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Influence of nature-related risks on loan pricing and the financial sector

Biodiversity losses pose risks not only to environmental health but also to global financial stability. This column examines the propagation of nature-related transition risks from international borrowers to European lenders. Using a database of international borrowing firms that receive funds from European lenders in the syndicated loan market, the authors find that the level of exposure varies across countries, with Germany, France, Luxembourg, Netherlands, Spain, and the UK being the most exposed. The pricing of syndicated loans is influenced by the level of nature-related risk faced by borrowing firms, implying that lenders charge a premium to account for the risk associated with biodiversity exposure.

The depletion of nature poses a wide range of risks that go beyond the environmental impact, affecting economic activities and our overall financial system. Many industries rely on ecosystem services, and the combined effects of these dependencies are often overlooked. For instance, the decline in biodiversity and possible damage to ecosystems could affect agriculture. The loss of biodiversity could lead to a decrease in the population of pollinators, such as bees, which are crucial for crop pollination. At the same time, a lack of diverse ecosystems could intensify the risk of water contamination by failing to filter out pollutants and excess nutrients, affecting the quality of groundwater used for irrigation. Both situations could reduce crop yields and increase costs for farmers, who may need to invest in alternative pollination and irrigation methods, thereby affecting their creditworthiness.

The loss of biodiversity is the result of multiple factors, including ecosystem exploitation, pollution, invasive species, and climate change. Therefore, climate-related risks and biodiversity loss are interconnected and could exacerbate each other. Rising temperatures, for example, could alter the composition and structure of many ecosystems. As with climate-related risk, nature-related risks can affect the economy in two ways. Physical risk stems from potential ecosystem degradation, negatively affecting economic sectors that depend on these services, while transition risk stems from the growing hurdles that industries face because of tighter legislation aimed at preserving and restoring nature or reducing negative impacts on the environment, such as industrial waste that pollutes water bodies. A study conducted by the World Bank quantifies that economic consequences of biodiversity loss are substantial, and a collapse in ecosystem services could cause a decline in global GDP of $2.7 trillion by 2030 (Johnson et al. 2021). Boldrini et al. (2023b) shows that 75% of all corporate loan exposures inside the euro area have a strong dependency on at least one ecosystem service.

Nature-related transition risks are important new challenges for financial institutions

The financing of activities that rely heavily on ecosystems is likely to be affected by transition risks. Hence, it is crucial for the financial sector to take into account the potential impact of nature-related transition risks of their borrowers. Policy initiatives are underway to encourage financial institutions to incorporate these risks into their risk management practices and provide appropriate monitoring and assessment tools (Croitorov et al. 2024, European Commission 2024). We argue that, by integrating nature-related risk assessment into their management strategies, financial institutions can not only support the protection and conservation of biodiversity, but also safeguard their own financial stability. This may involve reallocating their portfolio to more sustainable and biodiversity-friendly projects and sectors, as well as taking measures such as adjusting interest rates or tightening lending criteria to reflect the risks associated with biodiversity degradation. 

Over the last few years, there has been significant growth in academic research focused on the financial risks associated with nature degradation and biodiversity loss. A growing number of papers have laid the ground for investigating and understanding the potential financial implications. The seminal papers by Van Toor et al. (2020) and Svartzman et al. (2021) evaluate the exposure of financial institutions to the risk of biodiversity loss, focusing on France and the Netherlands respectively, while Calice et al. (2021) analyse biodiversity risks for the financial sector in Brazil. In a recent study, Boldrini et al. (2023a) find that the financing of euro area economic activities with a high global impact on nature is concentrated, with ten banks responsible for financing around 40% of the total global impact of euro area firms. Although the development of tools, standard scenarios, or targeted stress tests is still in its early stages, ongoing research is shedding light on the impact of biodiversity risks on financial markets.

Our paper (Becker et al. 2023) contributes to this debate by examining the propagation of nature-related transition risks from international borrowers to European lenders. We identify EU lenders vulnerable to nature-related risk and investigate whether banks are incorporating the pricing of these risks into their financial strategies. To do so, we use a database of international borrowing firms that receive funds from European lenders in the syndicated loan market. This dataset includes about 1,400 entities across 61 countries, with information on their balance sheet as well as the level of exposure to nature-related risks for each company’s geographic segments.

Lenders are exposed to nature-related risk through their participation in the syndicated loans market

As a first step, we build nature-related indicators for both borrowers and lenders. Borrowers may exhibit different levels of nature sensitivity based on the locations of their branches, so to calculate a ‘nature exposure score’ for each firm, we weight the exposure score of each borrower in a specific location by its operating revenue in that location. Lenders who have extended substantial loans to borrowers with high nature exposure may also be vulnerable to nature-related risks, as they could face loan defaults if their borrowers cannot pay back their debt. Therefore, we compute lender scores by weighting the biodiversity score of the borrowing firms by its loan amount. Lastly, the average lender exposure in each country is computed by considering each lender’s score based on the volume of loans granted to reflect their market share within that country. Figure 1 offers an intuitive understanding of the concentration and distribution of nature-related risk within the financial sector. We find that lenders in Germany, France, Luxembourg, Netherlands, Spain, and the UK have the highest exposure to such risks through their participation in the syndicated loans market.

Figure 1 Map of biodiversity exposure of syndicated loans, 2020–2022

Figure 1 Map of biodiversity exposure of syndicated loans, 2020–2022
Figure 1 Map of biodiversity exposure of syndicated loans, 2020–2022

Have banks started incorporating the pricing of nature-related financial risks?

In a second exercise, we analyse price dynamics of syndicated loans activated from 2017 onwards. We deploy our database within an econometric model to measure the effects of various determinants on loans prices, including the nature-related indicator. Our findings indicate a clear association between an increase in loan margin and a higher exposure to nature-related risks. Exposure of borrowers to these new risks leads to an increase in the loan margin offered by banks by 10 to 20 basis points, depending on the model specifications. The longer the score is available before a loan is issued, the more it affects pricing. Lenders who have had more time to observe this metric, along with other nature-related risk indicators, may have developed a better understanding of how biodiversity affects economic activities and, therefore, may be more inclined to adjust their lending decisions and to incorporate specific borrower risk into pricing.

The location of lenders and borrowers also plays a crucial role: when we control for it, the nature exposure indicator becomes even more significant, especially when distinguishing between EU and non-EU transactions. This suggests that the European financial sector is responsive to the efforts of regulators and policymakers in addressing nature-related risks. We also find evidence that lenders place greater emphasis on nature-related risk when issuing green or sustainable loans. Figure 2 illustrates a positive and increasing marginal effect on the loan price of the borrower’s nature-related exposure score, with a 95% confidence interval.

Figure 2 Predicted prices and nature-related exposure

Figure 2 Predicted prices and nature-related exposure
Figure 2 Predicted prices and nature-related exposure

Conclusions

We develop a measure of nature-related transition risk for European lenders and find that the level of exposure varies across countries, with Germany, France, Luxembourg, Netherlands, Spain, and the UK being the most exposed. Our analysis shows that the pricing of syndicated loans is influenced by the level of nature-related risk faced by borrowing firms. This implies that lenders charge a premium to account for the risk associated with biodiversity exposure, similar to the concept of a ‘carbon premium’ on emissions.

As debtors cannot immediately detach themselves from their dependence or impact on natural capital, they must either adjust their business models in the long run or continue facing increased costs imposed by their financial institutions, with concerns about long-term profitability and sustainability of their operations. In line with Garel et al. (2024), our analysis suggests that lenders integrate nature-related risks into their management strategies to safeguard their own financial stability. Banks may decide to adjust interest rates or tighten lending criteria, as many are currently doing. Alternatively, they could reallocate their portfolio to more sustainable and biodiversity-friendly projects and sectors to support the protection and preservation of nature.

Further research in this area is necessary to augment the data quality on natural capital. These metrics can inform investment decisions and reflect nature-related spillovers as a factor for credit risk evaluation.

Source : Voxeu

GLOBAL BUSINESS AND FINANCE MAGAZINE

GLOBAL BUSINESS AND FINANCE MAGAZINE

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