Deforestation Risk and German Financial Institutions Assessing and quantifying German exposure to companies without policies in place to mitigate deforestation risk Developed by: In Association with: Supported by: Report Cove | Table of Contents | DEFORESTATION RISK AND GERMAN FINANCIAL INSTITUTIONS EXECUTIVE SUMMARY 1 INTRODUCTION 5 SECTION 1: UNDERSTANDING DEFORESTATION 6 RISK SECTION 2: METHODOLOGY 10 SECTION 3: RESULTS OF FOREST 500 ANALYSIS 12 SECTION 4: RESULTS OF ORBITAS ANALYSIS 21 SECTION 5: CONCLUSIONS AND 23 RECOMMENDATIONS Authors: Josh McBee and Niamh McCarthy With Contributions From: Ameer Azim, Linh Nguyen, and Mark Kenber Deforestation Risk and German Financial Institutions | 1 Executive Summary Meeting the goals of the Paris Agreement will require transformations in every sector of the global economy. These systemic shifts – and the new sources of risk they present - are already widely recognized in the energy and transport sectors. However, the impacts of climate change and the transition to a net zero carbon economy are less well-understood elsewhere, including agriculture. Global agriculture and other land use contributes twenty-three percent of anthropogenic greenhouse gas (GHG) emissions, in large part because agricultural activity is a key driver of forest loss, especially in tropical regions.i Because tropical deforestation will have to end in any reasonable scenario that keeps the global average temperature rise close to 1.5 degrees, the agriculture sector is exposed to a range of financial risks as the international community pursues strategies to mitigate climate change, reverse biodiversity loss, and meet the UN Sustainable Development Goals. These risks include policy and legal risks, technology risks, market risks, and reputational risks. Commodity producers and traders have already been in the spotlight due to their direct links to activities causing deforestation as high-profile investors increasingly push for action on deforestation from both companies and governments. For example, in June 2020, investors with USD 3.7 trillion in assets under management signed a letter to the Brazilian government citing fiduciary duty to shareholders and the “widespread uncertainty about the conditions for investing in or providing financial services to Brazil.”ii According to Orbitas, upstream producers also face a real risk of asset stranding, as some landholdings are likely to become impossible to develop as a result of policy or market shifts.iii However, deforestation risk is far from limited to direct investments in upstream agricultural producers and midstream traders. Downstream wholesalers and retailers have been taking increasing actions to prevent reputational damage as a result of supply chain linkages to deforestation. In late 2020, for example, seven French retailers committed to including no- deforestation clauses in supplier contracts.iv Previously, over 40 British retailers threatened to boycott Brazilian commodities if legislation was enacted that would have paved the way for a rise in deforestation rates.v Government actions have amplified the financial risks of sourcing commodities linked to deforestation, as France, the UK, Germany and the US all have either enacted or are considering measures to reduce imports linked to tropical deforestation abroad.vi As government policies are adopted to increase supply chain transparency and prevent forest risk commodities from entering supply chains, impacted downstream companies are likely to face a combination of supply chain disruptions, reputational damage, legal fees, and ultimately an increase in their cost of capital if these risks remain unmitigated. Despite this and the fact that climate-related risks affect almost all capital providers to a greater or lesser extent, agricultural sectors are often overlooked by investors working to mitigate climate risks. This is due to a lack of awareness, the sector’s relative complexity, inadequate measurement tools, and the absence of reliable data, among other factors. In fact, when Orbitas recently surveyed 24 capital providers--all of whom had tropical commodity exposure--not one had screened their loan books and/or investment portfolios for agricultural transition risks.vii As a result, the likely disruption brought about by climate transition to the sector as a whole continues to be a blind spot in the investment decision and allocation process. climateadvisers.org Deforestation Risk and German Financial Institutions | 2 In order to better understand the exposure of the German financial sector to unmitigated deforestation risk, this report quantifies German loans to and holdings in two categories of companies that operate in forest risk commodity sectors, those with weak deforestation policies and those with outsized stranded asset risk. These act as a useful proxy for understanding broader exposure to deforestation-related risks. The aim is not to “name and shame” those institutions with particularly large exposures but rather to provide insights to type and scale of risks that German investors and lenders face and suggest ways that this risk can be better understood and mitigated. In so doing, financial institutions will contribute to protecting both forests and their investments. Key Findings • German financial institutions have minimal exposure (USD 3.2 million) to upstream companies with stranded assets risk in the Indonesian palm oil sector, indicating that German financiers do not generally lend directly to producers of tropical agriculture and/or are generally employing deforestation risk mitigation policies and processes to reduce direct exposure to deforestation risk. • However, German financiers have considerable exposure to commodity manufacturers and retailers without the policies and processes in place to mitigate deforestation risk, including at least USD 17,166 million in shareholdings and USD 1,504 million in loans. • While these companies are only indirectly connected to deforestation by way of their suppliers, reputational damage associated with exposure to them can have significant financial implications. • Moreover, if not assessed and managed carefully, restrictions on deforestation can lead to supply chain disruptions, increased input prices, and output price volatility that could affect the ability of companies to repay loans and maintain their market value. climateadvisers.org Deforestation Risk and German Financial Institutions | 3 Key Recommendations Although German financial institutions’ direct exposure to agriculture-related deforestation is relatively low, this does not mean that the risks can be ignored. If left unmanaged, their indirect exposure has the potential to cause reputational damage, affect the creditworthiness of food manufacturers, wholesalers, and retailers, and lead to poor investment decisions. Banks and investors can mitigate exposure to deforestation risk – and capture the opportunities that climate transitions and adaptation strategies bring - in a number of complementary ways, including: • Requesting clients to assess and disclose agriculture and land use-related climate transition risk and vulnerability as recommended in the TCFD guidelines. Some global agricultural companies like Olam have already hired in-house practitioners or outsourced consultants to assess climate transition risks; investors should encourage and/or require all investees to do the same. • Assessing in-house and client exposure to climate and climate transition risks based on information disclosed by clients and analytical research. • Working with clients to ensure they understand and manage the risks to their supply chains from climate impacts and climate transitions, eliminate deforestation, and thereby build in greater resilience to climate change-related external shocks. climateadvisers.org Deforestation Risk and German Financial Institutions | 4 • Predicating lending to, and investment in, producers on adopting sustainable practices and sourcing from sustainable suppliers. Sustainable investees protect investors from immediate reputational risks while also acting as a hedge against future climate transition risks. • Providing favorable financing for profitable emissions mitigation measures, sustainable yield enhancements, and technology innovation. • Engaging with policymakers to support financial stability regulations and to standardize climate risk disclosure throughout the financial sector. climateadvisers.org Deforestation Risk and German Financial Institutions | 5 Introduction Accounting for 16-19 percent of annual global greenhouse emissions, tropical deforestation is responsible for a larger share of anthropogenic CO2 emissions than all other sources except for fossil fuel combustion.viii In fact, emissions from tropical deforestation are so high that, if tropical deforestation were a country, its emissions would be the third highest in the world.ix In addition to exacerbating climate change, deforestation threatens the tremendous biodiversity present in tropical forests, as well as the ancestral territories of forest-dependent communities, whose lands— in some cases sacred, and often integral to traditional cultures and lifestyles—are sometimes deforested without their Free, Prior, and Informed Consent. Ending deforestation is therefore critical, not just to the fight against climate change, but also to efforts to ensure the continued existence of unique and endangered flora and fauna and to safeguard the human rights of forest- dependent communities. While