Stéphanie Mielnik, Research Director at Anthropocene Fixed Income Institute, examines the impact of the EU Deforestation Law on soy producers and their bondholders.
In what has proved to be a world first, the EU has adopted regulation aimed at dramatically reducing the economic bloc’s exposure to the deforestation that lies behind many of its supply chains for popular products such as soy, palm oil, beef and timber.
The regulation, adopted in April, requires companies selling products to the EU to prove that they do not contribute to legal or illegal deforestation on a global scale. The regulator may impose severe penalties for non-compliance, including:
- a fine of at least 4% of the company’s turnover in the EU;
- confiscation of revenues and products;
- exclusion from public procurement and access to public funding for up to 12 months; or
- a temporary prohibition from placing commodities on the EU market.
Of the commodities contributing to Europe’s deforestation footprint, it’s estimated that soy is responsible for almost a third. In countries like France and Denmark, it’s the leading cause of forest loss linked to imported goods.
With soy featuring so highly on Europe’s menu, the Anthropocene Fixed Income Institute took a closer look at the impact on the major companies involved and the investors in their bonds. Our research finds that soy traders are likely to incur costs and face deterioration of their credit quality, and that these costs and penalties for failing to meet the rigours of the regulation are not reflected in credit spreads.
Many of the largest bond issuers, with considerable ecosystem footprints, have public bonds and are regularly in the market. Bondholders exposed to leading soy traders therefore need to evaluate the risk and consider whether the market is pricing in such concerns. Some issuers may soon be refinancing because a large portion of their bonds mature over the next three years, giving investors the chance to engage on the issue of deforestation and how that could affect their trading positions.
The key financial risks for investors fall into three categories: the role of soy in the company’s revenue structure, the degree of exposure to ‘ecosystem conversion’ (that is, changing land use for growing soy) and the effectiveness of the company’s mitigation strategy. When comparing companies’ risks, it’s important to note that even if two companies share similar absolute levels of ecosystem conversion exposure, their risk levels may differ significantly based on the size and diversification of their operations.
To evaluate the financial risk stemming from land conversion, understanding companies’ footprints in proportion to their operations is crucial. We draw a parallel here with carbon intensity, a standardised metric used to assess companies’ climate risk relative to their size. To assess the effectiveness of a company’s mitigation strategy, we rely on the Forest 500 soy score, which ranks corporates’ reporting and implementation strategies towards deforestation.
The result of our analysis is that, out of a sample of 24 companies, American agribusiness Bunge and Latin America’s Amaggi stand out for having the greatest conversion risk compared to their revenues, making these companies more susceptible to the financial repercussions of non-compliance with EU regulatory requirements.
Food producer Cargill and animal feed supplier Archer-Daniels-Midland carry the second and third-highest conversion exposure respectively, while Asian companies like Marubeni, Mitsui & Co and Mitsubishi rank bottom among soy traders in terms of exposure in their revenue streams.
Digging a little deeper, it’s worth taking note that amongst large bond issuers with high credit ratings, Bunge – with US$2.9 billion bonds outstanding – appears the most exposed to a potential spread repricing. It is interesting to reflect on whether the company’s impact on nature is being sufficiently reflected in its credit spreads.
What is more, there is talk that the EU will extend the regulation to “other wooded land”, such as Brazil’s Cerrado, which has been so negatively impacted by conversion to agricultural use. Any extension of the regulation would of course impose additional tracking and reporting constraints on soy traders. It would therefore be prudent for bond investors to consider the full scope of ecosystems when carrying out a risk assessment of a bond issuer.
Financial institutions have not yet proactively addressed deforestation and ecosystem conversion in their investment policies. If they start reading the smoke signals and adopt more stringent policies, borrowing costs could become substantially higher for agricultural companies that poorly manage their supply chains.
Fire is looming on the horizon for soy-reliant businesses. The EU deforestation regulation requires the agricultural industry to act, and we suggest to investors that its response – or lack thereof -should be reflected in the prices of these assets.