global investors. Large Brazilian firms have faced pressure from investors as well as banks to address deforestation risks and present action plans. For example, the largest meat processing company in the country recently faced the exclusion of its shares from a large asset manager’s funds, as well as warnings by banks against investing in the company due to Amazon deforestation concerns.<sup>23,24</sup> In line with DNB (2020), the credit provided to firms involved in environmental controversies is our proxy for banks' reputational risks. The MSCI ESG Database keeps a record of the controversies of listed companies and assesses the severity of their impacts on the environment by a combination of the scale of the impacts (how widespread it was) and their nature (from minimal to egregious).<sup>25</sup> MSCI defines controversies as single events or ongoing situations where company operations or products allegedly have a negative environmental impact. The database takes into consideration the fact that the impact of some events is indirect or difficult to determine hence having a lesser impact on the final score. In contrast, other events can affect a particularly vulnerable ecosystem, or evidence is found that the company knowingly acted in disregard of the law or the environment, thus exacerbating the relevance of the negative controversy. After the enterprises with environmental controversies have been identified, the information in their annual reports allows us to determine the volume of loans that these companies have received from Brazilian banks.

# **3. Estimating financial risks of biodiversity loss**

## **Physical risks**

_Loss of ecosystem services_ Brazilian banks lend BRL 811 billion to firms whose business processes are highly or very highly dependent on one or more ecosystem services. This amount represents 46 percent of the corporate credit portfolio and 20 percent of the total credit portfolio (Figure 4). In other words, 46 percent of the loans that banks allocate to corporates are subject to potential financial losses due to a disruption of ecosystem services. By analyzing separately this aggregate estimate by the source of resources (earmarked vs. non-earmarked), size of banks, borrowers’ size, and loan quality, we find evidence of heterogeneity in the exposures to physical risks.

Earmarked credit is marginally more exposed to the risk of biodiversity loss. The Brazilian credit market is historically characterized by heavy government interventions for allocative purposes. Earmarked resources are credit granted by financial institutions with implicit or explicit subsidies

> 23 See https://www.reuters.com/article/us-brazil-jbs-nordea/nordea-drops-jbs-shares-over-environment-covid-19- <u>response-idUSKBN24X3VD</u> 24 See https://www.theguardian.com/environment/2020/aug/12/hsbc-sounds-alarm-over-investment-in-meat- <u>giant-jbs-due-to-deforestation-inaction</u>

> 25 We acknowledge that we might be incurring a significant underestimation given that we only account for listed companies. Nonetheless, to the best of our knowledge, the MSCI ESG database has the most comprehensive coverage of firms' environmental controversies in Brazil.

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