Abstract
Purpose of Review
Natural capital is a term for the stocks of natural assets (e.g. natural resources and ecosystems) that yield flows of ecosystem services that benefit the economy and human well-being. Forestry is one of the industries with the greatest dependencies on natural capital, as well as having the potential for substantial positive or negative impacts on natural capital. These dependencies and impacts create direct risks to a forestry enterprise’s ongoing financial viability, which translate into indirect risks for investors and society. There are growing demands from a variety of stakeholders for more reliable information to assess such risks, but at present, these risks are not always well understood, assessed or communicated in a consistent and comparable way. This paper addresses this problem by applying a standardized methodology to develop the first systematic, evidence-based review and financial materiality assessment of natural capital risks for the Australian forestry sector.
Recent Findings
The vast potential scope of forestry impacts and dependencies on natural capital can be reduced to twenty key areas of relevance to Australian forestry, of which only seven to nine have been assessed as highly financially material for each of the sub-sectors of softwood plantations, hardwood plantations and native forestry. The majority of risks assessed as highly financially material are related to dependencies on natural capital. This is in part due to the fact that current regulations and certification schemes focus on managing impacts, but tend to overlook dependencies. Nearly all of the natural capital risks rated as highly material are likely to be exacerbated by climate change.
Summary
An improved understanding of natural capital risks is an important input to better decision-making by forestry enterprises, as well as their lenders and investors, forestry regulators and other relevant stakeholders. This paper contributes to the preparedness of the forestry industry and its stakeholders to address questions about vulnerability to future changes and declining trends in natural capital.
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Introduction
Businesses are increasingly affected by the consequences of depletion and degradation of the natural environment: directly through reduced availability of resources and services provided by the environment to their business, and indirectly via regulation and social concern about business impacts on the environment. This relationship between businesses and the environment is now commonly viewed through the lens of ‘natural capital’ [1,2,3]. The natural capital approach extends the economic notion of capital (resources which enable economic production) to the natural environment, which is conceptualized as stocks of natural capital (e.g. soil, minerals and ecosystems) supporting flows of environmental goods and ecosystem services (e.g. food production, crop pollination and flood mitigation). This approach goes beyond conventional environmental management thinking insofar as it encourages businesses to consider their dependencies on the environment, in addition to their impacts. There are growing demands from lenders, investors, policymakers, and other stakeholders for more reliable information to help them assess business impacts and dependencies on natural capital and to understand how this translates into business opportunities and risks [4, 5•].
Forestry is one of the industries with the greatest dependencies on natural capital [6•]: the health and productivity of forests are underpinned by ecosystem services provided by natural capital such as fertile soil, adequate water and suitable climate. Changes in the availability of natural capital can threaten the productivity of forests, and thus the ongoing financial viability of forestry enterprises. At the same time, forestry operations and activities have the potential to impact (positively or negatively) on natural capital. This can also affect the financial position of a forestry enterprise, for example when society responds to natural capital impacts through regulation (such as fines) or changes in consumer acceptance (such as restricted access to certain markets in the absence of sustainability certification). Dependencies and impacts on natural capital can therefore create a variety of direct operational and financial risks for forestry enterprises, which translate into indirect risks for private or public sector investors in those enterprises, as well as further indirect risks for society. In this paper we describe these risks as natural capital risks.
Many of these natural capital risks (for example, water availability, bushfire, pests and diseases) are well-known to forest growers and may already be considered in forest management and planning. Nevertheless, assessing these risks in a structured and consistent way offers forestry enterprises additional opportunities to integrate natural capital risk management into their decision-making and risk reporting. It also offers opportunities for standardized, consistent and comparable communication with stakeholders [4, 7]. At present, forestry natural capital risks are not well understood by all relevant stakeholders (for example, lenders, investors, regulators, policymakers and others), due to a lack of shared knowledge, inconsistencies in terminology and conceptual framing of the issues, and the fact that natural capital risks are often highly context-specific, leading to a lack of agreement about which risks are material for particular industries and locations. This paper addresses this problem by drawing on a standardized methodology for natural capital risk assessment [8], originally developed for agriculture, and extending it to forestry, in order to develop the first systematic, evidence-based financial materiality assessment of natural capital risks for the Australian forestry sector.
This paper identifies the casual pathways that link forestry activities and natural capital. For each pathway we review the evidence and use that review to systematically assess the financial materiality of each natural capital risk for the three main types of forestry in Australia: native forests, hardwood plantations and softwood plantations. The value perspective taken [2, 8] is that of a lender or investor, primarily focussed on the risk of adverse financial impacts on a forestry enterprise – as opposed to a broader social perspective [9]. For this assessment, risk mitigation activities were only considered if they were standard industry practices, in which case they were assumed to moderate the underlying risk according to typical outcomes from those practices. Our assessment presents the financial materiality of natural capital risks at a broad industry scale. It is likely that materiality assessments for individual forestry enterprises will vary depending on geographical location, management activities and the full suite of current and future mitigation strategies. The value of an industry-scale assessment is to provide a starting point for finer-scale assessments, as well as a sense of industry-scale risks for portfolio investors.
The paper is structured as follows. In the next section, we discuss key concepts in natural capital risk assessment, such as impact and dependency pathways and materiality. We then set out our methodology for conducting our materiality assessment of natural capital risks for Australian forestry, followed by our results and discussion of our findings and conclusions in the final section.
Key Concepts in Natural Capital Risk
Natural capital risk assessment is a relatively new concept, and consistency in approaches has only recently begun to emerge. The Natural Capital Protocol [2] provides a generic approach to undertaking any type of natural capital assessment, including risk assessment, although it does not provide specific guidance on how to do this. A supplement to the Protocol, tailored to the forest products sector, is also available [10]. More specific guidance, based on the Natural Capital Protocol, has been developed by the Natural Capital Finance Alliance (NCFA) for portfolio risk assessment [6, 11] and individual asset-level risk assessment in agriculture [12•]. Here, we build on the existing approaches (in particular [12•]) to undertake a materiality assessment of natural capital risks for Australian forestry. Materiality assessment is a common step in any type of assessment which requires some narrowing down of scope to that which is most relevant according to the assessment’s objectives [2]. For example, it can help identify the risks that should be prioritized for further analysis or management response.
The concept of materiality has been adopted from the field of accounting [13, 14]. Broadly, something is ‘material’ if it has reasonable potential to significantly alter the decisions being taken by a user of the information being reported. In a financial accounting context, a materiality assessment is used to determine whether or not an item should be included in a financial report. Even within the context of financial reporting, however, the scope of issues that are considered to be material is broadening beyond financial matters to include environmental and social factors, and the timeframes over which materiality is assessed are changing to incorporate previously unaccounted medium and long-term issues (e.g. climate change) [7]. The concept of materiality is also a key feature in a variety of sustainability assessment and reporting frameworks, such as the Global Reporting Initiative (GRI) framework [15] and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) [16]. There are three distinct interpretations of materiality now in use that are relevant to corporate accounting and reporting: the narrowly defined purely financial scope, a broader scope of sustainability issues that are financially material for enterprise value creation, and a still broader scope of issues that are material from a social perspective [17]. We adopt the second of these interpretations, which is in keeping with the value perspective of a typical lender or investor.
Any assessment of materiality is to some degree subjective and context-dependent [13]. Unless a risk is already well understood – which is not the case for most natural capital risks – assessing the materiality of a risk essentially requires undertaking a preliminary or high-level risk assessment. This requires, firstly, an understanding of the causal pathways that link specific business activities and natural capital, known as impact and dependency pathways [2], and secondly, assessing the likelihood and magnitude of possible changes in these pathways that may lead to adverse financial outcomes for the enterprise. The concept of impact pathways is well developed [2, 18]: it involves identifying impact drivers (which may be inputs to the business, such as water use, or outputs, such as emissions), the environmental outcomes or changes in natural capital that result from the impact driver (e.g. an increase in levels of a pollutant), and the resulting societal impacts (e.g. health problems). In order to link changes in natural capital or societal impacts back to adverse financial outcomes for the enterprise, however, we must consider the possibility of either a direct feedback to ecosystem services that the company relies on (the ‘ecosystem response’ pathway in Fig. 1) or a societal response such as regulation, either of which can affect the company’s financial position. The concept of dependency pathways is somewhat less well developed, but we can likewise identify pathways that lead from various threats of environmental or social change (e.g. a build-up in chemicals which are harmful to pollinating insects) to changes in natural capital (e.g. fewer pollinating insects), which in turn affects the availability of ecosystem services (e.g. pollination) on which a business depends.
Dependency and impact pathways. Source: [8]
We take a broad view of ecosystem services including provisioning (e.g. production of timber), regulating (e.g. water regulation), cultural (e.g. recreation) and supporting (e.g. soil formation) services [3]. In some cases, the relevant ‘service’ might be the absence of conditions that would otherwise be unfavourable (such as extreme weather). Likewise, some aspects of nature may have negative effects on a business (such as pests and diseases) and can therefore be considered to provide ‘ecosystem dis-services’ [19]. These are also important to consider from a risk perspective.
Assessing the materiality of a potential risk is different to assessing the materiality of a dependency (as per [6•]) or an impact (as per [18]), because it requires not only an understanding of causal pathways, but also an assessment of the likelihood and magnitude of consequences that could result from changes in those pathways. However, in the case of an industry-level risk materiality assessment, it is not necessary to evaluate in detail the likelihood of a risk occurring: it is sufficient to consider whether the occurrence of a risk is plausible within the selected industry and geography, over a relevant time-scale. We considered a risk to be plausible if it has occurred in the past or in similar situations elsewhere, or if it is projected to occur in future, which we defined as approximately the next 30 years. If the likely future occurrence of a risk is scientifically highly uncertain, we erred on the side of caution and considered it plausible. This interpretation of likelihood allows us to focus our assessment on business outcomes, which we define as adverse financial impacts on a typical forestry enterprise resulting from a change to an ecosystem service on which such an enterprise depends, or a change to an impact driver that such an enterprise causes.
Methodology: A Combined Evidence-Based and Expert-Review Assessment of Financial Materiality
Our approach was iterative and open to either including new impacts or dependencies, or rejecting initial assumptions as further evidence was gathered. For each potentially material direct impact driver and ecosystem service we mapped out the impact or dependency pathway using the approach illustrated in Fig. 1. A major challenge facing any evidence-based assessment of natural capital risks is the general paucity of evidence that explicitly links impact or dependency pathways to the financial performance of forestry enterprises. To rectify this, our evidence collation was conducted in stages. We initially searched in both peer-reviewed and grey literature for each potentially material dependency or impact. Initial keyword searches (searched via Web of Science and Google Scholar for peer-reviewed and via Google for grey literature) were then supplemented by ‘snowballing’ from the reference lists of identified papers and reports. The outcomes of the initial evidence search were then reviewed through detailed discussions with approximately 15 forestry industry experts and representatives from forestry enterprises. This process allowed us to validate the initial evidence, identify any gaps and identify additional evidence which was subsequently reviewed and incorporated into the analysis. The evidence gathered was either focused specifically on Australian forestry or had broader applicability, including for Australian forestry.
Our assessment of financial materiality followed a standardized approach based on the totality of the evidence reviewed. For both impact and dependency pathways, the link between natural capital and financial risks for enterprises can be broken down into just two components, which are then combined. For dependency risks, we assessed (1) the degree of dependency of a forestry enterprise on the relevant stock of natural capital or flow of ecosystem services and (2) the severity of threats (both the current threats and any future changes, for example from climate change) to the same. For impact risks, we assessed (1) the degree of impact of forestry operations on the relevant stock of natural capital or flow of ecosystem services and (2) the severity of consequences of the impact (both the current and potential future changes to the financial viability of the forestry enterprise).
The degree of dependency was assessed by considering to what extent the enterprise could continue to be financially viable without the relevant ecosystem services (high/medium/low: disruption of the ecosystem services could result in severe/moderate/limited financial loss). This is broadly comparable to, but simpler than, the approach used by the NCFA for portfolio risk assessment [6•]. The severity of threat was assessed by considering the probability and magnitude of current threats and plausible changes for the future availability of the relevant ecosystem services. Again, this is broadly comparable to, but simpler than, the NCFA approach which involves combining separate assessments of the importance of natural capital assets to ecosystem services, and the influence of drivers of environmental change on natural capital [6•]. However, the NCFA approach does not consider probability. Factors such as the sensitivity of the natural capital asset to changes and the reversibility of such changes [6•] were taken into account in considering the magnitude of the threat. These elements have been combined as shown in Fig. 2, based on a simple rule whereby a high (low) severity rating increases (decreases) the degree of impact/dependency rating, while a moderate severity rating leaves the degree of impact/dependency rating unchanged.
Method used to combine the degree of impact/dependency and the severity of consequences/threats to determine financial materiality
The degree of impact was assessed by considering to what extent the relevant stock of natural capital or flow of ecosystem services could continue to function after a plausible impact. A high/moderate/low degree of impact would indicate the natural capital or ecosystem service is likely to be severely/moderately/minimally damaged. The severity of consequences was assessed based on how significantly the enterprise could be affected by societal responses (such as regulation or social concern) to any changes in natural capital or ecosystem services, and also by any ecosystem response which affects natural capital and ecosystem services that the business relies on, using the same financial loss criteria as used to assess degree of dependency.
Risk mitigation options for both impact and dependency risks were taken into account only if they were standard industry practices, in which case they were assumed to moderate the underlying risk according to typical outcomes from those practices. The rationale for this is that only standard industry practices can be assumed to be widely practiced and therefore applicable at the scale of this assessment.
We assessed the financial materiality associated with each pathway separately for softwood plantations, hardwood plantations and native forests, due to the different management systems used.
Finally, we evaluated the level of confidence (quantity, quality and consensus) in the evidence, following the four-box model adopted from IPBES [20] (Fig. 3). The four terms used to summarize the level of confidence are: well established, which represents robust evidence with high levels of agreement; unresolved, which represents robust evidence but with low agreement or contrasting conclusions; established but incomplete, which represents limited evidence, with high levels of agreement; and inconclusive, which represents limited or no evidence and little agreement. This qualitative assessment of the level of confidence in the evidence provides additional information to help users prioritize which risks are most important to assess, and where further research could be of most value (e.g. topics where the risks are highly material but the level of confidence in the evidence is low).
Level of confidence based on the four-box model in IPBES [20]. The level of confidence increases towards the top-right corner as shown by the increased strength of the shading
Results
Through the literature and expert review, we identified ten dependency and ten impact pathways associated with potentially financially material risks for Australian forestry. The review identified dependency pathways where natural capital provides services that contribute positively to forestry production processes (for example, water availability, suitable growing temperature or soil quality); in addition to dependency pathways where the service is the absence of negative effects (for example, bushfire, pests and diseases or weeds). The review also identified impact pathways from forestry activities that lead to changes in natural capital and ecosystem services, most of which are relevant due to societal responses to these impacts, such as regulation (for example, downstream water quality and quantity, or biodiversity) but some of which can directly affect the forestry business (for example, through on-site changes in soil quality). The risk definitions along with their associated dependency or impact pathways are summarized in Tables 1 and 2. The final column of each table shows the links to other risk topics, recognizing that there are often many interlinkages between causal pathways in complex systems (for further detail on the interlinkages between natural capital risk topics see: [21]).
The evidence used to assess the financial materiality of each dependency and impact risk is summarized in Tables 3 and 4. In accordance with our framework for financial materiality assessment, each table separates the evidence into that which addresses the degree of dependency/impact a typical forestry enterprise has on natural capital or ecosystem services, and that which addresses the severity of threats/consequences currently and in the future (as per the method shown in Fig. 2). Separate financial materiality assessments were developed for softwood plantations, hardwood plantations and native forest and are represented in the tables with the coloured icons.
Discussion
At a global level, forestry is known to have highly significant impacts and dependencies on natural capital, which can create direct risks for forestry enterprises and indirect risks for their investors, as well as for society more generally. There is a need for improved understanding of natural capital risks to enable better decision-making by forestry enterprises, as well as their lenders and investors, regulators and other stakeholders. Assessing natural capital risks offers a range of benefits to enterprises, from improved risk management to the ability to access new financial opportunities [4], but one of the biggest opportunities is the ability to communicate risk information in a consistent and comparable way to stakeholders. Reporting nature-related risks is not yet mandatory in most jurisdictions, but there are growing expectations that this will become mainstream practice in future [223], following the recommendations of the TCFD to encourage the disclosure of climate-related risks [16] and the recent establishment of an international Taskforce on Nature-Related Risk Disclosure (TFND) [224].
A first step towards detailed understanding of natural capital risks at individual estate level is to conduct a materiality assessment at a broader scale, in order to identify key risk areas of likely relevance, as the potential scope of natural capital dependencies and impacts for any industry is vast, with hundreds of different ecosystem services being identified in international classifications [225]. The financial materiality assessment presented here narrows down the potential scope to twenty key risk areas of relevance to Australian forestry, of which only seven to nine have been assessed as highly material for each industry sub-sector. This means that forestry enterprises, investors and other stakeholders can focus their available resources on more cost-effective assessment and management of a small set of highly material risks, which can be gradually expanded over time, if necessary and practicable, to include lower materiality risks.
The most financially material risks for Australian forestry were associated with water availability, temperature, bushfire, storms and floods, soil quality and pests and diseases (for all sub-sectors), and biodiversity (for native forests). All of these highly material risks arise from natural capital dependencies, apart from biodiversity, which was an impact risk for native forests only, and bushfire and soil quality, which were highly material in terms of both impact and dependency risks (noting that bushfire impact is only assessed as highly material for native forests) (Tables 3 and 4, with overall materiality scores illustrated in Fig. 4). For nearly all of these, there was high confidence in the assessments based on well-established principles and processes described in the literature, for both the degree of the dependency/impact and the severity of threats/consequences (with the exception of the severity of the threat for storms and floods, soil quality and pests and diseases and the severity of consequences for bushfire impact, which were all assessed as unresolved and thus are suitable targets for further research). Overall, there was relatively high confidence in the evidence for degree of dependency/impact (80%/90% well established) and lower confidence in the evidence for severity of threat/consequences (30%/50% well established). The lower confidence for the severity of threats relates to the uncertainty about the future threats from climate change and for the severity of the consequences relates to there being limited evidence to link to specific financial consequences for forestry enterprises.
Financial materiality assessment scores for dependency and impact risks for Australian forestry – softwood plantations (a), hardwood plantations (b) and native forestry (c). The size of the bars (and corresponding colour) represents the materiality score associated with each risk category, such that low materiality is represented with a short bar (close to the centre) and high materiality is represented by a long bar (which extends to the edge of the figure)
There is a reasonably high level of overall consistency in the materiality scores between the different sub-sectors in Australian forestry. However, there are a few important differences (Fig. 4). The main differences can be observed by comparing native forestry with plantations. For example, biodiversity is assessed as a more material impact risk from native forestry (high) compared to plantations (moderate) due to the potentially significant impact of clearfelling harvesting regimes in native forestry and the considerable community concern regarding impacts on threatened species. While plantations can also affect biodiversity, many plantation forests are now established on ex-agricultural or existing plantation land in Australia, and so the industry-level materiality of the risk is lower. Bushfire impacts are also assessed as a more material risk for native forestry (high) compared to plantations (moderate) due to prescribed burning being more common for native eucalyptus forests, and the use of fire for preparing seed beds in native forestry. Similarly, other air emissions are assessed as more material for native forests (moderate) due to the greater use of prescribed burning. Finally, water use is assessed as a lower risk for native forestry (low) compared to plantations (moderate) due to native forestry generally being a seen as a continuation of existing land use, and so not substantially altering the available water for users downstream.
Softwood and hardwood plantations have broadly similar risks. Greenhouse gas emissions are assessed as a higher materiality risk for hardwood plantations (moderate) due to the higher proportion of wood that goes towards short-lived fibre products. Fertilizer as a dependency risk is also assessed as higher risk for hardwood plantations (moderate) due to the greater use and reliance on fertilizer.
The limitations of this assessment include the fact that the results presented here apply only to the whole of industry level in Australia, at the current time. Location-specific assessments may differ by geographic location both within Australia and globally. At the forestry estate level, it could also be the case that assessments may differ within the individual estate due to the large geographical extent of many forest estates. The methodology used here seeks to assess each topic separately, however, we acknowledge that risks rarely occur in isolation and understanding the interactions and interlinkages will be important in further detailed analyses. It is also important to note that the financial materiality assessment presented here does not take into account the application of risk mitigation actions beyond standard industry practices (for example, those stipulated in industry codes of practice). Options for further mitigation are identified in [21], and can potentially be used to modify the materiality assessments at enterprise scale. As such the results presented here relate to natural capital risks that are potentially financially material for forestry enterprises and should not be interpreted as estimates of the actual risk.
Conclusions
Two key lessons emerge from our review: first, the most financially material risks for Australian forestry are largely associated with natural capital dependencies; and second, nearly all of the most material risks are likely to be exacerbated by climate change. In Australia, the management of forestry natural capital impacts is already highly regulated, with mitigation strategies in place. Dependency risks, on the other hand, are less well recognized, and more difficult to manage than impact risks. Greater awareness of these dependency risks is a first step towards taking more targeted action to mitigate and manage these risks. Climate change is identified as an underlying driver of environmental change affecting the most material dependencies, such as water availability, temperature, bushfires, storms and floods, soil quality and pests and diseases. Understanding how dependency risks will change in the future under a changing climate and how to mitigate those risks is a key challenge for the forestry industry.
Our framework and industry-level financial materiality assessment provides a guide to future assessments for individual forest estates. The use of frameworks and guidelines like this can (a) increase the comparability and credibility of assessments, (b) provide a systematic way for enterprises to identify what it is important to report against, and to manage in their operations, and (c) put the industry in a better position to disclose natural capital risks to markets and potential investors. Further research that builds on this paper will be required to enable individual businesses to undertake natural capital risk assessments. A key next step is to identify suitable data and indicators to address the most material risks. Those indicators and data sources should adequately represent each risk and need to be feasible and cost-effective to measure and collate. Ideally, they should be harmonized across the industry and meet the needs of all relevant stakeholders. Further research to identify data sources and indicators would help reduce transaction costs for businesses and promote trust in the reliability, consistency and comparability of reported information.
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Acknowledgements
The authors thank Tim Wardlaw for valuable insights and discussions during this work.
Funding
All authors received funding from the National Institute for Forestry Product Innovation (NIFPI) (Launceston) under the grant NT011, NIFPI is supported by the Australian and Tasmanian State Governments. This research was also co-funded by CSIRO, Forest Practices Authority (FPA), Forico, National Australia Bank (NAB), Reliance Forest Fibre, Sustainable Timber Tasmania, PFT - Tree Alliance.
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Smith, G.S., Ascui, F., O’Grady, A.P. et al. Materiality Assessment of Natural Capital Risks in Australian Forestry. Curr Forestry Rep 7, 282–304 (2021). https://doi.org/10.1007/s40725-021-00147-6
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DOI: https://doi.org/10.1007/s40725-021-00147-6