications of nature degradation and biodiversity loss for the economy and financial stability. It explores the drivers of biodiversity loss, its interconnection with climate change, and the material impact of these risks in the euro area. The article also highlights progress in quantifying nature-related risks, featuring a box with assessments by Dutch and French financial institutions. Finally, it outlines the next steps for managing these risks and their implications from a central bank perspective.

2 Drivers of biodiversity loss and the interconnection with climate change

Human activity impoverishes biodiversity and threatens the continued provision of crucial ecosystem services. Human demands have exceeded the planet’s ability to sustainably provide ecosystem services, resulting in unprecedented rates of nature degradation and biodiversity loss.^[6] Monitored wildlife populations across the world have declined by an average of 69% since 1970.^[7] The global rate of species extinction is currently tens to hundreds of times higher than the average over the past ten million years.^[8] Europe is no exception, with over 80% of habitats now deteriorating.^[9] The conservation status and habitat trends are worse for pollinators than for other species.

The primary drivers of biodiversity loss and ecosystem change are land and sea use, climate change, overexploitation of natural resources (living and non-living), pollution and invasive species.^[10] Land and sea use includes the conversion of pristine habitats such as forests and wetlands to other purposes, including agricultural land and urban areas. Nearly 420 million hectares of forests have been lost worldwide since 1990, an area the size of the European Union. Climate change is a rising threat for biodiversity, already endangering one in six species globally. It also jeopardises ecosystems that serve as vital carbon stores and are crucial for meeting climate mitigation targets. Invasive species, introduced by human activity, can disrupt local ecosystems, displace native species and significantly affect the economy, the environment and public health. They play a key role in 60% of global plant and animal extinctions, leading to global economic costs exceeding $423 billion annually in 2019.^[11]

Biodiversity loss can also amplify climate change and related risks, particularly when ecosystems that store carbon or provide adaptation benefits are degraded or lost. Restoring ecosystems can reduce climate-related risks. But the reverse is not always true: measures to combat climate change can benefit nature but may also contribute to its degradation. Examples include inadequately planned reforestation initiatives, such as monocultures, or the mining of minerals critical to the energy transition in biodiversity hotspots. These situations highlight the reinforcement of risks and potential trade-offs, necessitating an integrated approach to addressing climate and broader nature-related risks.^[12]

With the scale of nature degradation becoming clearer by the day, efforts to halt and reverse nature loss are accelerating, which in turn also requires financial institutions to manage related economic and financial risks. In December 2022 the EU and 195 countries adopted the Kunming-Montreal Global Biodiversity Framework (GBF), which is seen as being as important for nature and biodiversity as the 2015 Paris Agreement has been for galvanising action against climate change. The GBF incorporates targets such as the protection of at least 30% of the world’s land and water by 2030 and the reduction of harmful government subsidies by at least USD 500 billion per year. Additionally, it aims to mobilise at least USD 200 billion annually by 2030, from both public and private sources, to effectively support biodiversity strategies, such as encouraging private investments and promoting innovative financial mechanisms. Importantly, it requires signatories to act to ensure that financial institutions “regularly monitor, assess, and transparently disclose their risks, dependencies and impacts on biodiversity including […] along their operations, supply and value chains and portfolios.”^[13]

To address the concerning rate of ecosystem degradation, the EU, under the umbrella of the European Green Deal, is implementing a range of targeted policies and legislation. Examples include the EU’s biodiversity strategy for 2030, plans to enhance the EU Birds and Habitats Directives, and the EU Pollinators Initiative. In June 2024 the EU adopted the Nature Restoration Law, a regulation focusing on actions such as restoring degraded ecosystems, enhancing biodiversity, increasing green urban spaces and improving the resilience of natural habitats to climate change.^[14] EU countries are required to submit their National Restoration Plans to the Commission within two years of the law coming into effect. These plans must outline their strategies for meeting the established targets. The Nature Restoration Law introduces transition risks as businesses will need to adapt to new regulations, but it also offers long-term benefits for financial stability through the preservation of ecosystems and their services.

3 Nature degradation and biodiversity loss pose material economic and financial risks

Nature-related risks can affect price and financial stability through multiple transmission channels. As in the case of the more familiar climate-related impacts, the physical risks from the threat that nature degradation poses to economic activities dependent on ecosystems can be distinguished from the transition risks arising from changes in policy, legal precedent, consumer preferences and market sentiment, etc. Litigation risk, as a subset of physical and transition risk, can arise from a variety of factors, including liability claims, policy and regulatory changes and misconduct.^[15]

Physical risks occur in both acute and chronic forms and particularly affect sectors that are more dependent on specific ecosystem services (Figure 1). Acute degradation is abrupt, arising for instance from forest fires, oil spills and pests. Chronic degradation, such as land degradation that eventually renders cropland unsuitable for cultivation, accumulates over time. Distinguishing between acute and chronic impacts can be difficult, since the various elements in nature are strongly interconnected, leading to compounding effects and tipping points which are hard to anticipate.^[16] In this way, chronic degradation can result in a sudden major deterioration in ecosystem services at a particular point in time.

Transition risks particularly affect activities that cause nature degradation and are hence responsive to efforts aimed at protecting and restoring nature (Figure 1). Governments are stepping up their efforts to protect nature and biodiversity by strengthening regulations and policies that limit the exploitation of natural resources or ban certain products that trigger degradation. Technological innovation, new business models and changes in consumer or investor sentiment could similarly result in transition risks and costs as firms are forced to adapt.

Figure 1

Nature degradation, including biodiversity loss, leads to physical and transition risk for the European economy and the financial system

The materialisation of both physical and transition risks can have major implications for the European System of Central Bank’s (ESCB’s) price stability objective under the Treaty on the Functioning of the European Union and trigger losses that can threaten financial stability (Figure 2). These impacts can be direct, for example soil erosion and loss of pollinators impairing agricultural productivity and pushing up food prices, while also reducing land values and farmers’ income. The impacts may also be indirect, as value chains transmit impacts occurring elsewhere in the world through to the domestic economy. For individual financial institutions or financial systems, economic impacts can subsequently translate into financial risks (including credit risks, market risks and underwriting risks) through financed activities. Such risks can be amplified by the compounding of individual risks or through financial contagion, and may well be endogenous, arising from the damage to nature caused by economic activity financed by these institutions. The macroeconomic effects of these nature-related risks could affect monetary policy implementation, including through disruption to financial stability. In addition, the even transmission of monetary policy impulses across the euro area could be impaired if nature-related risks crystallise differently across countries.

Figure 2

Transmission channels in the nature-related risk assessment framework

Beyond the direct impact on the primary objective, the ESCB must also consider further Treaty provisions. Where nature protection directly contributes to climate crisis mitigation, it can be considered consistent with the ESCB’s obligation to support the general economic policies in the EU.^[17] Moreover, under Articles 7 and 11 of the Treaty, the ESCB must ensure consistency with Union law, integrate environmental protection requirements into its policies and activities, and refrain from making decisions that counter these requirements.

4 Progress in quantifying nature-related risks

Recent ECB analysis revealed that the euro area economy and financial system are critically dependent on nature and the ecosystem services it provides.^[18] Out of 4.2 million non-financial corporations (NFCs) in the euro area, 72% are critically dependent on ecosystem services and would experience significant economic problems as a result of ecosystem degradation. For example, vegetation cover reduces soil erosion, prevents avalanches and landslides and provides flood and storm protection. Some 75% of all corporate loans in the euro area are granted to NFCs that are critically dependent on at least one ecosystem service (Chart 1). Loan portfolios may be significantly affected if environmental degradation continues to follow current trends, with stronger vulnerabilities concentrated in certain regions and economic sectors.

Chart 1

Exposure of euro area banks’ loan portfolios to nature-related risks

(December 2021, y-axis: percentages; share of loans with high dependency scores)

Further ECB analysis explores how the euro area economy is affecting nature and its ecosystem services and demonstrates the double materiality of nature-related risks. The euro area economy has significantly affected nature and biodiversity through two principal drivers: land use and climate change.^[19] In total, euro area NFCs generate a local impact equivalent to the loss of around 365 million hectares of natural habitat in the euro area alone. This measure covers the loss of biodiversity resulting from (i) land conversion that has already been observed, and (ii) potential biodiversity loss in the next 100 years due to the global warming potential of greenhouse gas emissions in 2021.

Nature-related risks have a global reach, with euro area NFCs’ supply chain demands extending their environmental impact worldwide. Euro area NFCs depend on raw materials sourced from outside Europe, promoting activities such as mining that contribute to nature degradation. Asia and Africa are the areas most affected, owing to high dependency of euro area NFCs on the supply of agricultural, mining and manufacturing products from these continents. In total, euro area NFCs cause around 217 million hectares of natural habitat loss outside the euro area. The combined European and global impact is equivalent to the loss of 582 million hectares of pristine natural areas worldwide (an area nearly 60% of the size of continental Europe). Given that this calculation excludes some other important drivers of biodiversity loss, such as unsustainable exploitation of natural resources and pollution, it is likely to underestimate the real figure for biodiversity loss.

The negative impact on biodiversity financed by euro area banks is highly concentrated (Chart 2). The ten banks with the greatest impact on nature are responsible for financing approximately 40% of the estimated worldwide global biodiversity loss caused by euro area NFCs. This share reaches around 90% for the 100 banks with the greatest impact – out of 2,500 included in the study – indicating a high concentration of financing activities with a negative impact on biodiversity and, in turn, transition risk. Legislation aimed at reversing nature degradation could bring financial repercussions for these financial institutions.

Chart 2

Concentration of impact on biodiversity financed by euro area banks

(December 2021, y-axis: percentages, x-axis: number of banks)

It is essential to understand how banks and the financial system at large are exposed to the amplification of climate-related risks due to degradation of ecosystem services. The highest risk for euro area banks is likely to materialise as a compound effect of both climate and nature. Chart 3, panel a) illustrates sectoral dependency on surface water provision and projected exposure to drought risk between 2030 and 2040. An economic sector’s greater dependency on surface water provision can be compounded with a high risk of drought, which may amplify the impact on NFCs in those sectors and on the banks that lend to them. A large share of loans in southern Europe are granted to NFCs in sectors that are exposed to both risks (Chart 3, panel b).

Chart 3

Physical risk in climate and nature space

a) Average level of risk by country-sector

(y-axis: average level of water stress index for 2031-40, x-axis: average dependency score)

b) Share of loans by country of residence and level of risk of NFCs

(December 2021, y-axis: percentages; share of loans by level of risk)

ECB analysis takes a forward-looking perspective and identifies euro area banks’ vulnerabilities to future biodiversity losses (Chart 4). If the world follows its current emission pathway and continues to exert significant pressure on biodiversity (adverse scenario), losses for euro area banks could be on average almost three times higher than they would be under a Paris-aligned, resource-efficient future scenario (sustainability scenario). The analysis shows that the biggest losses would occur in Germany, given how dependent the country’s strongest economic sectors, such as manufacturing, are on biodiversity levels. Additional findings of the analysis show that banks with lower capital are more exposed to biodiversity risk. Smaller banks tend to have more concentrated portfolios and focus on smaller regions, while larger banks are better able to diversify.^[20]

Non-bank financial institutions (NBFIs) are also exposed to the economic consequences of nature degradation and biodiversity loss. The European Insurance and Occupational Pensions Authority (EIOPA) reports that approximately 30% of insurers’ investments are critically dependent on nature and the ecosystem services it provides.^[21] The IPBES Global Assessment^[22] and the Dasgupta Review^[23] emphasise that by incorporating biodiversity considerations into their investment decisions, NBFIs can play a pivotal role in mitigating the risks associated with nature degradation while promoting the conservation of ecosystems.

Other Eurosystem research highlights the growing recognition among central banks and supervisors of the significant macroeconomic and financial stability risks posed by nature degradation. De Nederlandsche Bank (DNB) revealed that a total of €510 billion of investments by Dutch banks, pension funds and insurers (representing 36% of the portfolio of more than €1,400 billion under review) are critically dependent on ecosystem services.^[24] DNB also assessed potential transition risks, finding significant exposures to nitrogen-emitting sectors and global ecosystem protection policies. Similarly, the Banque de France found that 42% of the value of securities held by French financial institutions comes from issuers that are critically dependent on ecosystem services, with a biodiversity footprint comparable to the loss of 13 million hectares of pristine nature.^[25] Assessments for the Irish and Lithuanian financial sectors have reported similar findings, underscoring the widespread relevance of nature-related financial risks.^[26] Box 1 explores the ongoing research in more detail.

Chart 4

Ratio of changes in expected losses of banks’ credit portfolios between adverse biodiversity and sustainability scenarios by 2050

(December 2021, ratio of banks’ expected losses)

Box 1
Nature-related risk assessment for Dutch and French financial institutions

Prepared by Marie Gabet and Sjoerd van der Zwaag

Phase 1: identifying sources of risk

Both De Nederlandsche Bank (DNB) and the Banque de France have analysed the exposure of their national financial systems to ecosystem services in order to better understand their impacts and dependencies.

DNB’s study finds that 36% of the portfolios of Dutch financial institutions examined have a critical dependency on ecosystem services, but this only reflects direct dependencies on nature.^[27] The Banque de France’s study of securities held by French financial institutions improves on this analysis by including indirect dependencies.^[28] It provides estimates based on data from the ECB’s Securities Holding Statistics by Sector (SHSS) dataset, focusing on listed shares and debt securities issued by non-financial corporations and held by French financial institutions at the end of 2019. It finds that 42% of value comes from issuers that are critically dependent on one or more ecosystem services, such as water provision, erosion control or flood and storm protection.^[29] Disruption of these ecosystem services would likely result in substantial disruption to production, indicating that the portfolio could be highly vulnerable to potential shocks.

The study also finds that the economic activities financed by French financial institutions have a substantial impact on nature, comparable to the estimated loss of at least 13 million hectares of pristine nature – equivalent to the complete degradation of land covering a quarter of mainland France. This impact comes mainly from pressure exerted by changes to land use. Several economic sectors contribute to this footprint, including the production of chemicals, processing of dairy products and manufacture and distribution of gas.

DNB also conducted a pilot study using an integrated LEAP (locate, evaluate, assess and prepare) approach developed by the Taskforce on Nature-related Financial Disclosures ^[30] on two of its own-account equity portfolios.^[31] The study focuses on the electric utilities sector, combining asset-level location data and individual financial risk scores to gain insights into nature-related risks at company and portfolio levels. It finds that while the energy production mix in its Paris-aligned mandate is less carbon-intensive than the passively managed broad market portfolio, this does not substantially lower its associated nature-related financial risks. This is mainly because the energy production mix has a higher exposure to hydroelectric power, which has low carbon intensity but relatively high impacts and dependencies on water. Instead of carbon intensity, differences in risk are mainly driven by the location of power plants (for example, being close to important ecosystems).

Phase 2: assessing economic and financial risks

Moving beyond these initial studies, more recent work has aimed to better quantify the potential economic impact of nature-related financial risks. A study of a French transition policy aiming for “no net land take” by 2050 and a halved rate of land take by 2031 finds differences in vulnerability across sectors.^[32] Some of the sectors contributing most significantly to land take, such as wholesale and retail trade, have a relatively higher adaptive capacity and are therefore less vulnerable. By contrast, sectors like agriculture and accommodation and food services would be hardest hit. Some sectors producing public goods (waste and water treatment) could also face financial difficulties.

The impact of nature-related risks depends on the speed of further nature degradation and policies enacted to reverse it or slow it down. Analysis by DNB explores the economic and financial stability risks associated with five nature scenarios (Figure).^[33] The global scenario of ending all explicit and implicit fossil fuel subsidies suddenly and fully, and without considering the offsetting effect of fiscal stimulus, has a significant peak impact on GDP of a 3% decline in year two. In the Dutch nitrogen scenario, in which insufficient measures are taken to reduce the nitrogen footprint, the peak impact on Dutch GDP is a decline of 1.4% in the second year after the shock. By contrast, the scenario of reducing agricultural production sufficiently to tackle the nitrogen problem entails a peak GDP decline of 0.7%. Preliminary estimations of the credit losses for Dutch banks under the two scenarios associated with the largest economic impact find limited system-wide capital depletions of between 5 and 30 basis points. These preliminary results suggest that it should be possible to enact nature conservation policies without substantially affecting the Dutch economy and financial stability.

Figure

Taxonomy of nature-related scenarios

The modelling of the economic impacts of nature-related risks is currently in its infancy, and the DNB study^[34] has several limitations, including (i) studying policy measures in isolation, whereas more realistic scenarios would account for multiple shocks at the same time; (ii) the use of a computable general equilibrium model is likely to underestimate short-term stresses; (iii) many interdependencies are not yet captured, including interactions with climate; and (iv) heterogeneity of effects across sectors is not always captured in economic models and is never captured in the stress-testing models used. Taken together, the uncertainty associated with nature-related risks and the exploratory methodologies applied in this study point to an underestimation of impacts on the real economy and on financial stability.

5 Managing nature-related risks: next steps

A systematic, proactive and comprehensive approach to quantifying and assessing the impact of escalating nature-related economic and financial risks on price and financial stability is required. Integrating climate and nature considerations into the ESCB’s functions involves capturing a complex set of dynamic interactions between biodiversity, ecosystem functioning, the economy and the financial system. The steps for developing these approaches should be (i) identifying the most material sources of physical and transition risk from a macroeconomic, microprudential and macroprudential perspective; (ii) evaluating economic risks; and (iii) assessing risks to, from and within the financial system.

Economic and financial models currently employed to assess climate change impacts do not fully capture all nature-related issues and therefore underestimate the likely cumulative impact and subsequent risks. Given the multidimensionality of nature-related risks, a broader spectrum of nature-related challenges needs to be assessed alongside climate concerns. Such enhanced assessment will require (i) gaps in nature-related data to be addressed and financial data disclosures to be improved; (ii) integrated climate and nature scenarios to be developed to enable forward-looking risk assessment; (iii) modelling capabilities to be enhanced to evaluate the localised impacts of nature loss on both regional and global scales; and (iv) quantitative risk assessment frameworks, such as integrated climate and nature stress tests, to be created.

Advancing from exposure analysis to risk assessment will be essential for a more nuanced understanding of the implications for the ESCB’s mandated objectives. To achieve this, data-driven methods and modelling tools need to be further developed. Spatial data granularity is very important in order to accurately assess specific biomes, regions and sectors. The inclusion in scenarios and assessment frameworks of more sectoral and geographical granularity, as well as multiple metrics, in order to capture non-linear and indirect impacts is key to evaluating indirect and cascading impacts throughout global value chains. Furthermore, a joint research effort from the legal and financial perspective is required to understand the repercussions of legislative changes for financial institutions, while acknowledging the global nature of these risks and the need for international cooperation. The Network for Greening the Financial System (NGFS) Taskforce on Biodiversity Loss and Nature-related risks is making significant progress on integrating nature-related risks into the operations of central banks and financial supervisors.^[35]

Banking supervisors are already taking nature-related risks into consideration, and banks themselves are increasingly concluding that nature degradation and biodiversity loss pose material risks.^[36] The precautionary approach calls for proactive measures, even when faced with imperfect data and methodologies. As with climate-related risks, nature-related risks can lead to the impairment of assets and collateral, lower corporate profitability and impair insurability, affecting traditional financial risk categories. The increasing availability of data, coupled with the development of knowledge alongside scientists and regulators, provides a solid foundation for supervisors to take timely action to integrate nature-related risks into their policy frameworks.^[37] This is especially critical in addressing sectors such as agriculture, forestry, mining and energy which already have the most detrimental impact on nature and biodiversity and for which data and methodologies are relatively advanced and can facilitate further action.

Furthermore, central banks might consider incorporating nature-related considerations into their corporate sustainability plans and actions. This could involve integrating nature into reserve management strategies and using indicators to monitor identified risks. Given the significant interplay between climate change and nature degradation, aligning climate action plans with nature conservation principles, consistent with the Global Biodiversity Framework, could be beneficial. This holistic strategy highlights the potential role of central banks in managing nature-related financial risks, balancing immediate actions with long-term strategic planning. ECB Banking Supervision and Eurosystem central banks have already launched some initiatives (Box 1).

A key focus in the ECB’s climate and nature plan for 2024-2025 is to further explore the impact of nature-related risks on our economy, in addition to better understanding the physical impacts of climate change.^[38] The complexity of environmental challenges and the potential risks they pose to both the ECB and national central banks highlight the need for a collaborative effort with the banking system while fostering coordinated initiatives with the scientific community. Various stakeholders, including policymakers and researchers, will need to be brought together to ensure the comprehensive and effective integration of nature considerations into the central banking framework.

6 Conclusions

The risks arising from nature degradation and biodiversity loss pose potentially significant challenges to the ESCB’s Treaty-based objective of maintaining price and financial stability. Addressing these challenges requires a systematic, proactive and comprehensive approach to quantifying and assessing the escalating nature-related economic and financial risks. The accelerating rate of nature degradation underscores the urgency of these considerations, and neglecting them could jeopardise critical ecological stability and economic resilience. If we are to avoid the unpredictable knock-on effects of biodiversity loss, policymakers and financial institutions should fully incorporate the costs of nature degradation in their decision-making processes.