Financial institutions must address deforestation and conversion risks

Posted on June, 27 2022

In a new report, 'Seeing the forest for the trees - a practical guide for financial institutions to take action against deforestation and conversion risks', 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.

Financial Risk

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. 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. We must protect ecosystems from degradation and destruction, and live off the ‘interest’ they provide rather than eating into the ‘capital’ itself.

Financial institutions are highly exposed to the impacts of deforestation, ecosystem conversion and associated human rights risks. These can be categorized into three types.
  1. 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.
  2. 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.
  3. 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.

Eliminating risk and driving change

Financial institutions are in a unique position to reverse nature loss and help restore natural systems. And in its new report, WWF offers detailed step-by-step guidance on eliminating risks.

Step 1 - Understand material risks: Before being able to take action effectively, a financial institution must develop a clear understanding of its risk profile. This involves first understanding which regions and sectors carry the highest risk, and then mapping current clients and investees against this set of regions and sectors to identify which have probable exposure to deforestation and conversion risks.

Step 2 - Develop a deforestation and conversion free policy: Once a financial institution understands its risk exposure, the next step is to develop a policy that effectively targets these risks, ensuring sufficient breadth, including a credible target and setting clear expectations for clients and investees.

Step 3 - Conduct due diligence and monitor progress: Incorporate deforestation, conversion and associated human rights factors into ongoing risk management and other decision-making processes, assessing both existing and potential clients on their deforestation and conversion risk profile and mitigation efforts.

Step 4 - Engage clients and investees: Active, early engagement is essential to support clients and investees in their journey to align their activities with the terms of the financial institution’s deforestation and conversion free policy.

Step 5 - Report transparently: Regular, transparent reporting ensures recognition for the progress being made and generates pressure on other financial institutions to eliminate deforestation and conversion from their portfolios. 

Nature positive finance opportunities

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. Financial institutions developing ‘green financial products’ and instruments and offerings that embrace sustainability can capture these opportunities. Specific examples include:
  • Green bonds: Fixed income instruments aimed at raising funds for projects that deliver environmental benefits.Market interest in such instruments is growing at pace with more than US$200 billion in green bond issuance worldwide in the first eight months of 2021.
  • Sustainable fund investments: Portfolios of equities and/or bonds for which environmental factors are core to the investment process. These portfolios are rapidly gaining in popularity, bolstered by their returns becoming increasingly competitive against conventional funds.
  • Innovative insurance products: Insurance offerings facilitating risk management to promote environmental sustainability. A growing application of this product is to the management of risk to enable sustainable agriculture practices and resilient land management.
  • Sustainability-linked loans: Loan instruments that tie their conditions to the performance of the borrower against a set of predetermined sustainability objectives, applying higher risk premiums or lower interest rates based on performance against these objectives.
Download the report here and visit the dedicated website here.
Seeing The Forest For The Trees – a practical guide for financial institutions to take action against deforestation and conversion risks - June 2022