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Natural Capital Risk Analysis - Sector Profiles

Businesses are increasingly confronted with the consequences of natural capital depletion, be it through water shortage or new legislation around greenhouse gas emissions. Yet, while more companies are assessing their natural capital footprint as part of their growing awareness of their role in natural resource depletion, many are failing to explore the related risks and mitigation options available.


In the report "Measuring and managing environmental exposure - A business sector analysis of natural capital risk" AGCS analyze the natural capital risks that business sectors and companies face. Specifically, the research takes a closer look at seven risks posed by the five natural capital factors – biodiversity, greenhouse gas emissions (GHG), non-GHG emissions, waste and water – for 12 selected sectors.

How to read the spider graph

The example graph below indicates the average level of natural capital risk and mitigation within a sector, distinguishing between the seven risks around the five  natural capital factors. The farther a risk or mitigation dot is located away from
the center, the higher the respective risk/mitigation on this specific risk is. Within this  graph, the relative gap between the risk/mitigation dot illustrates the level of potential risk exposure.

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Automotive

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More than other sectors, automotive has been pressed to improve its environmental performance. The traditional sector has not only gradually increased its output of hybrid and electric models, it has also reduced GHG and other emissions in its complex international supply chain. The sector is advanced in the evaluation of its impacts, yet for some reason does not explicitly link these activities to natural capital initiatives.

For this publication, AGCS focuses on the natural capital risks related to the production of motor vehicles and parts, as well as the global supply chain, excluding risks associated with the product itself. The sector engages and collaborates with a wide range of stakeholders (for example, international policymakers, academia and investors) on these risks. Overall, the awareness and preparedness to address and mitigate these risks is relatively high.

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“High emissions of criteria air pollutants brings heavy regulatory scrutiny and higher costs of operation, while handling chemicals carries the possibility of accidental spills and releases which pose risks to workers, local communities and local ecosystems.” MSCI ESG Research Industry Report: Auto components (August 2017)

Risk scenario example for an automotive company
Social and political pressures increase on a supplier due to its biodiversity impact (toxic releases to the environment), which leads to a supply chain interruption for several automotive companies. Costly technical measures to clean up the
releases and prevent future spills are implemented to remedy the situation.


Chemical

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The chemical sector encompasses chemical companies around the globe dealing with commodity, diversified and specialty chemicals. The sector is characterized by complex supply chains and interlinkages. The chemical sector is relatively exposed to social and regulatory pressures, less so to political pressure. The sector is mainly exposed to natural capital impact risks, such as water, waste and emissions to air. These extend from the core operations to the supply chain. Chemical companies are often well aware of their environmental impact and manage it accordingly with corporate risk management and technical measures.

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“Measuring our impact on the environment in monetary terms improves the understanding of the relevance of specific environmental impacts compared to other impacts assessed in our Value-to-Society approach. Using a monetary unit for economic, social and environmental impacts improves our understanding of their interdependencies along value chains. At BASF, impact valuation is systematically applied at corporate level. It provides a frame to better understand our total benefits and costs to society, to support decision-making processes and to inform strategy development together with our risk management.” Christian Heller, Senior Manager Corporate Sustainability Strategy, BASF SE

Risk scenario example for a chemical company
Due to increasing legal and political pressures, GHG and non-GHG air emissions are capped in one country. This affects an operating entity based there and leads to a business interruption in the short term as the production processes need to change over time to reduce emissions. The technical refurbishment creates
additional costs for the operating entity.


Clothing

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The sector is dominated by a relatively small number of multinational retail companies that have significant influence along the entire value chain. The production of raw materials and clothing usually takes place in developing and emerging markets, therefore some of the risks are not always visible initially.
While the clothing sector is moderately exposed, compared with other sectors, when it comes to natural capital risk, the awareness of, and preparedness to, mitigate the issues are relatively high. This may be explained by the direct reliance on natural capital and the early and visible action of some individual companies.

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“Within the textile, apparel, and luxury goods industry, leather and cotton, are identified as raw materials with the most significant environmental impact. Leather hides are associated with a high carbon footprint due to deforestation and
methane emissions linked to cattle ranching. Apparel goods’ environmental impact is primarily attributed to high intake of water and pesticides in cotton crop production.” MSCI ESG Research Industry Report: Textile, Apparel, And Luxury Goods (September 2017)

Risk scenario example for a clothing company
Cotton monocultures in a specific geographical location are rapidly expanding and involve allegations of land grabbing, pesticide use and excessive water use. Social and political pressures create a reputational risk for the cotton producer. Court cases against the alleged land grabbers are filed by activists, creating a liability for the company. At the same time, water overuse creates an instability of supply and increasing costs. enterprise risk management (land acquisition) and technical measures (water management) are needed to manage growth sustainably.


Construction

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The construction sector encompasses the production of building and construction materials, as well as the actual construction and engineering of buildings and infrastructure. Like the manufacturing sector, companies in this sector vary greatly in terms of size and setup. Investments in infrastructure and a property boom in
many parts of the globe means that the sector has performed reasonably strongly in the past decade on a global average.

The sector is confronted with social and regulatory pressures and, in some cases, political influence. The reliance on natural construction materials, such as wood, can create supply chain risks when scarcity occurs. At the same time deforestation is likely to have a negative impact on biodiversity. Technical mitigation plays a limited role in the sector, while corporate risk management plays a more important role.

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“Cement production is among the most carbon-intensive manufacturing
activities, however, despite potential for regulatory pressure to reduce
carbon emissions in the future, only 44% of companies in the set have long
term carbon reduction targets beyond 2020.” MSCI ESG Research Industry Report: Construction Materials (November 2017)

Risk scenario example for a construction company
A cement producer is active at multiple locations worldwide with carbon dioxide (CO2)-intensive processes. The producer faces legal action as the company is seen as a liable driver of climate change and its adverse effects. As the company is one of the largest emitters of CO2, social and political opinion surrounding the trial creates additional pressure to minimize CO2 emissions.


Food and Beverage

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The food and beverage sector covers a wide range of companies involved in
processing raw food materials, as well as packaging and distributing them. The
industry is fragmented, and production is divided among many companies. Due to
its nature, the industry heavily relies on agricultural products that are expected to
be impacted by climate change in the coming years.

The food and beverage sector tends to be characterized by biodiversity impacts and dependencies on natural capital risk factors at the same time. All types of risks are relatively high, while mitigation is present throughout all aspects. The highest
risk scores for this sector relate to water dependency followed by waste impact.

While the food and beverage sector is moderately exposed compared to other sectors when it comes to natural capital risks, awareness and preparedness to mitigate the issues are also moderate.

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“Despite the significant risk of supply disruptions as a result of water stress, only 20% of MSCI All Country World Index (ACWI) Food Products companies have actually begun to address water stress in their agricultural supply chain, while 72% are only focused on operations. Eight percent do not manage water stress at all.” MSCI ESG Research Industry Report: Food products (February 2017)

Risk scenario example for a food company
Local flora and fauna suffers as a result of excessive fertilization and pesticides used at a supplier’s plantations. At the same time, the area becomes less fertile and more vulnerable to external environmental impacts. The supply from the plantation becomes more expensive and volatile, creating regular interruptions in the supply chain. Enterprise risk management addressing the supplier’s plantation management practices from an environmental sustainability perspective is necessary.


Manufacturing

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The manufacturing sector is a broad, globally-connected sector and includes primary and end products ranging from consumer to capital goods. This sector often involves long, complex and dynamic supply chains that make the natural
capital risks of the sector not always visible initially.

In comparison to the mining and utilities sectors, the manufacturing sector is not experiencing the same regulatory, social and political pressures. This generally means that fewer risks will materialize in practice. At the same time, outsourcing practices, supply chain interconnectedness and dependency on raw materials, resource input and the flow of intermediate products is key to manufacturing. Natural capital risks can materialize at specific manufacturing companies through impact (production scale-down at a plant due to excessive emissions) or dependencies (production halts due to water shortage) and can also spill to downstream users of the product within the sector and beyond.

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“Due to the interconnected global supply chains, our operations are dependent on water, energy and a range of raw materials and components. We are aware of the associated business risks which are addressed by our supply management function and through the integration of the circular economy principles into our business model. Not only to manage compliance, but also working together with our suppliers to create a positive impact.” Simon Braaksma, Senior Director Group Sustainability, Royal Philips

Risk scenario example for a manufacturing company

Excessive waste from its production processes and the local incineration of toxic and non-toxic waste becomes a major issue for a company after social and political pressure. To anticipate local licensing or regulatory changes, the company implements costly technical measures to minimize the waste and has excess waste handled in specialized, remote locations according to best practice. Due to the transition phase of these measures, small scale business interruptions occur.


Mining

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Mining encompasses the extraction of precious and non-precious metals, such as gold, bauxite, iron or copper. Mining provides key raw materials and resources for many industries. The last 10-year “raw material super cycle” ended in 2011, so it is only recently that the sector has begun to increase productivity after years of declining commodity prices.

While the mining sector seems technically well-equipped to mitigate natural capital risks, the exposure to social and political pressures can be considered high, which translates into equally high legal and regulatory pressures. To manage these formal and informal pressures and expectations, the sector needs to make further investment in technical and corporate risk management measures to handle its natural capital risk dependencies and impact – for example, ensuring the rehabilitation of landscape and biodiversity after mining operations have ceased.

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“Over 91% of global iron ore production is derived in areas that are high risk for water stress, biodiversity, corruption or a combination.” MSCI ESG Research Industry Report: Non-precious metals, mining & steel (March 2017)

Risk scenario example for a mining company
A local mine has an excessive impact on the watershed, both in terms of water use and pollution, as well as on local soil erosion and on flora and fauna. As a result, it faces social and political pressures that over time translate into a stricter regulatory regime and significant clean-up costs demanded via a court ruling. The company must then invest in technical and enterprise risk management measures to ensure it will keep its operating license.


Oil and Gas

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The oil and gas sector encompasses companies handling the exploration, production, refining and marketing of natural oil and gas, whether as a diversified or as an integrated entity. Oil and gas prices have seen a global downturn since 2008, resulting in considerable economic pressure in the sector to increase productivity and efficiency, while driving market consolidation.

Even more so than the mining sector, the oil and gas sector is exposed to impact and dependencies relating to natural capital risks. Regulatory, political and social pressures generally play a major role for the sector. While technical mitigation remains key, certain risks such as GHG liabilities call for other risk instruments (e.g. integrating carbon dioxide pricing in decision-making).

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“Risks of increased freshwater use and oil spills as well as community opposition increase with companies focusing on unconventional shale oil and gas developments in the U.S.” MSCI ESG Research Industry Report: Integrated Oil and Gas (December 2017)

Risk scenario example for an oil and gas company
An upstream oil and gas company suffers repeated spills, which affect the local water table and flora and fauna. Local opposition against the operator increases and the government not only fines the operator but applies further regulatory pressure on the company. The company must invest in technical and enterprise risk management measures to ensure a continuation of operations.


Pharmaceutical

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Although demand for medicines is growing more rapidly in emerging economies than in the industrialized economies, the overall growth of the pharmaceutical sector has slowed over the last few years. However, due to recent advances in
technological innovation, the market is expected to grow in the future.

The sector is characterized by both impact and dependencies on natural capital
risk factors at the same time. All types of risks are relatively high, although
mitigation is present throughout all aspects. Yet, despite the relatively high
dependency on biodiversity, for example, there is limited mitigation in the sector.

While the pharmaceutical sector is relatively exposed compared with other sectors when it comes to natural capital risk, awareness and preparedness to mitigate issues is moderate. Given its reliance on biodiversity, higher mitigation might be expected.

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“Importantly, only 28% of rated companies disclose programs aimed at working with suppliers to reduce toxic emissions. 72% of companies lack disclosure or have only limited oversight of suppliers.” MSCI ESG Research Industry Report: Pharmaceuticals (November 2016)

Risk scenario example for a pharmaceutical company
The harvesting of natural ingredients for pharmaceutical products puts stress on a local resource due to overuse. After the resource declines, supply chain interruptions occur. As the main buyer of this product, the company must find a short-term substitute. As well as incurring additional cost the company also experiences a serious business interruption due to the limited supply of the ingredient.


Telecommunications

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The telecommunications sector continues to be a key enabler of growth and innovation across multiple industries. The sector is relatively active in collaborating on natural capital risks, even though it has a low exposure to these risks.

Businesses are increasingly including natural capital risk considerations into decision-making and telecommunications is often seen as part of a solution. There are tremendous opportunities for telecom companies to develop solutions to limit natural capital exposure in other sectors. Digital communication and management
solutions can help enable more efficient resource use.

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“Vodafone is a key enabler of growth and innovation across multiple industries when it comes to climatefriendly solutions. The telecommunications sector can support business to manage their risks, as we provide data and communication management solutions. There are tremendous opportunities for the telecommunications sector to further develop competitive solutions in the emerging field of natural capital risks.” Martin de Jong, Director Societal Value, VodafoneZiggo

Risk scenario example for a telecommunications company
A telecommunications company, operating an energy-intensive server center in a given location, is faced with a planned price for carbon dioxide (CO2) creating additional costs going forward. A refined internal enterprise risk management framework deals with the risk, attempting to mitigate the adverse financial impact as much as possible.


Transportation

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Fueled by economic growth and globalization, the transportation sector is enjoying unprecedented demand. Yet, factors like energy-efficiency are becoming more and more critical in transportation choices.

The transportation sector has a relatively high impact on biodiversity, and on GHG and non-GHG emissions, as well as on water. While less exposed compared with other sectors when it comes to natural capital risks, the awareness and preparedness to mitigate the issues is relatively low.

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“Transportation-related carbon emissions have increased by 250% since 1970 and account for 23% of total global emissions. The majority of the transport sector’s emissions are generated through road transport and largely through the combustion of petroleum-based products such as gasoline, diesel or heavy fuel. Road & Rail and Marine companies that rely on the combustion of fossil fuels face growing regulatory pressure to lower their carbon footprint.” MSCI ESG Research Industry Report: Road and Rail Transport (May 2017)

Risk scenario example for a transportation company
A marine transportation company is confronted with stricter regulation regarding toxic non-GHG emissions and must write off parts of its fleet sooner than expected. Technical measures can help certain vessels to remain in operation; however, additional costs are required to keep the fleet in operation and avoid business interruptions.


Utilities

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The utilities sector encompasses gas and electric companies involved in the production, distribution and trading of energy for households and businesses. The
sector is currently caught up with a trio of challenges concerning goals relating to
affordability, reliability and decarbonization. The overall sector underwent a remarkable shift toward renewable power generation in the last few years and
expectations are that renewables will grow by another 30% in the next five years. [10]

Like mining, the utilities sector is heavily impacted by regulatory, political and social pressures when it comes to natural capital risk. Impacts are as important as dependencies and extend to companies’ own operations and the supply chain. At a given location, the impact on air quality can play a role in business interruptions as significant as insufficient levels of cooling water on the dependency side. Technical mitigation and corporate risk management need to be complemented with strong stakeholder engagement and risk transfer.

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“The European Union, and now even China, through its regional carbon markets, have instituted emission trading schemes (ETS). Power plants in these regions are faced with increasing compliance cost under those schemes following the auctioning of allowances.” MSCI ESG Research Industry Report: Utilities
(March 2017)

Risk scenario example for a utilities company
Due to increasing political and regulatory pressures concerning carbon dioxide (CO2)-intensive electricity generation, a utilities company takes the decision to split off CO2-intensive power generation from the core company. This strategic decision enables the company to avoid a stricter regulatory regime when it is introduced a few years later. Apart from escaping the resulting social and political pressures and reputational damage, the company also avoids the potential additional costs relating to CO2 (CO2 price), business interruption (CO2 cap) or even loss of business (power plant write off).

[10] International Energy Agency, Renewables 2017, October 2017