Deforestation: what could be the market impact of new EU ban?

The EU looks set to require companies to demonstrate that agricultural products they import do not contribute to carbon dioxide (CO2) emissions and climate change through deforestation.

The bloc is finally making efforts to ensure more sustainable consumption habits, with new legislation aimed at curbing deforestation and forest degradation linked to imported commodities such as palm oil and soy.

The expansion of agricultural land used to produce specific commodities, and the associated deforestation, has transformed some areas of the world into net emitters of CO2 from sinks capable of absorbing greenhouse gases (GHGs).

The proposed legislation envisages replacing EU demand for deforestation linked commodities with sustainable products and deforestation-free supply chains.

In its latest report published on 4 April, the Intergovernmental Panel on Climate Change (IPCC) reminded us that tackling land degradation and halting deforestation are key to reducing GHG emissions, an urgent priority to fight global warming.

Addressing tropical deforestation, among other natural climate solutions, could deliver more than one-third of the GHG savings required to meet the 1.5C target of the Paris Agreement.

Tropical forests hold more carbon than any other type of woodland and are home to the greatest diversity of species.

Focus on “imported” deforestation emissions

It’s clear investors in European companies and overseas countries linked to unsustainable production of commodities involved in deforestation need to consider the impending regulatory changes.

In addition, the changes also highlight material risks that can stem from demand-side mitigation measures and from behavioural shifts towards a more sustainable consumption.

More broadly, financial institutions could start to be exposed to risks arising from policies to protect the natural environment and reduce the depletion of natural resources.

Forests play an important role in the transition to net zero. They cover around 30% of the world land area, absorbing 2.6 gigatons of carbon dioxide (Gt  CO2) in 2020, according to the Food and Agriculture Organization (FAO).

That was one-third of the CO2 released from burning fossil fuels in 2020, underling the global importance of forests as a fundamental carbon sink.

Meanwhile, expanding agriculture is the main driver of deforestation and its associated carbon emissions have been estimated to account for about 20% of global “anthropogenic” CO2 emissions, or emissions associated with human activity.

There is a history of trying to address this issue.

In 2015 the EU, together with other United Nations (UN) member states, committed to stop deforestation by 2020. The pledge was incorporated into the UN’s Sustainable Development Goals, which are a blueprint towards achieving a more sustainable future.

Despite these efforts, EU consumption remains a major driver of global “imported” deforestation emissions linked to international trade of agricultural commodities. Imported deforestation emissions are defined as changes to carbon stocks due to forest loss and the impact of the subsequent land use.

The EU imports a significant amount of emissions due to deforestation, accounting for more than 100 million tonnes of carbon dioxide (Mt C02) annually (see chart 1, below). This is equivalent to the overall annual emissions produced by a country like Greece.

Other large countries like China, India and the US also drove important amounts of carbon emissions beyond their borders through their demand for agricultural commodities.

These imported deforestation emissions, however, have not historically been accounted for by policymakers.

Only emissions occurring within a country’s territory are accounted for as GHG emissions, according to the principles of the United Nations Framework Convention on Climate Change (UNFCCC) and IPCC best practices.

This implies that national GHG reduction targets and commitments by consumer countries ignore a significant source of emissions.

We often focus our attention on climate change risks stemming from the generation of CO2 in the production side of the economy. But behavioural changes and changes in regulation driven by the need for more sustainable consumption could make financial markets think of them from another perspective.

This change could result from linking carbon emissions to the demand for goods and services.

Between 2005 and 2018, the EU was the largest importer of deforestation emissions when it was responsible for 2.7 million hectares of deforestation, emitting 1,515 Mt CO2.

The bloc’s imported emissions accounted for more than 25% of all its agricultural emissions during this period.

For some countries, like Italy and Spain, imported emissions represent more than 40% of national agricultural emissions. For countries like Belgium and the Netherlands this share rises to above 65% (chart 2, below).

The new proposed EU regulations follow a fresh pledge made at UN’s COP26 climate conference in Glasgow last November.

In what was seen as one of the conference’s successes, 100 individual country leaders came together, as well as a number of companies, including Schroders, and committed to ending deforestation by 2030.

The EU regulation will cover legal and illegal deforestation and will impose mandatory due diligence rules on importers requiring strict traceability for six commodities that are the main drivers of land degradation.

These commodities are cattle, cocoa, coffee, palm oil, soya, and timber, where the EU plays an important role in the global demand.

Data from the FAO shows the EU accounted for more than 60% of global imports of cocoa, 50% of coffee imports and 30% of cattle imports (see chart 3, below).

The proposed ban signals a step change in Europe’s response to the pressing global challenge of deforestation and will help European countries reduce their carbon emissions.

The ban will also help address biodiversity loss that countries drive through their consumption of these key commodities. It is also set to lead to important shifts in EU trade towards “low risk” producer countries from “high risk” producer countries, affecting the economics of global trade.

More broadly, with the world moving to a low-carbon economy, more stringent policies to tackle climate change are likely to reduce market access for companies that fail to cut down emissions. With regulatory scrutiny set to intensify, we will start to see bans affecting revenues and reputational risks increasing.

Companies exposed to deforestation and biodiversity loss are also set to face the higher operational costs and to see a negative impact on their credit quality that will lead to higher funding costs.

Deforestation risk has also implications for countries’ sovereign health, affecting their capacity to issue debt and repay it consistently with environmental regulations. The loss of a country’s “natural capital”, that is elements of nature that provide important economic benefits, negatively affects its long-term performance.

Countries that heavily depend on the export of goods connected to deforestation may see their balance of payments hit by the EU import ban. This could occur through a reduction in export revenues given the importance of EU demand in global trade flows.

Between 2005-2018 palm oil, soy and cattle were the commodities with the largest embedded tropical deforestation imported emissions into the EU, followed by cocoa and coffee. The data shows that Indonesia, Brazil and Malaysia are the exporting countries mostly vulnerable to the new regulation.

The South-East Asian countries are exposed for their production of palm oil, with the EU importing the equivalent of €1.7 billion euros from Indonesia and €1 billon from Malaysia in 2019. From Brazil, the EU imported more than €1.6 billion euros of soy in the same year.

Given the importance of EU demand in the global trade of these commodities, the new regulation will have an effect on global levels of deforestation. It is possible, however, that EU supply chains will become deforestation-free while simply diverting the commodities, and the risk associated to their trade, to other markets, for example China or the US.

The EU ban should be seen as a stepping stone in tackling consumption-based emissions, but until we see similar bans being implemented by other large consumer countries, the risk of simply diverting emissions to other markets will remain elevated.

This highlights the need for global cooperation and coordination in the fight against climate change.