Finance
For about an hour on the afternoon of Monday 19th August 2019, Brazil’s largest city, São Paulo, was plunged into darkness. The cause was not a solar eclipse or a power cut – but smoke billowing from forest fires burning nearly 3,000 kilometres away in the states of Amazonas and Rondônia. Fires in the Brazilian Amazon in August this year have been even worse, hitting 33,116 according to INPE, Brazil’s national space research institute – the highest number for the month since 2010. Clouds of grey smoke blanketing the southern states of Brazil are now increasingly commonplace during the “fire season” from August to October.But what does this have to do with the finance sector? Unlike in the temperate forests of the US, wildfires are very rarely a natural phenomenon in the Amazon.
While fire can be used to help clear overgrown pastures and crop residues, the principal culprits are cattle ranchers, illegal farmers and land grabbers who torch trees to clear forest unlawfully. And the commodities they grow on that land find their ways into global supply chains. At Glasgow’s COP26 climate conference in November 2021, more than 30 financial institutions with over $8.7 trillion in assets under management committed to use best efforts to eliminate agricultural commodity-driven deforestation risk in their investment and lending portfolios by 2025. For these suited signatories, their concerns about the health of the planet are tied to concerns about the health of their investments – and the growing extent to which the two are becoming interlinked. Their apprehension can be summed up in one word – risk.
Perspectives interviewed Graham Stock, a partner at RBC BlueBay Asset Management and a specialist investor in sovereign bonds in emerging markets, to find out more. Stock is co-chair of the Investor Policy Dialogue on Deforestation (IPDD), an investor-led initiative created in July 2020 by a group of asset owners and managers with the support of the Tropical Forest Alliance. The IPDD’s members worry that ongoing deforestation and the violation of human rights among forest communities that often accompanies it are creating widespread uncertainty around the conditions for investing in Brazil, as well as hampering the country’s socio-economic development. The destruction of tropical forests – driven largely by palm oil, soy, beef, pulp and paper – accounts for 8% of all CO2 emissions, more than the entire EU. The eastern Amazon for example – more heavily deforested than the western Amazon – is now emitting more carbon dioxide than it can absorb.
If Brazil continues along this path, explains Stock, we will see increasingly severe impacts of climate change not just globally but also locally within Brazil itself. Deforestation is already reducing rainfall in the Amazon and revenues In the agriculture sector. Smoke levels from forest fires could make some cities unliveable. These climate-induced risks will undermine Brazil’s macro-economic growth and could leave the country struggling to service its foreign and domestic debts.
We feel the Brazilian government is underestimating the financial risk posed by deforestation.”
Graham Stock, co-chair of the IPDD
Brazil, like many countries, raises money for its development by issuing sovereign bonds, a form of debt raised on international financial markets for which the borrowing country pays lenders a fixed income or interest rate. Countries with a reputation for safe macro-economic management, such as Germany or Canada, attract the highest AAA rating from ratings agencies such as S&P or Fitch and as a result only have to pay out a few percent interest on their sovereign debt.
Emerging markets like Brazil or Pakistan or South Africa are considered riskier investments – their ratings are lower (Brazil’s is BB-) and the interest they have to pay out on their sovereign debt is correspondingly higher. The risk for global fixed income investors is that if a country such as Brazil develops a bad reputation for macro-economic management, its rating will go down, the interest rate on its bonds will go up, and the the country could default on its debts.
It is no secret that Brazil’s environmental reputation has taken a beating under the Bolsonaro administration. “They’ve been slow to issue green bonds and social bonds given their track record”, says Stock, “and it’s proved hard for the government to push its agenda on carbon credits.”
Reputation these days is no longer just based on economics – increasingly, investors are looking to invest in financial products, companies and countries with solid environmental, social and governance (ESG) performance. For asset managers such as Graham Stock, their first priority is a “fiduciary” duty to act in the best long-term interests of their investors. “Our clients expect us to incorporate the evaluation of ESG risks into our investment process”, says Stock. However, the risks from investing in “forest-risk” commodities and the countries from which they are sourced are not only environmental, social or reputational – they could also expose companies to litigation arising from new regulations. In the past year, the prospect of stricter environmental regulation for corporates in both Europe and the US has grown clearer. On 13th September 2022, for example, the European Parliament passed a ground-breaking vote on the draft EU law to eliminate deforestation and forest degradation from all products and commodities imported by the bloc.
The new European law, likely to come into force in 2023, will encompass, among other things, all the soy, beef and palm oil imported by the EU from Brazil, Indonesia and elsewhere. New deforestation regulations impose due diligence obligations on EU financiers investing in forest-risk sectors. In addition, it will give Indigenous peoples and local communities on the frontline of deforestation the right to bring evidence of non-compliance and raise complaints before European courts.
While the majority of Brazil’s beef production is consumed by Brazilians not Europeans, Stock sees this new European legislation as the canary in the coalmine. “We’ve seen European consumers pressuring their governments on this issue and young urban consumers in Brazil are also starting to think about how the products they buy affect deforestation,” he says. In a positive domestic move, Brazil’s Central Bank is introducing a green taxonomy which will limit the ability of commercial banks to lend to rural producers if they do not conform to Brazil’s strict Forest Code. “The regulatory environment for deforestation in Brazil is tightening up”, says Stock, although enforcement is still lacking. “Financial regulation can be a Trojan Horse”, he adds, “because it doesn’t rely on boots on the ground,
it’s someone in head office saying you can’t lend to this farmer unless their rural credit rating is up to date and the tracking shows they’re not deforesting.” However, concedes Stock, this approach only works for companies operating within the law. “Illegal activity in the rainforest needs law enforcement”, he says. Based on his recent conversations with agribusinesses in Brazil, Stock believes their stance has shifted in the past decade. While they were once opposed to controls on deforestation, agribusinesses now recognize the need for more progress, not only in terms of eliminating deforestation from their supply chains but also in cleaning up Brazil’s international reputation.
While regulation and law enforcement have an important role to play in combating deforestation, dialogue is equally vital in helping to maintain trust, share best practice and change behaviours. This is the basis of IPDD’s unique approach, which aims to influence ministries, banks and industry sectors in both supplier and consumer markets. The IPDD now counts 64 financial institutions from 19 countries (including Brazil) as members with around $10 trillion of assets under management. Through coordinating a public-policy dialogue on halting deforestation, the group’s members aim to improve the long-term financial sustainability of investments by promoting sustainable forest management and respect for human rights in the countries where their members invest. Stock told Perspectives about his recent experiences lobbying in Brazil on behalf of IPDD. Despite the negative reputation of the Bolsonaro government on environmental protection, Stock was surprised at how receptive individual ministries were to IPDD’s position on halting deforestation.
“We’ve had a very good dialogue with the Ministry of Agriculture, the Ministry of Environment and the Central Bank”, he says, adding: “They understand our arguments about the importance of the issue.”
What has surprised us is how much sympathy for our stance on deforestation there is within Brazil’s government ministries – they understand how important this is”
There are disagreements too, of course. “We think it’s critical they prosecute more of the perpetrators in cases of deforestation”, says Stock. If that means changing procedures, working with the police more closely and allocating more resources, then so be it. “But due to budgetary constraints, they are trying to work on a more intelligence-led approach”, says Stock, who adds: “This is clearly not working.” And although in April 2021 President Bolsonaro pledged to double Brazil’s budget for environmental enforcement, the country’s environment agency spent just 41% of its enforcement budget last year. As part of IPDD, Stock also joined discussions with administrations in the states of Mato Grosso, Pará and Minas Gerais, which are beginning to require producers to be more transparent about their supply chains. Nevertheless, says Stock, “While the big beef processing companies in Brazil say they’re moving towards transparency in their supply chains, most investors would argue they could move faster.” As well as talking with public and private sector actors in Brazil and Indonesia, the IPDD has a working group engaging with the EU, UK, US and China. “We don’t just want to tell emerging markets to stop cutting down their forests,” says Stock: “It’s also important for consumer countries to do their part and reduce the incentives for deforestation.”
