Time to live off the interest not the capital — why financial institutions must address deforestation and conversion risks
Kayan Patel, Global Finance Practice, WWF International
With a new report, ‘Seeing the forest for the trees’, and dedicated website, WWF highlights the risks posed to financial institutions by deforestation and conversion and provides practical guidance for how private financial institutions can eliminate these risks from portfolios.
Forests and other natural ecosystems provide services of fundamental importance to human well-being, from regulating our climate to maintaining biodiversity and supporting human health and livelihoods. And estimates suggest that over half of the world’s GDP is moderately or highly dependent on nature.
We must balance humanity’s needs for resources with the need to sustain healthy ecosystems, protecting them from degradation and destruction, and living off the ‘interest’ they provide rather than eating into the ‘capital’ itself. But despite their importance, ecosystems are being destroyed at a rapidly accelerating rate: almost 50% of the world’s habitable land has now been lost, with half of this destruction taking place in the last 100 years.
Financial institutions are in a unique position to reverse nature loss and help restore natural systems. In 2019 alone, the world’s largest investment banks provided $2.6 trillion of loans and underwriting services linked to the destruction of nature. Redirecting these financial flows away from destructive activities towards nature-positive ones presents a powerful opportunity to tackle deforestation and the wider conversion of ecosystems for other uses, most frequently agriculture.
Why financial institutions need to care
While financial institutions can be a powerful driver of change, they are also highly exposed to the impacts of deforestation, ecosystem conversion and associated human rights risks. These risks can be categorized into three types.
- Physical risk results from the impacts of deforestation and conversion negatively affecting those businesses that depend on these ecosystems. This has a knock-on impact on the financial institutions that support or invest in them.
- Transition risk arises from policy measures, litigation, changing consumer preferences, and technological developments that come into force to combat the rate of deforestation and ecosystem conversion. Financial institutions not prepared for these changes are exposed to significant potential losses.
- Systemic risk refers to the larger-scale risk of the breakdown of an entire system. It is usually made up of a combination of tipping points that result in a variety of physical and transition risks.
In addition, there is no pathway to net zero without protecting and restoring nature, making it critical that financial institutions address their exposure to deforestation and conversion if they are to meet their bold net zero emissions commitments.
Financial institutions can take tangible steps to eliminate these risks
Financial institutions’ recognition of the importance of these risks is rapidly increasing. Deforestation took center stage at COP26 with over 30 financial institutions with over $8.7 trillion assets under management to eliminate commodity-driven deforestation from their portfolios by 2025.
The data, tools and methodologies exist to enable financial institutions to start taking action today. The first step is for a financial institution to develop a clear understanding of its risk profile and then a deforestation and conversion-free policy that effectively targets these risks. These components then provide the foundation for effective due diligence and engagement to monitor progress and support clients and investees to align their activities with the terms of the financial institution’s policy. Finally, a financial institution should report regularly to ensure recognition for progress made and pressure other financial institutions to take similar steps.
In our new report, we provide detailed guidance supporting the implementation of each of these steps and outline specific tools and frameworks that can be used at each stage of the journey.
The opportunity to profit commercially from investments in the protection and restoration of key landscapes is larger than it has ever been
Beyond directing capital away from activities that drive deforestation and ecosystem conversion, financial institutions are also well-placed to direct capital towards nature-positive activities that protect and restore these key landscapes. Interest in sustainable finance investments has grown rapidly in recent years, presenting an attractive commercial opportunity to profit from these instruments while delivering a positive environmental impact. The Global Sustainable Investment Alliance (GSIA) estimated that 36% of all professionally managed assets in 2020 were directed towards investments considering ESG factors, representing a growth of 55% over the previous four years. A recent survey of 2,000 capital market issuers and institutional investors by HSBC implies this trend is likely to continue, with 94% of issuers expecting to move away from environmentally- and socially-challenged business models within five years.
Financial institutions developing ‘green financial products’ and instruments and offerings that embrace sustainability can capture these opportunities. These include green bonds, sustainable fund investments, innovative insurance products and sustainability-linked loans.
There are clear signs that the world is starting to move fast to address deforestation and ecosystem conversion and its associated risks. The European Commission recently proposed legislation requiring all importers of forest risk commodities and products made from these commodities to prove they are deforestation-free. And the Brazilian central bank has stated it will require all banks operating in the country to conduct climate-related stress tests from July 2022, with the results having implications for the cost of loans to high-risk sectors. Given that the largest source of emissions is deforestation and land conversion, this is particularly significant for the agriculture and forestry sectors. Financial institutions must act quickly to align their portfolios with this evolving landscape of regulations and expectations, or risk being left behind.
Visit the full report website here to find out more.
