Deforestation

An investment case

Deforestation is a hot topic among society, but also attracts more and more attention in the financial sector. Investors have a fiduciary duty towards the interests of their clients. Ensuring present and future availability of natural resources, is an essential part of this duty. Preventing deforestation, which is one of the causes of biodiversity loss and global warming, is an essential element of such a future-proof investment strategy.

GROWING DEMAND AND REGULATION

Increasing scrutiny by NGOs, consumers and even governments have been pressuring for stronger commitments from the financial sector towards a deforestation-free economic system. The French government, for instance, has committed to end deforestation caused by the import of unsustainable products by 2030 [1]. More recently, in 2019, an EU Communication has shown a furthering of the Union’s focus on protection and restoration of the world’s forests, with a look at the supply chain of soft commodities [2]. An assessment of possible regulatory measures to reduce EU consumption linked to deforestation is among the future developments by the Union. In the same direction, the Dutch government is currently working on a forest strategy, for which they also look at possibilities to include the financial sector. These movements suggest a regulatory uptake and increasing pressure over businesses and investors to address deforestation in their supply chain and portfolios, respectively.

Recent fires in the Amazon and Indonesia, important biodiversity and agricultural hotspots, captured the attention of the world and shed light on the significant challenge of halting deforestation in the supply chain of soft commodities.

Perceived short-term benefits of clearing forests arise from, among others, increasing food demand and profitability of the agricultural market. Deforestation opens the way for the production of soft commodities as soy, beef and palm oil, essential products in the food supply chain. In the Amazon, more than 15% of forest was lost in the last 50 years, due mostly to forest clearing for the purpose of cattle ranching [3]. However, the long-term and possibly irreversible damages from deforestation become clearer for countries, companies and investors worldwide. Deforestation is responsible for significant part of the GHG emissions and, consequently, to climate change.

But also on the medium term, the benefits may be significantly lower than perceived. On the one hand, companies that contribute to deforestation directly or through their sourcing practices are under increasing jeopardy. And a regulatory uptake by the EU may put whole economies and supply chains at risk.

On the other hand, productivity and consequently the value of companies are also at risk due to deforestation. Land conversion can impact agricultural production itself, by altering rain patterns and soil humidity, on which soft commodities production directly depend on.

Effects are already seen, for instance, as scientists cite diminishing productivity of crops such as soy, maize and coffee in Brazil already in 2013[4]. For countries’ economies, the risks are also significant, as shown by the 2015 fires in Indonesia, with an estimated cost of US$16 billion in economic loss for the country. [5]

Investors are faced with the challenging question of how deforestation is a risk and then how to deal with it.

Summary of Main Pressure of Forests in Different Deforestation Fronts

Source: Mongabay News. Deforestation Fronts Revealed

[1] Gouvernement (2018). Ending deforestation caused by importing unsustainable products.

[2] European Commission (23-07-2019). Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions – Stepping up EU action to Protect and Restore the World’s Forests.

[3] WWF (n.d.). Deforestation and Forest Degradation

[4] https://www.theguardian.com/environment/2013/sep/03/brazil-food-crops-climate-change

[5] World Bank (2015). Indonesia’s Fire and Haze Crisis

FROM REPUTATIONAL TO FINANCIAL DAMAGE

Companies face operational and reputational risks connected to deforestation practices, which can lead to loss of market access, legal risks and ultimately loss of value for investors.

Cases where deforestation practices have led to value drops for companies have happened in the past, as shown by the case studies developed by Ceres and Climate Advisers [6]. IOI Corporation Berhad, a palm oil producer company, was accused of illegally deforesting 11,750 hectares of forest and peatland in Indonesia, for which they did not possess the required environmental permits. This has led to their suspension from the RSPO (Roundtable on Sustainable Palm Oil) in April 2016.

The case has led 27 of its largest buyers (including Nestle, Cargill and Unilever) to cease relations with the company. Consequently, IOI reported a drop of net income in Q2 2016 to negative US$14.8 million, compared to a positive US$30 million in the same quarter of the previous year. Along with it, a drop of share price and decreased debt ratings by Moody’s affected investments in the company. IOI later presented plans to improve its sustainability issues and suspension was lifted by RSPO after six months, leading to a 5% increase of share price and the resuming of relations with some of the clients. Yet, other buyers did not promptly reconnect with IOI, as Unilever, which only resumed sourcing from the supplier by August 2017, upon considering IOI’s efforts sufficiently effective [7].

IOI Share price and volume (2016

Source: ETC Climate Advisors Case Study Series (2017)

RISKS THROUGH THE SUPPLY CHAIN

While the risks for investors get clearer, identifying their magnitude among investees remains challenging.

Supply chains can be highly complex and risks deriving from deforestation are not contained to producers who directly cause deforestation. Often times asset managers do not invest directly on non-listed, smallholder producers, but on large, multinational traders and FMCG companies whose supply chains may include the former. At the same time, such buyers often do not have satisfactory oversight of the activities of suppliers and/or transparency about the involved risks.

In 2018, several trading companies were fined due to sourcing soy from illegally deforested areas in the Cerrado biome in Brazil. Even though some of the companies have non-deforestation commitments and have considerably advanced the scope of its policy, the fines demonstrate perduring controversies and cases of deforestation in the soy supply chain [8].

Bunge, for example, was among the companies fined. Despite its zero-deforestation commitment across its supply chain, to be achieved by 2025, Bunge still sources from players such as SLC Agricola and BrasilAgro. These companies legally deforested more than 19 thousand hectares of native vegetation in Piauí, one specific state part of the Cerrado biome [9].

According to research, Bunge risks a value loss of 22 percent of its market capitalization if it continues sourcing from that Cerrado area [10]. This finding has considered the estimated revenue of Bunge coming from 23 buyers which have signed the Cerrado Manifesto [11]. The reputational damage and risks associated with it are significant. Even if some of these consumers do not buy soybeans from Bunge produced at that Cerrado area, their strong commitments towards deforestation may lead to a cease of relations with Bunge. But the research also shows the possible risk of losing financing partners. Bondholders and banks with higher lending standards in terms of sustainability can resort to engagement or ultimately divesting from companies like Bunge, which remain connected to deforestation despite their commitments.

[6] Ceres, Climate Advisers (2017). Case Study Series: Business Risks from Deforestation.

[7] Unilever (2017). Unilever responds to the RSPO decision to lift suspension of the IOI Group

[8] Chain Reaction Research (24-5-2018): Bunge, Cargill, Others Fined for Brazilian Deforestation in Cerrado; Investors Push Bunge to Ban Deforestation-Linked Suppliers

[9] Chain Reaction Research (2017). Bunge: Key Position in Cerrado State Puts Zero-Deforestation Commitment at Risk

[10] Ibid

[11] FAIRR (n.d.). Cerrado Manifesto – Statement of Support.

SUSTAINABILITY AND PROFITABILITY

While the challenges are many, opportunities are also clear. Risks from deforestation can be addressed both by companies and investors, who are poised to benefit from sustainable production and growing market demands.

Progress in regards to mitigation of deforestation risks across the supply chains is shown, for instance, by Unilever. The multinational has successfully pushed Brazilian suppliers in the cattle sector towards commitments with zero deforestation, disclosure through the CDP program and the development of origin maps for all the beef feedstock [12].

But a focus on deforestation-free supply chain is not only a risk-mitigation strategy but an opportunity to be seized by companies and investors on a long-term economy. Deforestation-free methods are based, among others, on improving productivity per hectare, which reduce input costs and increase profitability. Furthermore, a market price premium for deforestation-free products, even if small, can drive profitability up for players involved in sustainable production [13].

The company Natura, a cosmetics manufacturer, is an example of business model centred on sustainability. It takes advantage of the rich biodiversity of the Amazon as primary area of raw material sourcing for its products, while highly focused on promoting biodiversity of the biome. Its approach to deforestation halting includes involving and demonstrating to local communities that the forest can provide much more profit when preserved than when destroyed, providing also annual payment to smallholders for their environmental conservation services [14].

Investors are also stepping up their commitments with the halting of deforestation Increasing number of investors support initiatives to demand corporate disclosure, such as the CDP Forests programme, counting with 525 investors responsible for US$96 trillion in assets [15].

Other initiatives also focus on engaging companies towards establishing time-bound targets and mitigation strategies connected to land and biodiversity. ACTIAM contributes with several of these:

  • The Global investor engagement on meat sourcing, by FAIRR and Ceres
  • The Initiative for Sustainable Forests by Ceres and UNPRI
  • The Sustainable Palm Oil working group

CONCLUSION

Further attention from investors to deforestation-related risks and opportunities are, therefore, long overdue. In line with the fiduciary duty of preserving clients’ interests, and through their investment strategies, investors must safeguard both the future availability of natural resources and the sustainability of their returns. With the expected regulatory movement, as the EU, French and Dutch initiatives show, investors must be in line with deforestation commitments, in order to guarantee their returns are safe from value drops related to deforestation cases.

Such investment strategy is not without challenges. Complex supply chains, lack of oversight and/or transparency from investees make for a difficult path towards deforestation-free portfolios. Nevertheless, increasing number of initiatives aim to achieve further transparency and agreement around biodiversity-related targets and implementation. Seizing such opportunity can result not only in risk-mitigation, but in higher, more sustainable returns for companies and investors.

[12] CDP (2017). From risk to revenu: The investment opportunity in addressing corporate deforestation.

[13] Tropical Forest Aliance (2016). The Role of the Financial Sector in Deforestation-free Supply Chains.

[14] UNFCCC (n.d.). Natura’s Carbon Neutral Programme.

[15] CDP (n.d.) Forests


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