Companies and their financiers are exposed to a variety of financial risks when linked to deforestation, ranging from reputational damage to reduced market access. Of the companies that disclosed information on involvement with forest-risk commodities in CDP’s 2018 survey, two-thirds conducted risk assessments of forest-related issues and 92 percent of risk assessments identified substantive business risks stemming from deforestation. Similarly, consumers and governments are increasingly considering deforestation linkages in purchasing decisions, partially driving a slowdown in Indonesian palm oil sales in the European Union. In a recent UK public survey by WWF, 81 percent of respondents called for more transparency around product origin of imports and 73 percent recommended a halt to trade with “countries that fail to protect the natural environment.” Over two-thirds were not satisfied with the UK government’s efforts to tackle deforestation in the Amazon.

Efforts to mitigate deforestation risk in supply chains: Governments

In this vein, the UK recently proposed a law requiring large companies with UK operations to report on the origin of commodities, such as cocoa, soy, rubber, and palm oil. During a consultation period, the government received 63,719 responses with a 99 percent support rate for passing the legislation. Based on this overwhelming public support and recommendations from the Global Resource Initiative taskforce, the government has committed to passing the Environment Bill to combat illegal deforestation in supply chains of UK operations. Similarly, the German government announced its intention to pass a 2021 supply chain act that would hold companies to higher due diligence standards on product origin and mandate that companies remove deforestation and human rights abuses in supply chains. The French government already enacted a National Strategy to Combat Imported Deforestation (SNDI in French) in 2018 with the goal of ending deforestation caused by importing unsustainable forestry and agricultural products by 2030. The plan includes EUR 60 million per year in funding to help exporting countries “offer more sustainable produce, tackle deforestation and implement reforestation projects.” The country has already fallen short of a 2015 commitment to end deforestation linked to imported agricultural products by 2020 and is under pressure to move beyond voluntary commitments.

Efforts to mitigate deforestation risk in supply chains: Companies

Increased government action to prevent deforestation can provide companies with helpful information and resources to mitigate financial risk and standardize rules across an industry. During the UK consultation period for the Environment Bill, 21 retailers and food producers signed a letter pushing the UK government to go even further to mitigate deforestation risk in supply chains. “Restricting action to illegal deforestation would not achieve halting the loss of natural ecosystems, especially when governments have discretion to decide what is legal,” they said. For example, Indonesia recently announced a law allowing large-scale deforestation of protected land designated as “forest areas for food security.” Meanwhile, the lines are increasingly blurred between legal and illegal deforestation in Brazil as permits are issued to clear natural vegetation in the Cerrado and President Jair Bolsonaro’s administration works to weaken legislation around deforestation for agribusiness.

Without reliable regulation and enforcement of deforestation in the production of popular global commodities in tropical regions, companies are forced on their own to adopt internal processes to mitigate deforestation risk in supply chains. Some companies are opting to enhance traceability and monitoring of supply chains to reduce the risk of direct and indirect supply chain links to deforestation. Others have opted to reduce reliance on high-risk commodities, exemplified by a recent Marks & Spencer decision to replace soya feed for dairy cows after a study estimated that a fifth of Brazilian soya imports to the EU are linked to illegal deforestation.

Efforts to mitigate deforestation risk in investments: Financial institutions

Financial institutions have also appealed to governments to curb deforestation in global supply chains and mitigate exposures in portfolios. For example, 29 financiers with USD 3.7 trillion in assets wrote to the Brazilian government over the summer, calling for urgent efforts to combat deforestation and prevent widespread divestment. Financial institutions are exposed to the same deforestation risks as the companies they finance, but do not have access to the same level of proprietary information and decision-making power to address them. Therefore, it is in the financial interest of investors to use all available information to research, engage, and monitor companies as a means of mitigating portfolio exposure to deforestation risk.

With a goal to limit investment risk in the portfolios of the financial institutions it supervises, the Sustainable Finance Platform of De Nederlandsche Bank (DNB) aggregated a non-exhaustive list of key sources and uses of deforestation information in a recent report. The DNB laid out a four-step process to gather information on the deforestation exposure of portfolio companies, create an action plan to address it, engage with companies, and implement continuous monitoring and reporting processes.

Figure 1: DNB four-step process for evaluating portfolio deforestation risk

Source: The Sustainable Finance Platform

The DNB recommends conducting scenario analysis of possible outcomes based on company supply chains and quantifying outcomes through investment returns, market demand, risk probabilities, and environmental impacts like species growth or emissions statistics. As the availability of information detailing company involvement with deforestation increases over time with accessible satellite imagery, financial institutions are likely to face growing pressure to prevent reputational damage and build transparent portfolios.