The missing piece to the puzzle: financial institutions and the deforestation challenge

17 July 2018

by Christina Elvers and Lara Jackson

Britain, alongside large parts of Europe and indeed the world, are currently experiencing record summer temperatures. And building on the summer trend over the last three years, 2018 seems well on track to be one of the hottest years on record. There is general consensus that climate change is the number one contributor to this warming, and that urgent action needs to be taken to halt it.

Tropical forests have a crucial role to play in tackling climate change, potentially contributing up to one third of the greenhouse gas (GHG) savings needed. However, global tree cover loss reached a record high in 2016, with the loss totalling an area about the size of New Zealand. This only marginally improved in 2017.

Commercial agriculture is responsible for nearly 70% of that tropical deforestation, most of which results from the production of four soft ‘forest risk’ commodities: cattle products (beef and leather) palm oil, soy, and timber products (including paper).

In a recent report for the Tropical Forest Alliance 2020, which we developed together with the Global Canopy Programme, we argue that the role of financial institutions as financiers of agricultural companies needs greater attention - not only because financial institutions are important in the fight to keep tropical forests standing, but crucially because it makes business sense.

When making investment or lending decisions, financial institutions look at the potential risks and opportunities that might materialise. Our report highlights that financial institutions are exposed to a number of risks associated with deforestation - more so, we argue, than is commonly accounted for.

To date few financial institutions have gone beyond looking at the reputational risks associated with deforestation, not taking into account risks more fundamental to their business such as the risk of ‘stranded assets’. Put simply, stranded assets are assets (in this case: land) which a company expects it can use for commercial purposes (in this case: to plant and harvest soft commodities for profit), but which in fact won’t be commercially viable due to changes in regulation, market demand, or changes in physical conditions.

While the risks of stranded assets are widely understood in the context of the energy sector, we argue that with the Paris Agreement and countries’ accompanying Nationally Determined Contributions (NDCs), regulation is expected to restrict the access and ability to convert land. This could drastically impact the valuation of some companies and would directly affect these companies’ financiers.

Financial institutions need to better understand and quantify these risks potentially hiding in their loan books and investments and the business case behind taking action. We recommend that financial institutions conduct scenario analyses to understand the potential effect of macroeconomic changes over the next 5-10 years. This analysis should include how the Paris Agreement and the corresponding country NDCs and increasing public and investor pressure concerning environmental and social risks will influence changes in regulation, international and regional banking market centres and forest nations.

Our report also shows that while there are unexplored risks related to deforestation, there are also great opportunities in the space. A few pioneers are now exploring the range of opportunities in taking a ‘green’ outlook to their lending and investments. These opportunities include the use of sustainability performance linked loans, supporting landscape approaches with green finance and the issuance of green bonds.  With a renewed interest in Natural Climate Solutions (including stopping deforestation and restoring forest areas), opportunities could even exist for recommercialising assets previously threatened with stranding.  

Bold ambitions on climate change require bold action from all stakeholders linked to soft commodities. Those institutions who can capitalise on both the opportunities as well as mitigating the risks are likely to be the ultimate winners.

Ends

If you are interested in this topic and want to discuss it further, contact:

Christina Elvers

Sustainability and Climate Change

Mobile: +44 7701 295 958   Email: [email protected]