Does biodiversity risk affect asset prices?

ACADEMIC BLOG

Over the past decade, there has been an increasing focus on understanding how our economy and the environment interact. Much of this research has explored how climate change affects economic activity and asset values. But climate change is only one dimension of the feedback loops between the economy and the health of our planet. In our latest paper, we study a different and equally important dimension: the economic risks associated with biodiversity loss.

What is biodiversity risk?

Humans rely on biodiversity – defined here as the sum total of genes, species, and ecosystems – to survive and thrive. For example, diverse ecosystems are key to the production of food, while many medicines are derived from natural compounds found in plants, animals, and microorganisms. The recent losses of ecosystem services have been estimated to cause damages of USD$4trn to USD$20trn per year.¹

In addition to these physical risks, there are ‘transition risks’ from regulatory responses to biodiversity loss. One key example is the recent COP15 conference in Montreal, which led to an international agreement to put 30% of the planet under protection by 2030. These transition risks can have substantial effects on economic activity and asset values.

Despite its importance, biodiversity risk has been understudied in economics and finance research in part due to its complexity and the challenges in how to measure it. In our paper, we systematically measure aggregate biodiversity risk and release several measures of how exposed firms and industries are to these risks, based on information such as firms’ 10-K statements (i.e., their annual reports). These measures generally line up with investors’ views about biodiversity risks; they are also reflected in asset prices.

Do people worry about biodiversity risk?

In short, yes. We conducted a broad, global survey of the perceptions of biodiversity risks among finance academics, professionals, public sector regulators, and policy economists. Around 70% of respondents perceived physical and transition biodiversity risks to have at least moderate financial materiality for firms in the US, with private sector respondents reporting the highest perceived financial materiality.

We also analysed the news coverage around biodiversity in the New York Times, from 2000 to 2022, to better understand when bad news about biodiversity risks occurs. We created a corresponding news index to capture periods of bad news about climate change to explore commonalities and differences in climate and biodiversity risk realisations.

Which industries are most exposed to biodiversity risk?

Different sectors vary in their dependence on natural capital, which links to their physical biodiversity risk exposure. They also differ in terms of their effects on the environment, and therefore their regulatory biodiversity risk exposures.

We propose several ways to quantify different firms’ and industries’ biodiversity risk exposures. Our first measure looks at firms’ 10-K statements, which often disclose both physical and transition risks. For example, energy companies mention being exposed to biodiversity transition risks related to drilling and refining activities, which can affect the ecosystem and are potentially a target for future regulations. Utility firms face regulations on species and habitat protection, and the real estate industry faces restrictions on developments in areas with high biodiversity. Firms also report facing physical biodiversity risks, including pharmaceutical companies relying on biodiversity for drug discovery.

We construct other measures of industry-level exposures using information from our expert surveys and portfolio holdings of biodiversity funds. Figure 2 shows the biodiversity risk exposures across industries, combining our different measures into a composite industry-level exposure measure. We found that sectors with the highest biodiversity risk exposures include energy, utilities, and real estate, while semiconductor, software, and communication services sectors have minimal exposures.

Are biodiversity risks incorporated in equity prices?

We also explored whether equity prices reflect biodiversity risk exposures. To do this, we formed a portfolio of long positions in industries with low biodiversity risk exposures and short positions in industries with high biodiversity risk exposures.

If biodiversity risk is priced in, the return of these portfolios should covary with innovations in the aggregate biodiversity news index, behaving like a hedging portfolio. We find positive correlations between the returns of our biodiversity hedging portfolios and innovations in the biodiversity risk index, indicating that biodiversity risk has been at least partially priced in equities over the past decade.

Biodiversity risks versus climate risks

Throughout our paper, we explored the relationships between biodiversity and climate risks. Although these risks are conceptually separate – biodiversity risk focuses on threats to Earth’s variety of life, and climate risk involves adverse outcomes from climate change – they are interlinked. Climate change can exacerbate biodiversity loss, and biodiversity loss can contribute to climate change, for example through the depletion of carbon sinks.

Given the recent interest in climate change and its economic implications, it is important to distinguish climate and biodiversity risks qualitatively and quantitatively. We achieved this in several ways. First, we showed that the aggregate biodiversity index behaves differently from similarly constructed climate indices. Second, we documented that climate and biodiversity exposures are only weakly related in the cross-section of industries (for example, renewable energy firms benefit from climate transition risk realisations, but suffer from biodiversity transition risk realisations). Finally, we showed that portfolios built for hedging climate risk do not perform well at hedging biodiversity risk, and vice versa.

In conclusion, biodiversity services are essential for the economy, and risks associated with biodiversity loss can affect firms through various channels. Yet, those risks can be difficult to quantify and study systematically.

The goal of our paper was to introduce measures of aggregate biodiversity risk as well as measures of firms’ and industries’ exposure; to connect and validate these two; to study the pricing of biodiversity risks in financial markets; and to publicly release our biodiversity exposure measures at www.biodiversityrisk.org. We hope our findings will facilitate more research on this important topic.

The PRI’s academic blog aims to bring investors insights from the latest academic research on responsible investment

SDGs, Targets, and Indicators

1. Which SDGs are addressed or connected to the issues highlighted in the article?

• SDG 14: Life Below Water – The article discusses the importance of biodiversity in ecosystems, which is directly related to the goal of conserving and sustainably using the oceans, seas, and marine resources.
• SDG 15: Life on Land – The article focuses on biodiversity loss and its economic risks, which aligns with the goal of protecting, restoring, and promoting sustainable use of terrestrial ecosystems.

2. What specific targets under those SDGs can be identified based on the article’s content?

• SDG 14.2: By 2020, sustainably manage and protect marine and coastal ecosystems to avoid significant adverse impacts, including by strengthening their resilience, and take action for their restoration in order to achieve healthy and productive oceans.
• SDG 15.5: Take urgent and significant action to reduce the degradation of natural habitats, halt the loss of biodiversity, and protect and prevent the extinction of threatened species.

3. Are there any indicators mentioned or implied in the article that can be used to measure progress towards the identified targets?

• Indicator for SDG 14.2: Proportion of national exclusive economic zones managed using ecosystem-based approaches.
• Indicator for SDG 15.5: Red List Index, which measures changes in the overall extinction risk of species over time.

The article mentions the importance of protecting marine and coastal ecosystems (SDG 14) and halting the loss of biodiversity (SDG 15). It also discusses the economic risks associated with biodiversity loss and the need to quantify and measure these risks. The targets identified are directly related to the conservation and sustainable management of ecosystems and the prevention of biodiversity loss. The indicators mentioned in the article, such as ecosystem-based approaches and the Red List Index, can be used to measure progress towards these targets.

4. Table: SDGs, Targets, and Indicators

SDGs	Targets	Indicators
SDG 14: Life Below Water	14.2: By 2020, sustainably manage and protect marine and coastal ecosystems to avoid significant adverse impacts, including by strengthening their resilience, and take action for their restoration in order to achieve healthy and productive oceans.	Proportion of national exclusive economic zones managed using ecosystem-based approaches.
SDG 15: Life on Land	15.5: Take urgent and significant action to reduce the degradation of natural habitats, halt the loss of biodiversity, and protect and prevent the extinction of threatened species.	Red List Index (measuring changes in the overall extinction risk of species over time).

Behold! This splendid article springs forth from the wellspring of knowledge, shaped by a wondrous proprietary AI technology that delved into a vast ocean of data, illuminating the path towards the Sustainable Development Goals. Remember that all rights are reserved by SDG Investors LLC, empowering us to champion progress together.

Source: unpri.org

 

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