As reported by Chain Reaction Research, written by Gabriel Thoumi, CFA, FRM, Tim Steinweg, and Barbara Kuepper, the economic links between deforestation and climate change are increasingly recognized in, for example, the 2015 Framework Convention on Climate Change’s Paris Agreement and elsewhere. This recognition is particularly important, as the planet has lost about 129 million hectares of forest since 1990. As deforestation is largely driven by specific economic activities and is thus a sector-specific risk, investors and banks must now pay far greater attention. Legend: Orange sectors are drivers of deforestation, red sectors are key drivers per country.
Key Sectors Causing deforestation:
- Agriculture: Palm oil, soy, rubber, cattle, and smallholder farming
- Forestry and extractives: Industrial logging, mining, oil and gas, and fuel wood
- Infrastructure: Urban expansion, energy, and transport
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Figure 1: Drivers of Deforestation in six Latin American and African Countries
Legend: Orange sectors are drivers of deforestation and red sectors are key drivers per country.
Figure 1 above shows the diverse economic drivers of deforestation in six key tropical countries. In four Latin American countries (Brazil, Colombia, Ecuador and Peru), over 70% of combined deforestation is linked to cattle ranching. In two African countries (Liberia and DRC), large-scale and subsistence agriculture are the primary drivers. Palm oil and other agricultural commodities, as well as mining and the exploitation of oil and gas are threatening forested areas in various countries. Logging is a recurrent factor in all forests, while infrastructure and hydropower contribute to deforestation in several countries.
Banks and investors can be exposed to deforestation risks directly by investing in (multinational) companies operating in the identified sectors in these countries. But they can also be exposed indirectly through downstream companies that buy commodities from these countries, or through governments and public banks that make infrastructure developments possible.
Deforestation related financial risks:
- Lost price premium when unable to sell higher-margin certified products.
- Loss of customers when producers are noncompliant with customers’ zero-deforestation procurement policies.
- Increase of costs of goods sold for sellers when they must find substitute buyers when sellers violate buyers’ zero deforestation policies.
- Loss of banking and investor relationships due to noncompliance with their sustainability policies.
- Fines and other costs due to noncompliance with government and buyers policies.
- Concessions being revoked for illegal deforestation and land grabbing
Direct and indirect exposure to deforestation risks could impact banks and investors in different ways:
- The reputation of financial institutions with sustainability policies is at risk if the companies they invest in do not comply with their policies.
- If deforestation is tackled more seriously on international and national levels, the profitability of companies active in these sectors – or their buyers – could be at stake. Their financial stakeholders could then experience lower returns on investments, higher risk profiles and even defaults.
Forests and Climate
When the December 2015 Paris Agreement explicitly mentioned REDD+ as an important instrument to fight climate change, the movement to halt deforestation entered a new era. The world is paying attention to the link between deforestation and greenhouse gas emissions, which means that more funding will become available in the future to halt deforestation. More and more companies will commit to ‘zero deforestation’ policies, and public monitoring of forest stocks will increase. These developments fundamentally alter the market conditions for those sectors that have contributed to deforestation in the past.
Examples of such changes can be found in SE Asia, where the large palm oil company IOI Corporation (IOI:MK) (IOIOF) was suspended from the Roundtable on Sustainable Palm Oil ((RSPO)) for not complying with its principles, and where palm oil company Felda Global Ventures (FGV:MK) voluntarily withdrew specific mills and concessions from the RSPO after it had been found to be deforesting valuable peatlands. In both cases, the financial implications for these firms were significant. IOI’s large customers suspended trading and Moody’s subsequently downgraded the company. FGV may potentially lose customers with ‘zero deforestation’ policies and is expected to lose an estimated US$6-12 million in 2016 cash flow from certification premiums.
Since 2013, Chain Reaction Research ((CRR)) has uncovered the hidden financial risks associated with the sustainability performance of SE Asian companies such as IOI and FGV. However, deforestation and forest degradation are also major issues in the Congo and Amazon Basins. Similar hidden financial risks are therefore likely to be faced by firms active in these countries, particularly given the increasing level of global attention. This briefing provides a snapshot of the sectors that drive deforestation in six focus countries: Liberia, Democratic Republic of Congo, Colombia, Peru, Ecuador and Brazil, and that are therefore most susceptible to financial risks.
Deforestation Rates: Forests worldwide constitute large repositories of carbon pollution, provide a livelihood to millions of people worldwide – many of whom live in poverty – and contain some of the most varied biodiversity in the world. Despite the widely recognized global importance of forests, vast areas are still affected by deforestation and forest degradation. That leads to major carbon emissions, as well as loss of biodiversity, loss of livelihoods and other adverse sustainability impacts.
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Figure 2: Deforestation in South America and Central Africa
Source: Global Forest Watch.
As shown in Figure 2, deforestation hotspots in Latin America and Central Africa are highlighted. According to the Food and Agriculture Organization of the United Nations ((FAO)), approximately 129 million hectares of forests have been lost around the world since 1990. While the rate of global deforestation has slowed down in recent years, the world’s forests continue to shrink. Tree cover loss in the six focus countries is extensive and, despite a number of good efforts in different parts of the world, is expected to continue and to grow.
As shown in Figure 3, there are clear differences in the relative annual deforestation rates in each of these six countries, as well as in the absolute areas that are deforested every year. In terms of absolute values, deforestation is most pressing in Brazil, where almost one million hectares of forest are lost each year. The relative deforestation rates are much higher in the smaller countries, such as Liberia (0.7%) and Ecuador (0.6%).
The worldwide economic crisis starting in 2007 has had a major impact. Conservation programs have often been limited and governments have had to divert attention and resources to other issues. Liberia has suffered particularly heavily with the Ebola virus coming on top of the economic crisis.
|Country||Forested area in 2015 (in ha)||Deforestation|
|Annual deforestation rate, as % of total forested area between 2010-2015||Annual loss of total forested area in ha between 2010-2015|
Figure 3: Forested Area 2015 and Deforestation per Country 2010-2015
Source: FAO (2015) Global Forest Resources Assessment 2015
Main Economic Activities Driving Deforestation
Most deforestation is driven by the prospect of economic gains. Countries that have forests often look to develop their economy by exploiting their natural resources.
A variety of proximate human actions at a local level and underlying factors – both fundamental social processes – contribute to deforestation. Proximate causes are defined as immediate human actions at the local level, originating from intended land use and directly impacting forest cover, encompassing agricultural expansion,