Nature stress test: Assessing exposure of five African banking systems

Africa is both heavily dependent on nature and experiencing rapid nature loss. Some 62 percent of African GDP is moderately or highly dependent on the services that nature provides and 70 percent of communities in sub-Saharan Africa depend on forests and woodlands for their livelihoods. In parallel, momentum is building in the African financial sector in response.

This new joint report by McKinsey Sustainability and FSD Africa consolidates the findings of a nature stress test on the banking systems in five African countries: Ghana, Mauritius, Morocco, Rwanda, and Zambia. Nature-related risks and opportunities arise from an organization’s dependencies and impacts on nature. The analysis examines how business profits across these five economies could be impacted—positively or negatively—depending on different nature transition scenarios, and then considers potential knock-on effects for the financial sector. It assesses risks driven by 11 impacts and dependencies, such as deforestation, pollution, and water scarcity, across a selection of sectors expected to be at high nature-related risk. The findings are particularly relevant for financial regulators and private financial institutions in Africa, whose financial systems and portfolios are likely to be exposed to similar levels of risk. The appendix contains a more detailed description of the stress test and methodology.

While the financial impact on businesses and commercial lending is the focus of the report, it is only one of many considerations relevant to decision makers. Against the backdrop of a decline in nature and continued global attempts to move toward a net zero and nature-positive transition, this report seeks to evaluate the financial impact of pursuing an orderly nature transition, in comparison to a disorderly one or not pursuing any transition at all. Understanding the impact of the possible transition scenarios could help relevant stakeholders respond more effectively. Risks that impact business profits, the primary focus of this report, can also have important parallel impacts on issues such as job creation, economic growth, and community empowerment, and private companies will be important funders and financiers of the actions required for an orderly and effective transition.

The nature stress test of the five national banking systems represents a spectrum across Africa of economic structures, natural landscapes, and emerging nature-related risks. The countries whose banking systems were examined were chosen based on interest among national stakeholders and to capture a range of different risk profiles across Africa. Some of the economies rely heavily on agriculture, mineral and commodity exports, services, and tourism, while others have more diversified industrial and manufacturing sectors. Their natural landscapes vary from those with highly biodiverse forest ecosystems to those with arid areas or which are island nations. While the exposure of individual banking systems will vary, the results demonstrate how different factors may increase or reduce risk exposure. These five countries are sufficiently diverse that the insights can be extrapolated to much of the continent.

The stress test presents three key metrics: unweighted profit losses by sector, weighted profit losses for the banking system as a whole, and credit losses. Unweighted profit losses by sector represent the potential change in the net present value of future profits for sectors to which the banking system lends, such as agriculture, mining, and manufacturing. Weighted profit losses for the banking system are an average of the previous metric, which is then weighted by the credit exposure of the national banking system in each country to each of their real economy sectors. Credit losses represent the expected losses to the banking system itself due to changes in the value of its loans to sectors in the real economy. Results for profit impacts in the real economy and expected credit losses for the financial sector are both expressed relative to a baseline scenario in which there are no nature-related risks.

Real economy risks and opportunities

Across all the scenarios considered, financial risks are lowest under an ‘orderly transition’ aligned with the goals of the Global Biodiversity Framework (GBF). Exposure to physical and transition risks is assessed across three scenarios using McKinsey’s NatuRisk toolkit, exploring the ambitions of decision makers and businesses to implement nature-positive policies and practices. The stress test compares a “current policies” scenario with two possible transition scenarios aligned with the goals of the GBF. The first scenario is a “disorderly transition” in which decision makers and consumers take action to reverse nature loss in line with the goals of the GBF, yet businesses do not substantially reduce their negative impacts on nature and, in some cases, pay the regulatory costs associated with these damages. The second scenario is an “orderly transition” in which businesses also take action. Under current policies, businesses in most countries are exposed to moderate levels of profit loss by 2030, weighted by the exposure of the national banking system (Exhibit 1). Under a disorderly transition scenario, risks for businesses increase in most countries relative to current policies. Under an orderly transition scenario, risks for businesses are lower than in both the disorderly transition scenario and the current policy situation in most countries. A closer look follows.

Transition scenarios

The NatuRisk toolkit assessed three transition scenarios.

Current policies

If current policies and business practices continue, nature-related physical risks could be substantial for some sectors. Under a current policies scenario, the analysis shows that risks could be significant and heavily concentrated in particular sectors, such as agriculture, utilities, and manufacturing. For example, at their extreme, physical risks such as declining pollinator populations, soil quality, and water availability could decrease net present value (NPV) profits from 2020 to 2050 in the agricultural sector in Ghana by more than 50 percent. Water shortages in Morocco could cause equivalent losses of 15 percent in food, beverage, and fertilizer manufacturing and of 4 percent in electricity, gas, and utilities.

After weighting by credit exposure, risks for the banking system as a whole are considerably lower, though risks for the broader macroeconomy are still significant. The sectors mentioned above collectively account for a low share of loan book exposure in each banking system (14 to 35 percent). The highest exposure-weighted NPV profit losses from physical risks are in Morocco, at 7.7 percent from 2020 to 2050, relative to a world in which there are no nature-related risks. The banking systems in the other four countries examined experience exposure-weighted losses of between 0.5 and 3.0 percent over the same period. While exposure-weighted risks for the banking system could be low, risks for the broader economy could be substantial given the importance of these sectors for economic growth, job creation, and community empowerment.

Five key risk drivers could account for most real economy profit losses under a current policies scenario involving extreme physical risks:

1. Increasing withdrawals from freshwater sources combined with warming temperatures could result in higher water stress, requiring sectors that depend on water to invest in water saving measures.
2. Increased pollution of freshwater sources could lead to the need for sectors that depend on high-quality water, such as agriculture, food, and beverages, to treat incoming water used in production processes.
3. Soil erosion and increased soil salinity could degrade arable land, leading to a reduction in yield per hectare for farmers.
4. Loss of natural habitats could cause a significant decline in natural pollinator populations, resulting in lower yields per hectare of arable land for crops that depend on pollinators, such as fruit and vegetables.
5. Though not quantified within this stress test, increasing rates of land use change and pollution could degrade the health of natural ecosystems with significant impacts on ecotourism.

Disorderly GBF-aligned transition

With concerted global action to reverse nature loss, most of the nature-related physical risks could be mitigated. As demonstrated in Exhibit 1, physical risks are low across all banking systems under the disorderly transition scenario (as well as the orderly transition scenario). This is because global efforts to meet the goals of the GBF reduce the rate at which natural ecosystems are degrading and improve their ability to provide the ecosystem services that businesses depend on.

However, a disorderly nature-positive transition could create significant transition risks. Under this scenario, profit losses due to nature-related risks in the most-affected sectors could be similar in magnitude to profit losses due to climate-related risks for emissions-intensive sectors. For example, the analysis shows that by 2050, annual unweighted profit losses from nature-related risks in agriculture, mining, and some manufacturing subsectors could reach as high as 50, 32, and 18 percent, respectively. By comparison, in a net-zero climate transition scenario, climate-related risks could generate losses in mining, chemicals, and manufacturing of 25, 15, and 10 percent, respectively (Exhibit 2).

According to the assumptions of the disorderly transition scenario, five key drivers account for most risks to companies that do not adapt:

1. The agriculture sector could experience increases in production costs. Critical action to prevent deforestation and protect highly biodiverse areas, both domestically and internationally, could constrain the land available for agriculture. Producers may then need to quickly adopt new agricultural practices and technologies that use less land but are more expensive.
2. The agriculture and broader food and beverage sectors could experience changes in revenue for certain products. Global diet shifts, reduced food waste, and a shift to sustainable farming practices could substantially reduce demand for products, such as animal proteins and fertilizers.
3. Manufacturers and utilities could experience increases in production costs. Worsening water quality could demonstrate the need for regulations that require heavy-polluting industries to introduce or improve the treatment of their wastewater discharge. This action could tackle pollution and support the health of local ecosystems as well as raise the cost of doing business for these sectors.
4. The mining sector could experience changes in revenue. To maintain the health of protected areas and quality of local water supplies, mining companies could face difficulties in securing contracts to open new mines in sensitive locations. This could result in disruptions to production and lost revenue. It could become increasingly important to work with and ensure benefits for local communities.
5. Downstream sectors could experience increases in production costs. In response to higher production costs, the price of some agricultural commodities could rise, increasing input costs for other sectors, such as manufacturing and retail.

Risks in this scenario are heavily concentrated in seven sectors. The variation in exposure-weighted profits across each banking system can largely be explained by its credit exposure to these seven sectors. Both physical and transition risks in the case of all five countries are concentrated in a handful of sectors: (1) agriculture and forestry; (2) mining and quarrying; (3) food, beverage, and fertilizer manufacturing; (4) consumer goods retail; (5) electricity, gas, and water; (6) construction; and (7) metals and minerals manufacturing. Tourism is also expected to experience high physical risks, but these are not quantified in this stress test. In banking systems, such as Rwanda, where exposure to priority sectors is lowest (21 percent), exposure-weighted NPV profits from 2020 to 2050 decline by only 1.1 percent in the disorderly GBF-aligned scenario. However, in banking systems such as Zambia, where priority sectors make up nearly half of the portfolio exposure, exposure-weighted NPV profit impacts are much greater at –6.7 percent. It is worth noting that a sector can account for a large share of GDP but only a small share of loan exposure. As a result, the macroeconomic consequences of nature-related risks in terms of job and GDP losses could be greater than the exposure-weighted profit results for the banking system. For instance, the mining sector in Zambia accounts for 12 percent of GDP and more than 50 percent of gross exports, but only 6 percent of commercial loans.

In the disorderly GBF-aligned scenario, cumulative expected credit losses could increase by up to 21 percent by 2050 in some banking systems, with much higher impacts for individual sectors. Banking systems with higher exposure-weighted profit impacts generally see higher credit losses (Exhibit 3). However, the typical credit rating of borrowers within a country is also an important factor in determining credit losses: for any given profit change, losses are generally smaller if the borrower has a better credit rating. As for profit impacts, unweighted expected credit losses could be substantially higher within priority sectors relative to exposure-weighted losses for the portfolio as a whole.

Orderly GBF-aligned transition scenario

If businesses take action to reduce their impacts on nature and adjust the prices of their products in response to cost shocks, a significant portion of transition risks could be mitigated—up to 4.1 percentage points of exposure-weighted impacts in some cases. As shown in Exhibit 1, an orderly (or mitigated) GBF-aligned scenario, in which businesses reduce their impacts on nature and mitigate risks, could lead to lower overall profit impacts than under a current policies scenario where extreme physical risks occur.

There are various actions businesses can take to adapt in line with the transition, minimize their exposure to nature-related risk, and leverage nature-related opportunities. For example, in agricultural value chains, sustainable farming practices could be adopted or working with suppliers to reduce upstream deforestation. In mining, it could be ensured that mines are located outside protected areas and away from areas at risk of freshwater contamination. In all sectors, stakeholders may choose to consider amended pricing strategies to absorb some of the cost increase, alongside protecting consumers and recognizing important socioeconomic impacts on food poverty, economic growth, and community empowerment.

Across the five banking systems, these actions could mitigate 27 to 78 percent of exposure-weighted NPV profit losses under the GBF-aligned scenario. Businesses in countries with a higher share of profit losses from mining license risk have a greater ability to mitigate risks by moving production locations. Businesses in countries with a higher share of profit losses from deforestation regulations have a greater ability to mitigate risks by switching to deforestation-free practices or supply chains. Businesses in countries with a high share of profit losses from demand impacts have less ability to mitigate risks.

Coordinated action in an orderly scenario could also bring several benefits that are not quantified here due to data constraints. These include productivity gains from improved natural capital, such as crop yield improvement from higher quality soil, co-benefits for sectors, such as tourism and hospitality, as healthier local ecosystems attract more visitors, and new or more diversified revenue streams.

Credit risks

Nature-related risks could increase exposure-weighted cumulative expected credit losses by up to 9 percent by 2030, and by up to 21 percent by 2050. Profit impacts due to nature-related risks can affect the creditworthiness of a business and, in turn, the level of credit risk it poses to financial institutions that lend to it. Under the disorderly GBF-aligned scenario, where businesses do not adapt in line with the transition, projections suggest that nature-related risks could increase exposure-weighted cumulative expected credit losses by up to 9 percent by 2030, and by up to 21 percent by 2050. Similar to the pattern seen for profits, the change in exposure-weighted loan book value can misrepresent the magnitude of expected credit losses in priority sectors, which could reach as high as 75 percent by 2050. By 2030, in four out of five banking systems unweighted cumulative expected credit losses increase by more than 10 percent in at least one sector. However, business action under the orderly GBF-aligned scenario could lead to a substantial decline in credit risk for most banking systems. The largest reductions in credit risk are seen in Zambia and Ghana, which reduce cumulative losses by 18.5 and 10.2 percentage points, respectively, by 2050. In relative terms, Morocco and Mauritius also see large reductions in cumulative losses, with 2.2 and 1.1 percentage point increases, respectively, in loan book value by 2050.

Macroeconomic risks and opportunities

Beyond changes to credit risk, several additional, important macroeconomic implications could be relevant to central banks’ mandates to control price inflation and maintain financial stability:

• If production costs and prices increase for agricultural commodities, food prices would rise causing inflationary pressure. This would have important parallel socioeconomic impacts, in particular on low-income and vulnerable communities, such as the unemployed, presenting challenges for economic growth and local communities. This would be more of a concern for countries whose agricultural sectors could experience the highest cost increases, and hence potential price increases, such as Ghana and Zambia.
• Financial risks in sectors, such as agriculture, that support a large share of employment could lead to job losses or disruption in income. This could impact economic growth and have knock-on impacts on the ability of these communities to service personal debt. This is particularly the case for countries, such as Ghana, Rwanda, and Zambia, where agriculture accounts for 39 to 59 percent of employment.
• If nature-related risks drive cost increases for exports, these could have knock-on impacts on international competitiveness and foreign exchange risk. Countries that rely heavily on exports of primary commodities, such as Ghana, Rwanda, and Zambia, are more exposed to these risks.
• Specialized lenders with high exposure to sectors heavily exposed to nature-related risks may face acute risks and even solvency concerns. These risks are more of a concern for countries with financial institutions specializing in agriculture, mining, and food and beverages sectors.
• Nature-related risks could lead to large and systemic socioeconomic impacts. For example, food and freshwater shortages may increase the risk of forced migration and subsequent challenges.
• An orderly nature-positive transition could help mitigate physical and transition risks, but also drive a broader range of benefits not quantified here, such as new nature-linked financial instruments, additional revenue streams, and productivity-driven economic growth.

Enabling environment

The right enabling environment could help support action across the commercial financial sector and, in turn, real economy sectors. A clear business case could help commercial financial institutions to assist in creating a nature-positive impact. Such a business case would need to both demonstrate the materiality of nature-related risks to their activities (for example, by using a stress test similar to the one used in this report), as well as a clear understanding of what possible first steps they could take. If they make the decision to help create a nature-positive impact, financial institutions could benefit from having training materials and services available to upskill teams across the organization that may have not had such exposure before, for example, relationship managers and risk practitioners. The development of market infrastructure similar to that which currently exists for climate-related issues could be unlocked by a nature-positive impact. For example, the inclusion of nature in green taxonomies could help channel finance to activities with nature-positive impacts, and the standardization of disclosure requirements could help to develop best practices and minimize the reporting burden on the private sector.

The stress test results demonstrate that nature-related risks could be minimized if businesses adapt in line with the orderly transition scenario which also adheres to the GBF goals. Expected profit and credit losses could be considerably lower if businesses, alongside decision makers and consumers, act together to reverse nature loss in line with the goals of the GBF. In addition, there are a range of possible macroeconomic benefits including improved employment, stronger export receipts, and reduced pressure on household debt. This demonstrates how the alignment of the private sector with the nature-positive transition could generate a range of environmental and economic benefits.

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