Asset owners are exposed to natural capital risk whether they like it or not, whether they know it or not, and whether they manage it or not. The risk manifests itself in investment portfolios in often unexpected ways, and those risks are now beginning to crystallise, the Investment Magazine Fiduciary Investors Symposium has heard.
If treated as a discrete asset class, natural capital risk should be obvious; but even portfolios with no explicit or deliberate natural capital exposure may face risks from the poor stewardship of natural resources.
JANA head of sustainability Rachel Halpern said there’s little doubt if the natural capital risk is going to crystallise in portfolios.
“It’s [the risk] crystallising right now,” she said.
“The rational thing to do is to understand where the hotspots in your portfolio are and take action.”
REST head of asset allocation Paul Docherty said natural capital is “the stock of renewable and non-renewable natural resources – things like land, water, air, animals, plants, et cetera – and it’s that stock that creates benefits to humans”.
“So, part of that will form part of an investable universe,” he said.
“But a big part of it is not investable, at the same time; yet taken together, it still has an important impact on our portfolios.”
Inevitable exposure
Docherty said an estimated half of global GDP is linked to natural capital which means “that preservation piece becomes very important across all our portfolios, even for the for the component that isn’t investable”.
Nuveen Natural Capital head of APAC and Africa Kristina Hermanson said natural capital is “the foundation of the economy”.
“In what we do every day, we think about the value of food, fibre, timber; very clearly we understand that,” Hermanson said.
“But more importantly, [we think] about the value of all those ecosystem services around natural capital: bees in their pollination services [are] worth US$600 billion in food production annually; you think about the mental health and recreational services that we see right around this area [the NSW Blue Mountains]; as well as erosion control; clean air; clean water.”
Hermanson said that while when assessing natural capital asset owners need to take a whole of portfolio perspective, they should at the same time “absolutely think about it as an asset class”.
“The traditional financial arguments are pretty well known,” she said.
“And they’ve really proven themselves well. It’s got inflation-hedging capability, possibly better than gold – higher returns [with] a third of the volatility; low and negative correlation to other asset classes as well.
“Now we’re talking about this next dimension, where you have the focus to be able to deliver productivity and profitability, which is ultimately communities thriving. But at the same time, you’re addressing carbon intensity in agricultural practices, or in timberland practices, and biodiversity.
“The Venn diagram is coming right together, and a lot of investors are finding that extremely interesting.”
But even if asset owners have not invested in natural capital as a discrete asset class, they are still very likely exposed to risk through other investments in a portfolio.
“In approaching this, it helps to take a whole-of-portfolio view at the outset,” Halpern said.
“That reflects that a lot of the conversations that we have with clients. They might come in and say, ‘tell us a really nice, profitable strategy that’s in the natural capital space’, and that could be across many different asset classes. It could be in fixed income, it could be in alternatives, carbon, biodiversity, hedge funds, and so forth.
“But going straight there I think misses the point of looking at the entire portfolio and assessing the risk to the portfolio that natural capital poses. That’s why I think that it’s too myopic to think about it as an asset class.”
Nuanced risk assessment
Docherty said REST is “early on the journey” in working out how to assess the risk natural capital poses to the fund.
“It’s challenging, because a lot of the existing frameworks I’d argue are over simplified,” he said.
“A lot of them just look at sector-based measures, for example, and then map that across your portfolio. We would like to be kind of more sophisticated and nuanced than that.”
Docherty said REST is adopting a “crawl, walk, run philosophy to this”.
“We’re in that initial crawl stage, which largely involves us engaging in a broad research piece and working to understand how our strategic partners and managers are thinking about this, bringing that that kind of information internally to assess it,” he said.
Docherty said the issue of natural capital risk assessment and management is “probably five to 10 years behind” mitigating climate change in terms of frameworks and regulations.
The Fiduciary Investors Symposium heard that the Taskforce on Nature-related Financial Disclosures (TNFD), the Greenhouse Gas (GHG) Protocol, and natural capital accounting are combining to give investors clearer direction on identifying and quantifying portfolio risks.
Halpern said TNFD reporting is compulsory in some jurisdictions, but not yet in Australia, although there’s a pilot program underway.
“The idea is that it brings to light for the first time the risks related to natural capital to the company, and therefore it’s meant to the idea was meant to roll up, and you can apply that lens to your portfolio,” Halpern said.
Docherty said “the world is awakening” to broader issues around managing natural capital and the greater attention it is receiving from policymakers and regulators.
“What that’s got the potential to do is to kind of create this tipping point where there is a significant regulatory intervention that results in the re-rating of asset values that results in stranded asset risks,” he says.
“But also, potential policies, like a carbon pricing mechanism, could potentially increase the value of carbon sequestration assets at the same time.”
