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Why Investors Should Care About Natural Capital

August 24, 2016 |

A photo by Anders Jildén.

This article has been submitted as part of the Natural Capital Coalition‘s series of blogs on natural capital by Adams Koshy, environment, carbon and finance analyst, eftec.

We are all investors in one sense or another: through our pension; our mortgage; or even just setting aside a little money in a savings account. In one way or another, we have all gone through the thought process involved in making an investment decision.

To elaborate this, let me take the case of Joe, who’s decided to invest some money, and wants to understand how environmental factors could affect the safety of and returns on his investment.

Joe is your average 40-something, and has never considered himself an environmentalist. But like many of us, he recognises that individuals and businesses depend on the environment around us.

Working at a power plant, he’s already seen first-hand how much the plant depends on access to reliable water supply, and how its performance is affected by air pollution, waste management and so on. Ever the pragmatist, he realises that all companies must, to varying degrees, have impacts and dependencies on the environment, – whether directly through operations, or indirectly through the supply chain, labour force or other influences. But how do these relationships influence the ‘investability’ of a company?

The answer to this lies in how these factors affect the performance of the investment: namely through the security of these investments (risks) and their future performance (returns). The reason being that when you invest in a company, you do not invest in its current form, but your perception of a company’s future value. The current profit or loss (for example) only provides a snapshot of the state of the company, and a potential indication of the future.

This gives rise to two potential sources of uncertainty for investors.

Firstly, the gap between what a company’s management knows of their impacts and dependencies on the environment, and how much of that information is presented to the investors (aka information asymmetry); for example, through CSR/sustainability reports and the extensive Environmental, Social Governance (ESG) tools now available. However, these sources are restricted by the inadequacy of environmental information possessed and/or reported by some companies.

Secondly, macro-level risks for the future, such as the risk of potential regulation that could come into force, or environmental changes that could occur due to external stresses; e.g. a higher price of water due to water scarcity. This too has been compiled in innovative ESG tools. However, this information may be compiled externally, and so is often isolated from the company’s decision -makers.

As stewards of your investment, it is the responsibility of the company’s management (and its corporate governance) to ensure that the natural environment they depend on is appropriately accounted for and managed, such that both of these uncertainties are minimised.

The Natural Capital Protocol adds key insights into the established reporting and ESG tools. It shines a light on these (fundamental) management decisions, by presenting a clear and adaptable framework for companies to identify, measure and value their impacts and dependencies on the natural environment (or ‘natural capital’).

The Protocol’s four principles offer a checklist to illustrate whether a business’ natural capital analysis has a logical process, and allows scrutiny to ensure that financially material issues are acknowledged and dealt with. Although the Protocol is not a reporting, but rather a decision- making framework, this information should then be reflected not only in the operational strategy, but also in the external reporting of the business. Such that consistent, material information is provided to reduce the gap in knowledge between investors and company management, and to ensure that action is taken and strategies implemented to mitigate future risks.

This additional reporting should satisfy Joe’s curiosity, but means more for larger, institutional investors (like pension funds). For these investors especially, the Protocol could help them distinguish between different investments, exclude companies that could pose a risk, identify new opportunities for informed investment, and provide the basis to engage with, and challenge, companies that do not adhere to the Protocol.

To highlight the practical application of this, take the recent work led by the Natural Capital Declaration, on the impact to company performance (and their bonds) from risks to their water supply. One of the sectors considered was power: as the case of Joe has already highlighted, they depend on a steady water supply. Unfortunately, due to a variety of factors, some power companies are predicted to be at risk from global water shortage. For example, the state-owned South African company Eskom is at risk of financial deterioration from higher water costs (due to the shortage); and as they are already have large loans (i.e. are highly leveraged), it restricts their ability to invest in new water sources. Therefore, investors need to be aware of whether a company is at risk from these environmental stressors and how they are controlling these risks, in order to make a more informed investment decision. Identifying those that are accounting for and taking action against these risks, and excluding those that do not.

Let me be the first to accept that these insights hinge on companies reporting information under the Protocol. However, the greatest driver of investment returns are informational advantages that shrink the inherent uncertainty. Better information on environmental risk and opportunity has already proved its value as a component of investors’ tool box, through companies’ fundamental dependencies on the environment. As more companies begin to utilise the Natural Capital Protocol, its positive effect in investment selection and management decisions will develop. So eventually, investors like you, me and Joe can better incorporate relevant environmental information into our investment decisions.

Disclaimer: Articles in this series are submitted by people who work in organizations who are part of the Natural Capital Coalition, or people who are involved in the natural capital space more generally, the views expressed here do not necessarily represent the views of The Natural Capital Coalition, other Coalition organizations, or the organization that employs the author.

The content of this article is not intended as investment advice. The above link to Eskom is only an illustrative example, where Eskom is not a listed company, as a state-owned entity. Use your discretion in using examples presented here for your own investment purpose.

Adams Koshy is a natural environment, carbon and finance analyst with eftec (economics for the environment consultancy), based in London. eftec have been part of the technical author team of the Natural Capital Protocol, and work on natural capital for businesses, governments and civil society, at local, national and international levels. eftec also shared its environmental valuation expertise to the Natural Capital Declaration work on the ‘Corporate Bond Water Credit Risk Tool’.

Follow eftec on Twitter: @eftecUK

On 13th July 2016, The Natural Capital Coalition launched a standardized framework for business to identify, measure and value their impacts and dependencies on natural capital. This ‘ Natural Capital Protocol‘ has been developed through a unique collaborative process; a World Business Council for Sustainable Development consortium led on the technical development and an IUCN consortium led on business engagement and piloting. The Protocol is supported by practically focused ‘Sector Guides’ on Apparel and Food & Beverage produced by Trucost on behalf of Coalition.

Keep up to date with the Natural Capital Coalition on Twitter: @NatCapCoalition

Keep up to date with our series on natural capital here.

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