# **Physical risks**

# _Loss of ecosystem services_

The banking sector is exposed indirectly to physical risks by providing credit to enterprises whose production processes depend on ecosystem services. To assess this exposure, we determined the amount of credit that Brazilian banks allocate to firms with business processes dependent upon ecosystem services. We relied on the ENCORE database, which provides a list of 86 different business processes that directly depend on 21 ecosystem services (see Table 2).<sup>10</sup> We followed the methodology laid out in DNB (2020) to link our data on banks’ credit portfolio by economic sectors (e.g., agriculture) with their associated production processes (e.g., rainfed arable crops).<sup>11</sup> Furthermore, to determine which ecosystem services might be more critical to production processes and which potential impacts might be of greatest concern for banks, we leveraged on ENCORE’s dependence materiality assessment. Using sector research and expert interviews, ENCORE’s materiality assessment translates into a rating ranging from very low to very high reflecting how a disruption in the ecosystem service provision could materially affect business performance and be reflected in financial losses (see Figure 2 for an illustrative example).<sup>12</sup> Based on the sectoral credit outstanding of Brazilian banks, the materiality of potential dependencies and impacts of ecosystem services provide a preliminary estimation of banks’ physical risk exposure to biodiversity loss. We show the total amount of credit that, as of March 2021, is exposed to each ecosystem service by dependency materiality rating. For example, consider a company dependent on two ecosystem services (e.g., flood protection and disease control). Each Brazilian real this firm borrowed would count as one when measuring the exposure to each service. This metric provides a full account of the financial system exposure to each individual ecosystem service, though business processes are often dependent on multiple ecosystem services hence the former should be analyzed individually and cannot be added.

A second metric is calculated by accounting only for ecosystem services with high or very high dependencies to address the additionality issue. Assume that a company that borrowed one real is dependent on three ecosystem services, two of which have a high materiality rating while the third has a medium materiality. Then, the real borrowed will be equally distributed to the two ecosystem services with high materiality. This method would allow gauging the banks’ overall

> 10 The complete list of business processes and ecosystem services is available at: <u>https://encore.naturalcapital.finance/en/data-and-methodology/services.</u>

> 11 DNB (2020) linked ENCORE’s production processes (grounded in GICS) with the NACE Rev 2. We used this as a starting point to facilitate the linkage with the Brazilian economic sector classification standard, CNAE 2.0. The linkage is not univocal, as several business processes could be assigned to individual sectors or vice versa. Therefore, blending diverse business processes into one sector required assumptions of how these processes are used within the economic sector.

> 12 The ENCORE dependencies on ecosystem services data is grounded on literature reviews carried out for each ecosystem service class and production process combination using Web of Science, Google and key document searches (e.g.: TEEB for Business, leading companies in the sector and industry initiatives). Expert interviews were conducted with sector specialists to validate information or to address data gaps for some sectors or production processes. See https://encore.naturalcapital.finance/en/data-and-methodology/methodology.

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