Natural Capital and Its Role in ESG Risk Mitigation

Mar 4, 2021 | Blog, ESG Reporting

Natural Capital and Its Role in ESG Risk Mitigation

Natural capital refers to the natural resources that a company utilizes or owns – from renewable resources like water or trees to non-renewable resources like fossil fuels and minerals. 

The link between the wellbeing of natural capital and the wellbeing of financial capital is strong and must not be overlooked. Still, the connection can be hard to measure and track, in part because the value of natural capital is harder to quantify. Rather, its quantification has not been normalized like that of financial capital just yet.

Recent moves to address corporate social responsibility – in part due to companies themselves as well as government regulations – have forced businesses to take a closer look at natural resources in order to comply with ESG reporting. 

 

Ultimately, having a strategy to collect, measure, and analyze natural capital will be key for stakeholders trying to keep up with ESG reporting requirements.

 

This post looks at why it’s so important to identify the connection between these two types of capital – and how harm to natural capital can impact financial capital. Those businesses that take a proactive approach to protect natural capital will be better suited to deal with regulatory changes, climate change, and other risk factors – including risk to financial capital.

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What is Natural Capital?

The best way to define natural capital can vary from company to company because no two businesses have exactly the same relationship with natural resources. 

 

AQUAOSO defines natural capital as follows:

Natural capital is the measurement of the value that derives from natural resources. Examples of these natural resources can include water sources, forests, natural groundwater, ecosystems – anything that is naturally occurring creates value for humans. Natural capital is closely linked with financial capital; value that is diminished from natural capital is value that is diminished from financial capital.

 

In other words, the amount of natural capital that a company has access to – and its sustainability in the long run – can determine how successful it is as a business. 

For example, an agricultural operation may depend on measurable resources like soil and water quality, as well as more abstract types of natural capital, such as the ability of bees to pollinate crops or trees to maintain the overall health of the ecosystem.

Conservation International argues that putting a value on these resources can help to “inform more sustainable choices, including market-based conservation, which can be crucial for protecting nature from unrestrained consumption.”

Measuring natural capital can be complicated, though, because it requires detailed data collection and analysis. Conservation International relies on a process called Ecosystem Values and Accounting (EVA) to value natural capital:

“To determine the monetary worth of freshwater, for example, Conservation International’s EVA analysts add up the end values of the crops the water irrigates, the manufactured products that use it, the energy its flow generates through hydroelectric dams, and how it supports local households. Aggregating this information gives a more complete picture of a country’s water wealth.”

While gathering and assessing this data can be a challenge, it will become a necessity as ESG reporting requirements change and businesses face pressure to account for their environmental impacts and prepare for increased climate and water risks.

 

 

Natural Capital’s Relationship with Financial Capital

Financial and natural capital must be treated as equally important when assessing a company’s financial risk. In a set of recommendations released by the Task Force on Climate-Related Financial Disclosures, they point out that factors such as extreme weather events and changes in temperature or rainfall patterns can lead to:

  • “Reduced revenue from decreased production capacity”
  • Higher labor costs due to increased health and safety issues
  • Property damage and/or higher insurance premiums in at-risk locations
  • Higher operating expenses and other adverse impacts

In short, the connection between natural and financial capital runs deep, but it may not be apparent without access to the right data. As the Capitals Coalition explains,

“Without an understanding of their impacts and dependencies on natural capital, many decision-makers will be unaware of potentially significant risks and opportunities and will therefore be at least partly ‘flying blind’.”

For example, forests can help to ensure reliable water resources by maintaining healthy headwaters. If those forests are cut down, the value of that water is lost. While placing a dollar amount on the value of timber may be straightforward, an accounting of the entire ecosystem may be more complex and requires a more detailed analysis.

Better data can help lenders, investors, and other decision-makers identify the links between natural and financial capital, including any natural capital dependencies, or “environmental resources and processes on which an organization depends for the provision of goods or services that support its past, current or future prosperity.” 

 

 

The Importance of Natural Capital and Data in ESG Reporting

More and more companies around the world are striving to meet ESG standards, but according to a Bloomberg report, only around half are performing “very effectively” in terms of their own stated ESG goals. This contrasts with the recommendation of the Task Force on Climate-related Financial Disclosures, which argues that,

“One of the essential functions of financial markets is to price risk to support informed, efficient capital-allocation decisions…. It is more important than ever that businesses lead in understanding and responding to these risks.”

Stakeholders need access to natural capital and ESG data in order to approve the right loans, make better investments, and reduce their overall financial risk. Having access to granular datasets in the proper formats allows stakeholders to identify links between types of capital that haven’t been obvious before so that risk factors can be addressed and corrected.

Gathering this data now will allow stakeholders to be even more proactive in the future when ESG reporting becomes a legal requirement. Future ESG rules will require more scrutiny into the sustainability of loan and investment portfolios, so understanding how natural capital affects financial capital will be critical.

This understanding is the basis for successful risk mitigation and reporting compliance, and it all begins with data. Whether it’s using GIS data to mitigate risk in agriculture, or water analytics to identify more sustainable investments, understanding natural capital and its role in ESG risk management can “lead to smarter, more efficient allocation of capital, and help smooth the transition to a more sustainable, low-carbon economy.”

 

Read more about ESG reporting and capital risk in AQUAOSO’s explorable guide.

The Bottom Line

Natural capital can be harder to measure than financial capital, because it includes a wide range of factors – from forests, to water, to overall ecosystem health – that can impact a company’s bottom line. Properly valuing natural capital requires collecting, measuring, and analyzing complex data.

As ESG reporting becomes a non-negotiable expectation, stakeholders at all levels will benefit from identifying and understanding natural capital. Lenders and investors can use this data to make better financial decisions, assess the long-term sustainability of their investments, and reduce their overall financial risk.

AQUAOSO can help financial institutions and other stakeholders better understand data that relates to natural capital with purpose-built tools designed for agricultural professionals. AQUAOSO’s tools make it easy to identify and monitor water risk while taking into account other factors that can contribute to financial risk in the agricultural sector.

Request a free demo of the Water Security Platform, or sign up for the newsletter to stay up to date on water conservation and other ESG topic.

 

 

 Photo by Dustin Cox

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