Investors’ Forest Fight Heads North

Policy engagement on deforestation to widen focus to demand side.

The protection of existing forests and the eventual replacement of those that have been lost is generally seen as a matter for public policy, sometimes in partnership with NGOs. Indeed, in early December, the European Union agreed a new law to shut out of the single market products that could not verify that they were “deforestation free”.

To date, investors have engaged more with corporates than governments on the issue, encouraging them to report on their deforestation risks and exercise greater due diligence over their commodity supply chains.

But policy engagement by investors has grown on all fronts in recent years, with heightened concerns about the systemic risks posed by climate change and biodiversity loss ensuring that deforestation is part of this shift. A key forum is the Investor Policy Dialogue on Deforestation (IPDD), which recently published its latest progress report and has made its presence felt at the COP15 summit being held in Montreal.

Graham Stock, Co-Chair of IPDD and a Partner at RBC BlueBay Asset Management, is quite clear on the key objective. “It is to take deforestation out of supply chains,” he says, emphasising the centrality of the natural world to the economy.

“More than half of global GDP depends on nature,” he says. “Forests are absolutely critical from an economic point of view.”

Rampant over-exploitation

The IPDD notes that investors are concerned about the financial impact that deforestation and the violation of the rights of indigenous peoples and local communities may have on their clients and investee companies, by potentially increasing reputational, operational and regulatory risks.

It also raises investor fears that companies exposed to potential deforestation in their direct operations and supply chains in these countries will face increasing difficulty accessing international markets.

Perhaps of most importance to the governments concerned is that the sovereign bonds of these countries are also likely to be deemed high risk if deforestation continues.

Not the least of the forests’ importance is their role in taking carbon out of the atmosphere. Jan Erok Saugestad, CEO of Storebrand Asset Management and IPDD Co-Chair, notes that: “From the tropical forests of South America to the boreal forests of Russia, the trees, plants and soil that make up our biosphere absorb and store vast quantities of carbon.” Forests worldwide currently sequester a net 7.6 billion tonnes of carbon dioxide each year –1.5 times more than is emitted by the US.

But there is a darker side to this story. Rampant over-exploitation and raging fires in recent years have vividly illustrated the perilous condition of the world’s forests; the Amazon, largest of the rainforests, has switched from being a net absorber of carbon to being a net source; and tropical deforestation accounts for more carbon emissions than the whole of the EU.

Hopes for change in Brazil

The threats to rainforests have been increasingly well-documented over the past decade as over-use for mining, food production and other commercial purposes has intensified.

In July, National Geographic magazine reported: “Today, the greatest amount of de-forestation is occurring in tropical rainforests, aided by extensive road construction into regions that were once almost inaccessible. Building or upgrading roads into forests makes them more accessible for exploitation.”

It added that “slash and burn” agriculture is a major contributor to de-forestation in the tropics. Farmers burn large tracts of forestry, allowing the ash to fertilise the soil thus helping crops to grow.

But this method makes the soil fertile for just a few years, after which the farmers move on and repeat the process with fresh forestry.

The IPDD focuses on engagement with governments rather than with individual companies, and its first two work streams covered two of the most heavily forested countries in the world – Indonesia and Brazil. To date, progress in the former has been more positive than in the latter, although the election loss by incumbent right-wing president Jair Bolsonaro to his leftist predecessor Lula da Silva in October is expected to herald greater emphasis in Brasilia on the problems of de-forestation.

Laura Bosch Ferrete, Sustainable Investing Specialist at Robeco, said: “Indonesia works constructively with and supports relevant government authorities and other stakeholders. It engages with government departments, foreign embassies and civil society organisations.”

“Systemic risk to prosperity”

Investors’ relationships with the authorities in Jakarta have been fruitful, she said, but that there was still room for improvement. “De-forestation is a material risk for both equity and sovereign bond exposure,” said Bosch Ferrete.

“The bottom line is that there is a strong interest among investors to get a better understanding of where the risks lie.”

A key driver of deforestation in Brazil remains the expansion of the amount of land turned over to agriculture. According to Stock, the IPDD “has been closely monitoring legislative changes with potential regulatory impact on forestry protection”.

He cited three areas of concern. The first is a system of environmental licensing which IPDD fears could loosen forestry safeguards. The second concerns land registration procedures that, it is said, could prompt a scramble for territory and the third involves moves to increase mining in indigenous areas.

He said: “The deforestation rate has been falling in Indonesia and rising in Brazil. It is very disappointing and very frustrating.

“Deforestation poses a systemic risk to Brazil’s future prosperity. More needs to be done.”

Targeting big importers

Regarding the impact of deforestation on Brazil’s standing with investors, IPDD said: “Evidence of escalating rates of deforestation in recent years are creating widespread uncertainty about the conditions for investing in or providing financial services to Brazil.

“Investors want to continue to invest in Brazil and contribute to its economic development and protection of the environment.”

Storebrand’s Saugestad admits that the country’s recent direction of travel marks a failure with global consequences. “Deforestation is an issue at the heart of climate. There is much we can be proud of. Deforestation rates in India have dropped further.

“But we are aware that progress on the ground in Brazil is unacceptably slow.”

A new, third IPDD workstream will concentrate on the demand side of the equation, on those countries that provide ready markets for the products of de-forestation, not simply timber but beef, palm oil, rubber and other commodities. “A lot of importers continue to demand these,” said Reina Berlien, Head of ESG at Brandywine Global. “The largest importers are the US, EU and UK.”

“We need to be focused”

It is with these three markets that the third workstream will begin. The new EU law gets the work off to a good start and, according to Stock, similar legislation is planned at in the UK. Matters are a little more complex in the US, he says, with nothing of the sort currently planned at the federal level, although some individual states have acted.

IPDD keeps its central focus on the impact of deforestation on investment. The financial risks to investors, it says, include negative return on investment, non-performing loans and loss of capital, such as could occur as a result of assets being stranded.

Regulatory risk includes the inability to meet ESG criteria in due diligence and risk weighting, while companies could face litigation as a result of failing to integrate ESG considerations, thus breaching fiduciary duties.

On the reputational side, there is the risk to brand value and loss of credibility as a responsible investor.

The World Bank calculates that the percentage of the world’s surface covered by forestry fell from 31.6% in 1990 to 30.7% by 2016. If that doesn’t sound much, the bank adds that about 13 million hectares are lost each year.

This is a gross figure that is partly offset by re-forestation, but the net annual loss is still 5.6 million hectares, “an area bigger than Costa Rica”.

The bank paints a brighter picture about future possibilities: “Some two billion hectares of lost or degraded forests and landscapes could be restored and rehabilitated to functional and productive ecosystems.

“This would help generate economic opportunities in rural areas, deliver improved rural livelihoods and food security, strengthen climate resilience and mitigate greenhouse gas emissions while taking pressure off pristine forests.”

IPDD passed its second anniversary in July. Reflecting on the record to date, Bosch Ferrete said: “It has been a great journey,” while Berlien remarked: “It takes time and a lot of work to make progress.”

Saugestad said: “In order to make progress we need to be focused and we have been focused.”

Stock’s verdict? “It’s been hugely rewarding but there’s a lot more to do, of course.”

The development of the third workstream reflects the need of investors to further develop and broaden their engagement activities to an ever-wider range of governments.

“It is important that we do not come across as interfering foreigners. This is not about the North telling the South what to do,” said Stock.

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