How to manage deforestation risk
Deforestation is not only terrible for climate and biodiversity, but also poses financial risk to investors
Net zero targets are impossible to hit without them, and yet forests continue to disappear at an unsustainable rate.
While Asia has made some progress, Latin America and Africa remain off-track to reach the globally agreed goal of no-more deforestation by 2030, according to reports by the WWF and Forest Declaration Assessment.
Part of the problem is that most asset owners and managers highly exposed to deforestation risk still lack a deforestation policy. What are the challenges and benefits of integrating standards to tackle deforestation into investment portfolios?
Benefits of screening portfolios
The first point is that deforestation can result in financial risk, in the form of physical risk arising from nature loss, but also increasingly regulatory risk.
The EU’s Deforestation Regulation threatens fines of up to 4% of EU turnover for companies that can’t verify their products are deforestation free.
The UK’s Environment Act, not yet in force, also looks to hold companies account for their links to deforestation.
Although the Deforestation Regulation doesn't directly capture financial institutions, it still poses risks for investors, particularly those with exposures to companies in the agricultural value chain, as commodity driven agricultural deforestation (e.g. for palm oil and soy) is one of the leading drivers for conversion of forest ecosystems.
Net Zero Investor spoke with Schroders – an asset manager with one of the most robust deforestation policies in the world, according to Forest 500 – about the challenges and benefits of implementing such a policy.
“We have seen several companies lose the trust of their consumers and license to operate when they’ve been linked to deforestation,” said Sarah Woodfield, active ownership manager at Schroders.
By contrast, companies that have been investing in cleaning up their supply chain, are poised to benefit from continued access to EU markets and client preference for deforestation free supply chains.
Schroders has developed its own scorecard to help investment desks identify those companies which are most at risk of commodity driven deforestation. “We have been proactively using this screening to support our active ownership activity – engaging with companies to encourage them to set timebound commitments to end deforestation in their operations and value chain,” Woodfield added.
Meryl Richards, acting program director, food and forest, at Ceres, said screening portfolios for deforestation allows investors to make “informed decisions” such as engaging with individual or collective dialogues with companies or adjusting their portfolio exposure.
The main challenges are around obtaining comprehensive and reliable data. Some data sources do not go back far enough or have not been recently updated.
In some cases, screening requires company by company research by financial institutions, which can be time consuming.
“Very few companies are providing transparent information about their business footprint in high conservation value ecosystems such as old growth forests and few have full visibility over their supply chain,” said Woodfield.
For example, a timber company may be practicing sustainable forestry, using land that was converted to plantation centuries ago, whereas a pulp and paper company may be sourcing their timber from 100s of different suppliers from high-risk regions, with no traceability to the geolocation of production.
That means the answer to the question “is deforestation taking place” isn’t always simple.
“We need to engage with these companies to understand the risk properly and use our voice to encourage action,” Woodfield added.
Engagement typically means asking questions, such as are they operating in high-risk markets? Do they have traceability to the production site of commodities? Do they have a grievance tracker, which provides transparency on any incursions on protected land and steps taken towards remediation?
Emma Thomson, Forest 500 and tracking lead, at Global Canopy, commenting on the importance of engagement, said financial institutions are uniquely placed to influence companies to shift their practices towards becoming nature-positive and deforestation-free, as their capital gives them leverage over the companies they finance.
While data is imperfect, Thomson said there is “already sufficient data” for financial institutions to identify the “most significant” deforestation risks in their portfolio. Tools like Forest IQ and ENCORE can play a key role.
Further action needed
Thomson also encouraged investors to commit to using the Finance Sector Roadmap to eliminate commodity-driven deforestation, conversion and associated human rights abuses from their portfolios by 2025.
As part of the roadmap, financial institutions must report on their progress towards implementing any policies.
“Leading investors are increasingly adopting policies that address exposure to deforestation, as evidenced by the investors committing to the Finance Sector Deforestation Action initiative, which includes a commitment to adopt a deforestation policy,” said Richards.
Despite recent policy and regulatory developments, there is still no mandate for financial institutions to consider and address deforestation specifically.
In addition, policies are typically updated annually and require senior management buy-in across departments, which can take time.
However, Richards said a lack of policy does not necessarily mean that an investor is not engaging portfolio companies on deforestation risk.
The 89 members of Ceres’ Land Use and Climate Working Group and the 191 investors that have signed on to participate in Nature Action 100 do not all have deforestation policies, but they are nonetheless committed to address deforestation and other drivers of nature loss in their portfolios.