How deforestation risks for investors can become opportunities for conservation (commentary)

An Indonesian palm oil trader sees its share price drop as major clients take their orders elsewhere. Investors lose $42 million as a growing cocoa company in Peru collapses. A US hardwood flooring company is fined $13 million. In Brazil, the world’s biggest meatpackers find themselves embroiled in scandal, leading to a decline in value of over $2 billion.

The common theme running through all these stories? Deforestation. Across sectors and across continents, companies are discovering that deforestation poses material risks to their business success. And as investors are also waking up to these risks, a powerful movement is building that can help end the destruction of the world’s forests.

Under pressure from NGOs and increasingly aware consumers, many companies have made commitments to remove deforestation from their supply chains. For example, the Consumer Goods Forum — which represents over 400 of the world’s largest retailers, manufacturers, and service providers, with combined sales approaching $3 trillion — has pledged to mobilize resources to achieve zero net deforestation by 2020.

However, despite various pledges and policies, progress is currently far too slow. That not only threatens precious forests, but also puts profits at risk.

Recent research from CERES and Climate Advisers shines a spotlight on how companies that fail to properly manage their environmental performance leave themselves exposed. Deforestation in supply chains can have direct and indirect impacts on a company’s balance sheet, profitability, and cash flow, which in turn can have implications for shareholders and other investors.

Reputational risks

Consumers, especially in Europe and North America, care about the environment, and being linked to deforestation can be damaging to a company’s reputation. This is particularly relevant for retailers and other consumer-facing companies that place a high value on their brand equity — especially those that are also most likely to be targeted by NGO campaigns or receive negative media coverage. Companies with zero-deforestation commitments are facing increased scrutiny, bringing reputational risks for those that don’t live up to their pledges.

A failure to manage deforestation is ultimately a failure of corporate governance, and should ring alarm bells for investors, regulators, and campaign groups. This can have a cascading effect — as the JBS scandal demonstrates.

JBS, the world’s largest meat producer, was a founder of the Global Roundtable on Sustainable Beef and has a long-standing voluntary commitment not to buy cattle from newly deforested land in the Amazon. The company reacted angrily to a Greenpeace report in 2012 that alleged it had purchased cattle from illegally deforested farms, threatening to sue for the potential damage to its reputation and sales.

But in 2017, the Brazilian environmental protection agency IBAMA raided JBS facilities in the Amazonian state of Pará. Their investigations showed JBS had bought 59,000 cattle from illegally deforested land, either directly or through third-party transactions, contributing to the destruction of an area of rainforest the size of Manhattan.

At the same time, a string of other corrupt practices came to light: tainted meat, bribery of officials, fraudulent financial transactions, labor violations. In one of the biggest corporate scandals in history, the company’s owners admitted to spending around $185 million on bribing nearly 1,900 politicians. As part of a leniency settlement, they agreed to pay a record $3.2 billion fine over 25 years. The affair has left the company’s reputation in tatters and wiped $2.3 billion off the company’s market value.

Regulatory risk

Under the UN Sustainable Development Goals, national governments have committed to halt deforestation — and many have made further commitments under the New York Declaration on Forests, as well as the Paris Climate Agreement. In the coming years, we can expect to see more regulations put in place to protect forests — and tougher implementation of existing laws — both in forest countries and in import markets.

This presents a risk to companies that fail to comply — as Lumber Liquidators found to its detriment. In 2016, the hardwood flooring company fell foul of the Lacey Act, a US law dating back to 1900 that prohibits trade in illegal plants and wildlife. Lumber Liquidators was accused of importing illegally logged timber from the forests of the Russian far east, the last remaining habitat of the critically endangered Siberian tiger and the world’s rarest big cat, the Amur leopard.

A federal court found the company guilty. In addition to having its reputation damaged with a felony conviction, Lumber Liquidators was ordered to pay fines totaling $13.2 million. The company’s share price fell 25 percent as a result.

Market risk

As companies at the top of the value chain commit to sustainable sourcing, suppliers that don’t keep pace risk losing access to high value markets. The palm oil sector provides a prime example.

Most of the big retailers and manufacturers in European and North American markets have made pledges to source only palm oil certified as sustainable by the Roundtable on Sustainable Palm Oil (RSPO). IOI Corporation was one of the founders of the RSPO, and supplied around 6 percent of the world’s certified sustainable palm oil in 2015.

But in March 2016, IOI was suspended from the RSPO after it was discovered that its subsidiaries in West Kalimantan, Indonesia had illegally cleared 11,750 hectares of rainforest in Borneo. With IOI no longer permitted to sell certified sustainable palm oil, 27 of its major customers — the likes of Unilever, Kellogg, Mars, McDonald’s, and Nestlé — switched to other suppliers.

This hit the company’s bottom line, with shareholders seeing a loss of 59 million ringgits ($15 million) in the second quarter of 2016, compared to a profit of 133 million ringgits ($34 million) during the same period the year before.

Having agreed to an action plan to improve its sustainability and to restore the forests and peatlands it had destroyed, IOI was readmitted to the RSPO in August 2016. But the company remains under close scrutiny, its reputation and customer relationships have been seriously damaged, and its share price has yet to recover.

Operational risk

As regulations and sourcing policies against deforestation tighten, companies’ own business plans and day-to-day operations may suffer — a risk that smart investors need to be aware of. Companies may find themselves unable to develop concessions without breaking local laws, violating buyers’ zero-deforestation policies, or risking conflict with indigenous peoples and local communities.

Palm oil company Kuala Lumpur Kepong (KLK), for example, spent $8.7 million on a 51 percent stake in 30,000 hectares of oil palm plantations in Papua New Guinea in 2012. However, indigenous communities opposed the company’s plans, and two years later the leases were annulled.

Meanwhile, in Indonesia, government regulations preventing conversion of peatlands and international companies’ “no deforestation, peat or exploitation” (NDPE) commitments mean that around 30 percent of palm oil concessions cannot be developed. Like the fossil fuel reserves that can’t be burned if we’re to have a hope of keep global warming below 2°C, these concessions are effectively a “stranded asset.”

The case of United Cacao provides another cautionary tale. The company quickly became one of the largest cocoa plantation owners in Latin America after raising over $42 million in shares and bonds. Its strategy was based on rapidly developing this land in order to provide a return for investors — but in the end, the project was wound up before the first cocoa beans had ripened.

Although United Cacao claimed to have the necessary environmental permits in place, the Peruvian government, clamping down on illegal deforestation in the Amazon, disputed this. One of the company’s subsidiaries was ordered to cease operations in December 2014, the same month that United Cacao launched on the London Stock Exchange Alternative Investment Market (LSE AIM). And in 2016, the non-profit Environmental Investigation Agency presented evidence that companies linked to United Cacao were responsible for clearing 11,000 hectares, mostly primary tropical rainforest, in the Peruvian Amazon.

By January 2017, United Cacao had been suspended from the LSE AIM — which, as a member of the UN Sustainable Stock Exchanges Initiative, faced reputational risks of its own. In July 2017, the company was wound up.

Responding to risk

These stories aren’t isolated cases — and they are no small concern. Analysis by CDP has revealed that almost a quarter (24 percent) of the revenue of 187 leading global companies depends on the top four commodities linked with deforestation — cattle, soy, palm oil, and timber. That represents over $906 billion in turnover that could be put at risk. Among the agricultural producers analyzed, four-fifths (81 percent) say they have had to make substantive changes to their business because of impacts linked to deforestation.

So it’s hardly surprising that investors and financial analysts are paying increasing attention to deforestation. There’s also a growing body of research, databases, and tools to help investors manage the risks associated with deforestation: Chain Reaction Research is one such example.

More investors need to start using these tools to screen and grade companies and to guide their investment decisions. They should use their influence, including through shareholder resolutions and the threat of divestment, to push companies into better managing deforestation risks.

Indeed, some are already doing so. Norway’s $900 billion sovereign wealth fund — the largest in the world — excluded four major palm oil companies from its portfolio, citing deforestation. And members of the CERES Investor Network on Climate Risk and Sustainability — comprising nearly 150 institutional investors who collectively manage more than $23 trillion in assets — have pressed companies such as Kraft, DuPont, and Mondelez to address deforestation through shareholder resolutions.

Investors have the power to demand companies live up to their zero-deforestation or NDPE policies. They should demand that companies transparently report on their commitments, and how they are being implemented and monitored.

One solution is to demand companies make time-bound commitments to sourcing only credibly certified commodities — such as RSPO-certified palm oil, timber products certified by the Forest Stewardship Council (FSC), and Round Table on Responsible Soy (RTRS)-certified soy.

Powerful players can go beyond their own sourcing requirements by seeking to transform whole sectors. Mondelēz International, recognizing the risks around deforestation as well as exploitation in the cocoa sector, is investing a colossal $400 million in its Cocoa Life initiative. Projects include partnering with the UN Development Programme, government forestry departments, and civil society organizations to prevent deforestation in Ghana and Côte d’Ivoire.

This country-scale work is an example of another solution that’s beginning to gain traction: preventing deforestation by promoting smarter land use at a national, jurisdictional, or landscape level.

Companies like Unilever and Marks & Spencer, for example, are supporting “produce-protect” partnerships. The idea is that companies can avoid deforestation risk by sourcing from areas that have effective governance structures in place at a regional or landscape level to protect ecosystems and communities. One prominent example is the “Produce, Conserve and Include” plan of the Brazilian state of Mato Grosso, which aims to end illegal deforestation by 2020 and restore 2.9 million hectares of native forest while increasing soy, beef, and timber production.

A number of partnerships and investment vehicles have been set up to address these issues. &Green, a collaboration between public sector donors, private sector companies, and charitable foundations, aims to catalyze more than $2 billion of investment into sustainable forestry and agriculture projects in jurisdictions that have shown commitment to tackling deforestation.

Another example is the BioCarbon Fund Initiative for Sustainable Forest Landscapes, a multilateral fund managed by the World Bank. This fund works with companies that have pledged to reduce their impact on tropical forests to help them put their commitments into practice by supporting sustainable development and land use, again at a jurisdictional scale.

Ultimately, companies and investors need to remember that the other side of risk is opportunity. Companies that are dealing effectively with deforestation and other sustainability issues perform better than those that are not. It’s clear where the smart money should be going.

Gabriel Thoumi, CFA, FRM, is Director of Capital Markets at Climate Advisers. He works for the Chain Reaction Research coalition and leads other initiatives around governance and financial risk management.

Peter Graham is managing director of policy and research at Climate Advisers. He has previously led WWF’s forest and climate programme, and co-chaired negotiations at the United Nations Framework Convention on Climate Change.

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