The deforestation risks lurking in the banking sector

The signing of the Paris Agreement in December 2015 signalled a step change in government policy and regulation to combat climate change. While transitioning the energy sector has been an early priority, there’s no doubt that other segments including deforestation and commodities will come under future focus. On fossil fuels, the financial sector has already responded, and is increasing commitments to stop lending to or insuring the coal sector.

The financial materiality of emerging regulatory risks is increasing for high-carbon sectors. The growth of low-carbon products and technologies, such as electric and autonomous vehicles or smart and connected energy grids, is also disrupting sectors. Bankers, asset managers and institutional investors are increasingly casting a critical eye across their lending and investments for the financial risks and opportunities of climate change.

Financial regulators are also making their move. In June 2017, a G20-backed Financial Stability Board Task Force for Climate Risk Disclosure (TCFD) put forward a set of voluntary recommendations for companies with listed debt or equity, including financial institutions, to understand and disclose their climate-related financial risks. More than 250 companies have already signed up to support the Task Force’s recommendations, including more than 180 financial institutions responsible for just over 40% of global financial assets. Although voluntary at this stage, governments are considering national legislation to require disclosure.

But are financial institutions overlooking a critical climate risk - that posed by deforestation? Deforestation and forest degradation account for around 15% of human-made emissions, second only to fossil fuel combustion. More than half of deforestation is the result of the production of commodities such as soy, palm oil, pulp and paper, and cattle products.

The Paris Agreement is spurring government action by countries where most deforestation is taking place. As part of their pledges under the Paris Agreement, Indonesia, Brazil and Malaysia made strong commitments to address forest loss. Brazil, for example, has committed to reducing its emissions by 37% by 2025: almost half of that will be contributed by tackling emissions from its land use and forestry sectors.

Public concerns are also driving action. Around 500 companies, including some of the world’s largest consumer goods giants, have pledged to eliminate deforestation from their supply chains. These commitments could see demand collapse for unsustainably sourced soft commodities, and, like national regulation to conserve forests, could create economically ‘stranded’ assets.

The financial sector has been slow to respond. Global Canopy, a leading international NGO, analysed 150 financial institutions with the largest exposures to forest-risk commodity supply chains. In 2017, only four had made an overarching zero-net deforestation commitment covering all their lending and investments.

This summer, PwC supported the Tropical Forest Alliance 2020 - a platform for public-private collaboration to address forest loss - to set out the business case and framework for financial institutions to act on their exposures to deforestation.

Its recommendations included that financial institutions should:

- Carry out scenario analyses, using the TCFD framework for inspiration, to understand their physical, regulatory, legal and reputational exposures to forest-risk commodities

- Explore opportunities linked to new financial products, such as sustainable landscape bonds, green bonds or impact funds that target and promote sustainable agriculture and land use

- Develop robust policies and procedures to ensure funding is denied to companies and projects whose operations fail to protect globally important forests

- Encourage clients to use sustainable commodity certification schemes, offering favourable financial terms where possible to those that do

However, there is a balance to be struck between reducing risks within leading banks and forcing some clients into the arms of rivals with lax practices and no policies. Financial institutions should first engage with clients to encourage improved performance on deforestation, clearly setting out the business case for sustainable practices, such as market access and regulatory compliance.

They also need to work with governments and other stakeholders to ensure that tropical forest countries introduce - and enforce - robust regulations to protect valuable forests.

Commodity supply chains are complex and difficult to monitor effectively. However, technology is coming to the rescue. A growing number of not-for-profit organizations and commercial providers are coming forward with corporate and geospatial monitoring products that financial institutions can use to understand their exposures better.

At the company level, for example, Global Canopy’s SCRIPT portfolio risk tool collects data from a number of initiatives to score companies on the extent to which they are at risk of association with deforestation. Meanwhile, initiatives such as the World Resources Institute’s Global Forest Watch and the Starling collaboration between Airbus, the Forest Trust and Sarvision use satellite technology to monitor deforestation in near-real time.

Addressing tropical deforestation, among other natural climate solutions, could deliver more than one-third of the greenhouse gas savings required to meet the goals of the Paris Agreement. But these savings will not be achieved without the financial sector’s active involvement. The business case is clear. The opportunity for the financial sector to play a part in driving and integrating sustainable practices into forestry management is enormous.