Interview with the Financial Times

Interview with Frank Elderson, Member of the ECB Governing Board and Vice-Chairman of the ECB Supervisory Board, conducted by Martin Arnold on June 1, 2023

June 8, 2023

Why is the ECB concerned about the risk of biodiversity loss?

In order to pursue price stability, it is necessary to understand the economy. We need to understand how economic trends and shocks affect monetary policy spillovers. This is nothing new. We focus on trends such as demographics, globalization, innovation and digitization. We have always done this, and now we understand that climate change and, importantly, biodiversity are also on the list of things that impact the economy. In my opinion, if we do not consider climate, environment, biodiversity and nature-related aspects, we will not be able to fulfill our mission.

Any particular reason you’re watching this now?

Too little or too late should be avoided. As for the climate, we know that rising temperatures can lead to higher prices and ultimately higher inflation. However, the same is likely to apply to biodiversity as well. Pollination is required for farmers. Without pollination, crop yields can be low and prices can be high. Farmers need healthy soil. Without healthy soil, it’s the same thing. Crop yields may decline, impacting prices and inflation.

Now, all this is happening against the backdrop of an alarming trend. The Intergovernmental Science Policy Platform on Biodiversity and Ecosystem Services clearly states that we are on the decline in terms of nature and biodiversity. Of the species they assessed, 25% of the flora and fauna are threatened with extinction, to name a few. This means that one million species are threatened with extinction, many of which will be extinct within decades. 85% of wetlands have already been lost. 66% of the marine area is cumulatively affected. And 75% of the Earth’s surface has changed significantly.

Look at the Po river in Italy. It was already at normal August levels just a month ago. It was vacant in August last year. You can walk to the other side. This is very important if you rely on it. Economy depends on nature. If you destroy nature, you also destroy the economy. Analytically, we can use widely accepted frameworks for climate-related risks. Examine the physical and transition risks facing the economy related to biodiversity loss.

What are some examples of physical risks in biodiversity?

The agricultural sector’s reliance on insect pollination is an example of a physical risk. Insect populations are declining, and this is likely to have a negative impact on crop yields. Another example is that much of the tourism industry relies on natural beauty and diversity to attract tourists as customers. If the forest you want to visit is burned or cut down, you may not be able to visit the area. Because these physical risks affect supply, they can also affect prices. And this is where we might enter the realm of monetary policy, price stability, and inflation. But also consider the companies operating in these areas. Farm producers, tourism companies, but also construction companies that rely on timber and sand. They may suffer a decline or deterioration in the nature-related services on which they depend, which may impede or adversely affect profitability. Flood protection by mangrove forests is one example. There are many more. The economy depends on nature’s services. This is also why we need to dig deeper.

But that doesn’t mean there will be no wood or sand, right?

It may become scarce and the price may soar. These things are happening. The Netherlands has a big nitrogen problem. This has nothing to do with climate, but something that affects production. This will hinder profitability. And that, of course, can also affect banks that have exposure to these companies, which can affect credit risk.

What about migration risk?

The government is not sitting idle. They are taking action against biodiversity loss. There is already a Montreal Convention on Biological Diversity, and existing nature reserves could increase. Transition risks arise when a company’s activities take place on land adjacent to an existing protected area that is to be expanded. Consider nitrogen. There are already limits on how much nitrogen deposition is allowed. This directly affects the production of the farmers involved.

Another example is when a government wants to do something to prevent insect populations from declining. Someday there will be legislation on pesticides. It’s a transition risk. If you are a pesticide manufacturer, chances are your product will be phased out or banned.

Transition risks can also be driven by changing consumer preferences. Consumers do not want to buy products from companies known to be actively involved in deforestation, or they do not want to buy products and services from companies that have not signed certain voluntary associations or protocols. I don’t want to buy it.” This risk can materialize suddenly. As many environmental, social and governance (ESG) investment policies extend beyond climate, the same can happen to investors.

All of this could also affect the banks that lend to the affected companies. Because those companies may not be able to repay their debts. To what extent this will happen is unpredictable, but how the causal chain unfolds. This is why we will analyze these exposures and publish a report on them in the fall.

What will be included in this upcoming report on biodiversity loss?

We surveyed 4.2 million Eurozone companies to explore their exposure to nature-related services. We found that 72% of businesses (about 3 million companies) rely on at least one, and possibly more, of these nature-related services. I was talking about wood, clean water, pollination, sand, and healthy soil. That’s quite a lot.

And these companies weren’t the only ones we looked at. I also looked into bank financing. We found that 75% of bank lending goes to businesses that depend on ecosystem services. Banks are therefore clearly at risk.

This is a landmark analysis, as it is the first to examine the exposure to biodiversity loss in the eurozone-wide financial system.

what else did you find?

Our research is now going even further. Because just looking at who’s being exposed doesn’t give us all the answers yet. Also check how sensitive it is to impact. We need to go a step further and consider what would happen if there was some degradation of some of these nature-related services. How will that affect companies that rely on banks, and how will that dependence affect the exposure that banks have?

It’s a little premature to say more. We will provide more details when the full report is published. finer and deeper. We also assess the transition risk aspect by examining how a company’s activities affect biodiversity. This angle serves as a kind of proxy for what would happen to these companies if the kind of regulation I mentioned earlier was put in place.

What about bank supervision?

When we launched our guide on climate-related and environmental risks at the end of 2020, the breadth of it was a novelty, as most other regulators have so far focused solely on climate. It then called on banks to develop self-assessments and action plans for 2021. And in 2022, we conducted a so-called thematic review examining all banks under our direct supervision. One of the findings was that banks were less advanced on environmental risks than on climate-related risks. 25% of banks have not yet conducted materiality assessments for climate risks, while 40% have not yet done so for environmental issues. In other words, the glass is not even half full yet.

Have you seen any signs of progress since then?

Today, progress is being made when it comes to biodiversity. Very specifically, we have seen the first banks to actually allocate capital to environmental risks in their internal capital calculations. That’s an interesting development. But we want all banks to fully comply with our expectations. We strive to help banks by publishing good practices. At the same time, we have also clarified that it will be enforced if necessary. It’s a carrot and a stick.

what is the purpose here? Are you trying to save the planet and the natural world, or are you just focused on financial and economic risks?

Let’s be very specific here. Even if I could care less about the planet, even if I could care less about biodiversity, I would say the exact same thing. The fact that I may have certain concerns as a civilian has nothing to do with what I say here. What I’m trying to explain is that this is a risk that banks need to manage. My point is that biodiversity and nature-related services are generally relevant to the economy. This is not some kind of flower-strength or tree-hugging exercise. This is the heart of the economy. This is core financial stability, core macroprudential and core price stability. More data, more certainty, more clarity, would be great. But sometimes you have to deal with the knowledge you have. Based on the knowledge we have, we know that there are many more pages in this chapter. But it’s not about saving the planet. It’s about our mission. It’s about keeping prices stable. It’s about financial stability. It’s about a resilient banking system.

But how do we measure this? Climate change focuses on carbon emissions. What are the criteria for biodiversity?

There are similarities between climate and biodiversity that make both difficult. What they have in common is uncertainty and non-linearity of risk. We cannot simply infer from what we see today. There are tipping points that can have irreversible consequences, in which case there is no turning back, even if you change the way you live. And there is all the uncertainty about the likelihood, timing and magnitude of certain things happening. But what you say is true, there is not just one simple measure of biodiversity like carbon dioxide. But things are happening. We have his EU Corporate Sustainability Reporting Directive, which includes disclosure requirements beyond climate. It covers not only biodiversity and ecosystems, but also water and marine resources and pollution.

Could the ECB take more concrete steps to address these risks, not only in banking supervision, but also in asset portfolios and collateral rules?

When it announced measures to integrate climate change into monetary policymaking last July, the statement said the ECB Governing Body was prepared to reconsider all climate-related policies in concrete terms if necessary. included consideration of Use it as a reference to turn your attention to environmental issues. I’m not making any specific predictions here. Our actions follow where science, analysis and research lead us.

ECB looks like a bit of an outlier here, doesn’t it? Why aren’t other big central banks doing this too?

We are not alone. Before us, similar efforts were made by the Bank of the Netherlands, then the Banque de France, followed by Malaysia, Brazil, Singapore and the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). was also done by “Nature-related risks, including those related to biodiversity loss, can have significant macroeconomic impacts, and the inability to consider, mitigate and adapt to these impacts is critical to financial stability. cause associated risks,” he signed a statement. I think it is important for the world to recognize the importance of nature-related risks.

We are somewhat of an outlier, you say. Well, maybe some people speak more openly. When you believe something, say it. But it’s not just me. The NGFS statement is strong. All of this stems from efforts made in collaboration with many others, including the US Federal Reserve. Let’s take a look at the Basel Committee, where I co-chair the task force on climate-related risks. Climate-related risks are the scope there. But everything I said about an analytical framework that distinguishes between transitional and physical risks is all there. And this analytical framework is endorsed by the entire Basel Committee.