Why, and how, investors should integrate biodiversity into fixed income portfolios

Key points: 

• Managing risks, having a positive impact and meeting regulations are three reasons why fixed income investors should consider biodiversity within their portfolios
• Biodiversity loss is a complex issue - active engagement and detailed sector and issuer-level analysis are required to tackle it
• Biodiversity must be considered as part of a holistic sustainable approach, as opposed to in isolation to climate change and social factors

One of the fundamental features of biodiversity is that it reaches into every part of our lives – and that means the impacts of biodiversity loss are felt across investment portfolios too. In our view there isn’t an asset class or sector that would not benefit from a close consideration of how those effects might change outcomes or affect financial returns.

When we look specifically at fixed income, we see important reasons why investors should begin to integrate biodiversity into their decision making.

First, biodiversity loss presents risks that could impact the performance of fixed income portfolios. As with climate change, the starting point is to understand the risks in play, divided into two components. They may be physical risks from biodiversity loss and ecosystem degradation, or transition risks linked to global efforts to tackle the problem, which include increasing liability risks.

We expect that companies which do not proactively address these risks, and which fail to adopt more sustainable nature-positive business models, could face higher costs or lower revenues, therefore reducing their ability to repay debt in the future.

• Nature-related physical risks – The dramatic degradation of biodiversity and of natural resources has created, and will continue to create, significant pressures on issuer supply chains and manufacturing processes. This in turn may lead to a loss of revenue or reduced profitability, ultimately impairing the ability of an issuer to repay its debt. Examples of this could include increased flood risks due to soil and flora reductions, difficulties sourcing raw materials, reduced suitability of land for crop cultivation, or costs incurred from forced relocations of manufacturing bases.¹
• For instance, the nuclear sector and the paper industry are among sectors responsible for large-scale water withdrawal, and often have their operations positioned close to water sources. Over time water availability may become a real operational risk for these industries. Many new nuclear facilities are built close to the sea, but existing inland sites will likely face water stress risks at some level.²
• Nature-related transition risks – Consumers are becoming more aware of the dangers of biodiversity loss and could shift their spending habits to products and services least associated with having negative impacts on nature. The shift could be more acute in the face of controversial events where a boycott of a company’s products occurs across a wide consumer base. In addition, issuers could face further risks from evolving regulation, technological breakthroughs, market changes, and litigation.
• A good example of liability-related transition risks is the case of US litigation around perfluoroalkyl and polyfluoroalkyl substances (PFAS) i.e., a large complex set of synthetic chemicals used in consumer goods. This litigation has given rise to new regulatory measures in both the US and European Union with a potential ban targeting these so-called ‘forever chemicals’. Another recent example would be the introduction of taxes on plastic packaging in some countries, like the UK, seeking to encourage intensive plastic users to adapt the company’s business model.³

In our view, interactions between different categories of nature-related risks, in particular cascading interactions of physical and transition risks, could eventually lead to a nature-related systemic risk with consequences for global economies around the world.  

Asset owners: The momentum builds

A second reason why we believe fixed income investors need to take action is that we can see increasing interest from asset owners who want to mitigate their negative impact on biodiversity by reducing the biodiversity footprint of their investment and financing activities. This rationale extends beyond pure financial performance and into ‘double materiality’ – the idea that investors should consider not only the impact the external environment has on a portfolio, but also the impact a portfolio has on the natural and social capital in the world.

This process can occur in two ways – by reducing the negative impact a portfolio has, or by identifying and supporting nature-positive solutions that have the potential to drive change within different sectors.  

According to estimates from the Convention on Biological Diversity and the Intergovernmental Panel on Climate Change (IPCC), between $150bn-$440bn per year should be allocated to biodiversity solutions to reverse biodiversity loss.⁴ However, our view is that current financial flows from the private sector are merely a drop in the ocean. The Organisation for Economic Co-operation and Development (OECD) estimated that in 2020 only between $78bn-$91bn was invested in biodiversity solutions, with the large bulk of that from public financing.⁵ Clearly there is more work to do here and harnessing the scale of financial markets can contribute to plug the gap. Fixed income is such a huge asset class that it can create meaningful change to drive issuers to reduce their biodiversity footprint.

(More) regulations are on their way

The Taskforce on Nature-related Financial Disclosures (TNFD) was established in 2021 and aims to help factor biodiversity into financial and business decisions by creating a framework for disclosure and for assessing risks, impacts, opportunities and dependencies. The TNFD’s complete recommendations are scheduled to be completed in September 2023 and will centre around the same four pillars as the Task Force on Climate-related Financial Disclosures (TCFD) – namely governance, strategy, risk and impact management, and metrics and targets.

Thankfully, many investors would be able to leverage on their experience with implementing requirements from TCFD when considering biodiversity and applying the TNFD framework. While the risks, metrics and targets may be different, the learnings around access to data and implementation within portfolios may be applied with similar governance frameworks. We believe, similar to the TCFD, that the escalation of TNFD-adoption may quickly filter through to mandatory reporting for many investors, requiring a greater understanding of the topic among all investors.

These are the three drivers working to put biodiversity centre stage: The risks are becoming ever more evident; large asset owners are starting to measure their impact and consider how to adapt portfolios; and this process is spurred on by approaching regulatory demands. The next question then, is how can biodiversity be successfully integrated into fixed income portfolios?

Assessing portfolio risks and impacts

The extent to which fixed income investors can consider biodiversity is determined by the availability of information from which they can make credible portfolio decisions. Data availability, quality and coverage are all crucial, as is what the data aims to show (e.g. risks to the portfolio, impacts of the portfolio, or alignment to future nature-related goals). The availability of biodiversity data isn’t perfect, and portfolio-level decisions should acknowledge this, rather than it being a hurdle to starting integration.

The heatmap below shows four of the primary drivers of biodiversity loss across the global investment-grade credit sectors, as measured with the use of the Corporate Biodiversity Footprint (CBF) metric provided by Iceberg Data Lab.⁶ The CBF is expressed in square kilometres (km2) of mean species abundance (MSA) – a recognised proxy for the intactness of biodiversity compared to a pristine, undisturbed state. For example, a CBF of -0.2km2 MSA would tell us that the pressures generated by a company’s activities during a given year are estimated to have degraded entirely the biodiversity of an area equivalent to 200m².

Picking out the biodiversity hotspots

Image

Source: Iceberg Data Lab. Data as of 31/12/2022. For ease of illustration the CBF has been translated into a colour scale with the most impactful (red) having a score of about -0.2km2 MSA per million euros invested while the least impactful (light orange) having an MSA closer to zero.

One of the most striking findings is how heavily land use change contributes to overall biodiversity loss. The identification of land use change as the main pressure on biodiversity is in accordance with scientific consensus⁷ . Change of land use is one of the key areas to focus on in terms of minimising footprint and developing positive solutions. A second finding of note is the prominence of banking and financial services, perhaps a surprise given that these activities are usually associated with a smaller footprint (in carbon emissions), at least from their direct operations. The reason for this is that Scope 3, indirect, biodiversity impacts are considered as part of the CBF metric.⁸ What is similar to carbon emissions data is that the CBF data used in this exercise shows a clear skew in the impact between different sectors – some playing a much larger role than others – and this should be considered when integrating biodiversity into fixed income portfolios.⁹

Biodiversity as part of your investment process

After seeking out the portfolio ‘hotspots’ across sectors and specific issuers, investors can start the process of re-aligning their portfolio to reflect where best practice lies in biodiversity integration.

A basic starting point is to tilt portfolios away from issuers that have a high biodiversity footprint and little ambition to reduce it, towards companies in the same sector that have identified the risks and impacts and who are managing (reducing) and monitoring them. Detailed issuer-level analysis is critical here to assess the ambition and credibility of any corporate objectives.

Fixed income investors may also use the lever of bond maturities to mitigate biodiversity-related risks within their portfolios. For example, issuers with a high dependency on natural resources or a high biodiversity footprint could be invested in only at shorter maturities and only re-invested into upon maturity if they have made sufficient commitments to mitigate those risks or lower their footprint.

But what about managing this process of making changes to fixed income portfolios? While all investors can use portfolio inflows (and outflows) and active turnover to re-shape their strategies, fixed income investors also have the additional benefit of a certain portion of their portfolio maturing each year, often as much as 25% in short duration strategies. This natural turnover may give portfolio managers the choice of where to re-invest the proceeds to achieve their biodiversity goals in a cost-efficient manner to re-align their strategies to best practice in biodiversity integration.

The upcoming release of science-based pathways and sectoral guidelines, namely those expected to be provided by the Science Based Targets Network (SBTN), should further enhance the ability of corporates and investors to integrate biodiversity into their decision-making process.¹⁰  But ultimately, the objectives of clients will drive how asset managers integrate and re-align portfolios to take biodiversity into consideration. That means active collaboration, education and knowledge-sharing with clients is key to understand fully the issues around biodiversity loss and natural capital degradation. 

Engaging with key sectors and issuers

Having a constructive dialogue and actively encouraging issuers to shift their business practices to reduce their biodiversity footprint is a key method to foster positive change. From a financial perspective it helps identify those ‘hotspots’ within a portfolio and structure discussions with issuers around material nature-related topics – helping them to become more aware of, and resilient to, the implications of supply chain and consumer risks from biodiversity loss. In other words, avoiding any surprises that might impair their ability to repay debt.

From an impact perspective that dialogue should encourage sustainable investors to take their share of responsibility by working closely with the investee companies to foster systemic change that can help to protect natural capital.