Science

Engage the Chain Case Study Series #1: Business Risks from Deforestation

The Engage the Chain case studies are produced by Ceres and Climate Advisers and written by Julie Nash, PhD, Ceres, and Gabriel Thoumi, CFA, FRM, and Anthony Mansell, Climate Advisers.

Companies that fail to manage their environmental performance expose themselves to business risks. As consumer and investor awareness rises, for instance, about deforestation’s harmful impacts, companies sourcing commodities from deforestation hot spots are under pressure to ensure that their products are not sourced with illegal or questionable environmental practices. Companies that ignore this scrutiny subject themselves to potential regulatory action, or loss of customers, which can translate into negative financial consequences.

Illegal deforestation
ioa8320 / Pixabay

In this case study series, risk is broadly defined as the volatility of returns that could generate unexpected losses or profits associated with direct and indirect impacts from deforestation. These risks can be market related, such as input or output price volatility and/or loss of market access; reputational, where the firm’s brand equity could be impacted; operational, within the boundaries of the firm’s business activities and processes; or regulatory/litigation, where government actions could impact the firm’s operations or finances.

Overall, risks impact a company’s balance sheet (assets, liabilities, equity, valuation), income statement (revenues, costs, profitability, net income), and cash flow. This often has direct implications for the value of the company’s debt or equity, with pass-through to investors. Businesses can measure risks for their expected outcome and the probability that they will occur, and they can also mitigate or minimize them.

This case studies series examines the potential business risks for companies that source commodities from areas with deforestation. The series spotlights three companies (IOI Corporation, JBS, and United Cacao) and summarizes the business risks and negative financial consequences that the three companies faced.

  • IOI Corporation was suspended from the Roundtable on Sustainable Palm Oil (RSPO) because of 11,750 hectares of land cleared illegally by its Indonesian subsidiaries. With the suspension, RSPO prohibited IOI from selling crude sustainable palm oil (CSPO). This prompted 27 of IOI’s largest corporate buyers to suspend procurement contracts with the company, leading to a drop in its net income.
  • United Cacao’s illegal deforestation was a leading indicator of the broader corporate governance issues, culminating in its winding-up in July 2017. Its expansion plans conflicted directly with government regulations against deforestation – a risk the company itself identified in its bond issuance. On January 4, 2017, United Cacao’s nominated adviser resigned its role, leading to the suspension of trading of its equity on AIM and its bond on the NEX Exchange, and the delisting of United Cacao from the AIM on February 6, 2017.
  • The case of JBS demonstrates the cascading effect of uncovering actions that generate reputational risk. Investigations by Brazilian authorities into JBS have produced accusations of bribery, financial and accounting violations, labor standards and illegal deforestation. The accusations of deforestation provided additional reasons for investors and trading partners to be suspicious of JBS’ reputation. The cascade of scandals forced JBS to delay its initial public offering (IPO) for its foreign operations through JBS Foods International.

Reputational Risk

A company’s reputation represents the intangible assets held by the firm, such as its brand equity. Increasingly, investors, consumers and buyers within a supply chain are becoming conscious of environmental issues such as climate change.

For example, since 2014 over 400 companies have made deforestation-based commitments under the New York Declaration on Forests. Major companies such as Unilever, Procter & Gamble, and Tesco have gone further, committing to remove commodity-driven deforestation from their supply chains by 2020, as well as making No Deforestation, No Peat and No Exploitation (NDPE) commitments in their procurement policies.

These commitments are partially in response to increased pressure from consumers, particularly in Europe and North America, for products that are not sourced from deforested lands. The potential impacts on commodity producers are significant: 29 percent of Indonesia’s oil palm concessions cannot be developed without violating buyers’ NDPE policies. This means that 95 Indonesian palm oil companies each have at least 1,000 ha of stranded land

Meeting commitments to remove or reduce deforestation from supply chains means that commodity producers come under greater scrutiny.

Once an activity that threatens a company’s brand equity comes to light, it can expose the company to heightened scrutiny about its other activities. If corporate governance is systemically weak in mitigating these risks, regulators, investors and campaign groups may suspect that further harmful actions have occurred.

The case of JBS demonstrates the cascading effect of uncovering actions that generate reputational risk. Investigations by Brazilian authorities into JBS have produced accusations of bribery, financial and accounting violations, labor standards and illegal deforestation. These allegations focused on JBS and its parent organization, J&F Investimentos controlled by the Batista family.

The accusations of deforestation provided additional reasons for investors and trading partners to be suspicious of JBS’ reputation. The cascade of scandals forced JBS to delay its initial public offering (IPO) for its foreign operations through JBS Foods International. In September, the corruption-laced saga continued with Wesley Battista being arrested, Joesley Batista being jailed and JBS founder José Batista Sabrinho, taking over as CEO.

Poor governance was present throughout the company, from top-level executives engaging in bribery of officials and politicians, to alleged procurement from suppliers using illegally cleared land, in violation of the Cattle Agreement for the Amazon.

Illegal deforestation presents a reputational risk that can impact a company’s intangible assets, such as its reputation with its customers, investors and within its supply chain. This reputational risk can transfer to broader company performance, if damage to a company’s image deters customers or investors. In this way, reputational risk is linked to regulatory, market, and operating risks.

Regulatory Risk

Many countries have laws and regulations in place to prevent illegal deforestation in their forests. Major importers such as the United States and the European Union also have legislation and enforcement to prevent the import of illegally deforested products.

For example, the Lacey Act makes it a criminal offense to import illegally logged timber into the United States. In 2016, Lumber Liquidators was sentenced in federal court in Virginia and required to pay a $13 million criminal fine, a $1.2 million community service fine, and forfeit assets related to illegal deforestation of Russian forests. These forests are the last remaining wild habitat of the Siberian tiger and Amur leopard. The case against Lumber Liquidators was the first felony conviction related to the import or use of illegal timber and the largest criminal fine ever under the Lacey Act. Not only did the company damage its reputation, but through exposure to regulatory and litigation risk it suffered a financial penalty and criminal conviction. LL’s share price plunged 25 percent after the raid by U.S. federal officials.

As noted earlier, JBS has been subject to government investigations across a suite of alleged illegal activities. The most significant financially was a $3.16 billion fine over 25 years for J&F Investimentos as part of a leniency settlement over bribery allegations. However, federal prosecutors may also nullify $8 billion in suspiciously high valuation of assets sales by J&F Investimentos made over the summer of 2017.

In addition to national authorities, bodies such as RSPO can impose liabilities on companies that violate its procedures. Felda Global Ventures is currently discussing with RSPO remediation and compensation for a 95-percent owned subsidiary knowingly proceeding with non-compliant land clearing. This could potentially incur a fine of at least $5.1 million.

External groups can also influence bodies such as RSPO to take action. In July 2017, HSBC urged the RSPO to ask Noble Group, a client in the palm oil sector, to stop all deforestation while RSPO investigated possible violations. This pressure by Noble’s creditor HSBC may have influenced Noble to devalue its palm oil assets by $60 million in Q2 2017.

Market Risks

Evidence of deforestation creates market risks for companies, which means access to both buyer’s markets and financial markets can be jeopardized.

Companies can lose access to buyers’ markets for certified products (e.g. CSPO) in a number of ways. For example, buyers may suspend or cancel contracts with the producer proactively, or, the producer may be unable to fulfill existing contracts because of delayed production due to deforestation issues. While IOI Corporation was suspended from RSPO it lost access to sell CSPO, and therefore its clients purchased CSPO from its competitors such as Kuala Lumpur Kepong. As a result, IOI’s net income was negative $14.8 million in Q2 2016, compared to a $30 million gain in Q2 2015.

Kuala Lumpur Kepong (KLK) has itself encountered problems with developing 30,000 ha of oil palm plantations in Collingwood Bay, Papua New Guinea. It purchased a 51 percent equity stake in December 2012 for $8.7 million, but in May 2014 indigenous communities successfully contested KLK’s plans, and the leases were declared null and void. Under pressure to increase its RSPO-compliant assets, it launched a $441 million hostile takeover bid for MP Evans (MPE). This increased the share price of MPE but KLK failed in its takeover. MPE instead sold its RSPO-certified concessions by competitor Sipef group for $100 million.

Sawit Sumbermas Sarana (SSMS) had 81 percent customer base turnover between 2014 and 2015 because of non-compliance with its buyers’ No Deforestation, No Peat, No Exploitation (NDPE) commitments. Most recently Unilever, responsible for 8 percent of SSMS’ Q1 2017 revenue, suspended sourcing, citing concerns over deforestation. SSMS then announced its first NDPE policy in July 2017 in response to its loss of buyers.

United Cacao also provides an example of how deforestation can jeopardize access to financial markets. After regulatory enforcement on deforestation resulted in halted operations, on January 4, 2017, United Cacao’s nominated adviser resigned its role, leading to the suspension of trading of its equity on London Stock Exchange Alternative Investment Market (AIM) and its bond on the NEX Exchange, and the delisting of United Cacao from the AIM on February 6, 2017. A subsequent audit revealed fraud, illegal funding mechanisms, and misleading statements by company executives, including about the firm’s compliance with environmental regulations. United Cacao’s illegal deforestation was a leading indicator of its broader corporate governance issues, which culminated in its winding-up in July 2017.

Operating Risks

Illegal deforestation activities can hamper a company’s business plans to generate revenue. Failure to obtain free, prior and informed consent (FPIC) has caused many investments, particularly in Southeast Asia or Africa, to become subject to delays, community conflicts, and complaints filed through dispute bodies.

In the case of United Cacao, the company’s stated growth strategy to attract financing relied on rapid expansion of cocoa plantations, which conflicted directly with government regulations against deforestation. Ironicaly, the company had identified this risk in its bond issuance. The Environment Investigation Agency found evidence that United Cacao’s plantations involved illegal land clearing and ordered its operations to cease.

Conversely, the pressure to develop concessions can also strain a business model. Sime Darby has a 63-year concession agreement in Liberia to develop oil palm and rubber plantations. Failure to develop the land could result in a renegotiation of its lease with the government; yet, completing these developments means it would backtrack on its social and environmental commitments, potentially exposing it to future reputational and material risks. As a result, Sime Darby has stated that it will work with the Government of Liberia and local communities to support local green growth, FPIC, maintaining High Carbon Stock forests, and in 2018, achieving RSPO certification.