Sustainable finance

What are the main drivers of deforestation and forest degradation

and which role the financial system has to play?

Luciane Moessa, Ph.D.,

Fernanda Bianco, M.Sc.

and Marcio Gama, M.Sc.

Sustainable Inclusive Solutions (SIS)

Forests are natural sources of climate regulation, either through carbon capture (a result of photosynthesis) or due to other climate balance functions, such as the influence of forests in the hydrological cycle through the rainfall regime [i].  And deforestation itself is a major source of Green House Gases (GHG) emissions, because it releases the stock of carbon that was stored in the soil and on biomass, and contribute to biodiversity loss.

It is essential to understand that climate conditions depend not only of the GHG concentration in the atmosphere, but also on water vapour (which is another subproduct of photosynthesis of forest trees, as much as oxygen) in the atmosphere. In Brazil, for example, it has been proved scientifically that the water vapour of the Amazon Forest even moves for thousands of kilometers, directly affecting the rainfall regime in other regions of the country – a phenomenon that has been named “flying rivers”. [ii]

Also, given the fact that climate change increases significantly water risks, any factor that affects freshwater availability (and hence also human health and food security) should be regarded as a climate change relevant issue.

The commodities behind deforestation and forest degradation

According to data of FAO (Global Remote Sensing Survey) published during COP 26, agricultural expansion drives almost 90% of global deforestation, the vast majority of which taking place in tropical biomes.

Also, according to a study on Drivers of Deforestation published in “Our World in Data”, 60% of tropical deforestation is driven by beef, soybeans and palm oil.

Other commodities that are relevant drivers of deforestation are pulp and paper and rubber. At the Congo River basin, for example, according to Forest and Finance data, most of the forest-risk commodity finance goes to timber and rubber.

In absolute figures, the table below brings the top 10 countries for primary forest loss in 2020:

Source: FAOSTAT-Forestry database (2020)

Timber extraction, which is relevant in all the main three tropical forests basins (South America, Africa and Southeast Asia), is linked to very high rates of illegality, as described in the mentioned FAO report:

“Ensuring the legality of timber production and trade, and strengthening forest governance, are crucial for tackling deforestation. The International Criminal Police Organization (INTERPOL) estimates that the value of illegal timber trade lies in the range of USD 51–152 billion per year.59 The Convention on International Trade in Endangered Species of Wild Fauna and Flora (CITES) promotes the sustainable trade of approximately 300 timber species that are at risk of overexploitation through sustainability and legality standards. Demand-side commitments to legality, such as those made by both producer and consumer countries within the framework of the FAO-EU Forest Law Enforcement, Governance and Trade (FLEGT) Action Plan and associated bilateral Voluntary Partnership Agreements (VPA) processes, have shown that trade is an effective tool for incentivizing governance reforms to promote legal and sustainable forest management and economic development. Furthermore, demand-side legislation, including the European Union Timber Regulation (EUTR) and import regulation, the United States’ Lacey Act Amendment, Japan’s Clean Wood Act and the Republic of South Korea’s Act on Sustainable Use of Timber, among others, shape a global trade environment where the legality of timber imports must be demonstrated.

Voluntary certification is also a valuable tool and already covers more than one third of industrial roundwood production.60 Progress in addressing illegality requires continued commitments to transparency and to eliminating corruption, as well as adequate and predictable funding for enforcement. Effective law enforcement depends critically upon understanding and responding to the needs of indigenous peoples and local communities.61”

[Footnotes refer to Mitsugi, H. & Ikram Yaakob, M.S. 2018. Co-chairs summary report. Paper presented at CPF International Conference Working across sectors to halt deforestation and increase forest area. From aspiration to action. 14 March 2018, Rome, Collaborative Partnership on Forests]                 

      The role of the financial sector and recent global initiatives

Banks and institutional investors of course play a major role, since, without financing [viii], for example, large-scale forest exploitation operations wouldn’t be commercially feasible, because they require capital to buy equipment and machinery and to pay the costs of harvesting, processing and transporting to the markets. Analysis published by the UN-REDD Programme points out that, given the extent of illegal logging and illegal conversion of forest lands, exposure to companies that operate within wood products supply-chains is a risk for banks and investors, as the underlying companies face potential operational risks from disruption to supply and price changes. These companies represent both credit and reputational risks, meanwhile banks themselves face reputational risks in a global market where customers value the integrity of their banks, not to mention legal risks resulting from banking regulations and anti-money laundering laws [ix].

In the European Union, alongside the EU Legal Timber Regulation, the “Amsterdam Declaration” Towards Eliminating Deforestation from Agricultural Commodity Chains with European Countries, signed in December 2015 by major economies (UK, France and Germany) and also by some of the most advanced ones (Denmark, Netherlands and Norway) was the pioneer global initiative from governments. Nonetheless, the upcoming UK legislation on forest-risk commodities tackling illegal deforestation in supply-chains and the US-China Joint Statement on Enhancing Climate Action in the 2020s are clear signs of rising market risks for producers of these commodities, representing credit risk for banks and financial risks for investors who have them on their portfolios.

However, it is important to highlight, as pointed out by the research report of Our World in Data on Deforestation and Forest Loss, that only about 14% of deforestation is driven by consumption in rich countries (p. 11), once about 71% of deforestation-linked timber is for domestic production (p. 19), which makes clear that, with regards to credit, the involvement of banks from producing regions is relevant to any initiative that aims to have a positive relevant impact on reducing deforestation and forest degradation.

But, if investments are considered, there is a lot of funding channeled from developed countries (investors) to companies that operate in the countries where deforestation rates are high. And the banking sector has a leverage here both through investment banking and through asset management activities.

That is why recent global commitments of banks and investors are so relevant, but also need to be translated into action at local level and definitely need to focus the whole value-chain of the companies to which they lend or channel investments.

Last but not least, it is interesting to observe the latest developments of the Network for Greening the Financial System (NGFS), which is expanding its focus from climate risks to biodiversity risks, making it very likely that deforestation risks will soon come to the top of banking regulators agenda.