Investing in sustainable landscapes: It’s time to take the risk

Originally posted on CIFOR’s Forests News:

By Thomas Hubert.

BOGOR, Indonesia: If a tree falls in the rain forest, do investors care if it really fell ….or was it chopped?

More investors than ever before do care about how and why a tree hits the forest floor. And for public and private investment sectors, there are sophisticated ways of channeling funds to sustainable landscapes, through projects such as verified farming, forestry or mining ventures that avoid deforestation and respect local communities’ rights.

Investments like these in tropical landscapes, are often exposed to higher risk, for example by money being spread over countless smallholder farmers in remote areas, or working in countries with poor governance records.

Projects may also be interrupted due to local resistance or by failing to make a profit.

Some financial institutions have designed structured funds in which government-backed agencies from donor countries take equity shares bearing the first loss in case of poor performance.

It is increasingly apparent to investors that there is a risk of becoming involved in the production of ‘dirty stuff’ … commodities associated with deforestation and social problems

More senior (i.e. safer) tranches of the funds can then be based on debt rather than equity, guaranteeing that the capital is shielded from losses, which attracts private investors.

The European Investment Bank is one of the institutions creating and backing such tools, including the €200m Global Energy Efficiency and Renewable Energy Fund.

The GEEREF started with funding from the European Union, Norway and Germany, later joined by private investors, who are guaranteed a preferred return. It invests into funds focused on renewable energy and energy efficiency projects in developing countries.

The EIB “brings experience in layering project risk in tranches and relaying that risk to appropriate investors,” said its managerial adviser for structured transactions and fund investments James Ranaivoson.

“We think this is the best way of leveraging public money and the way forward for climate finance.”

GOING GREEN, GOING GLOBAL

Research director on forests and governance at the Center for International Forestry Research (CIFOR) Steven Lawry said that such schemes are no longer confined to “boutique, impact investors” and the failure to meet sustainability criteria is now on the agenda of mainstream investors.

“It is increasingly apparent to investors that there is a risk of becoming involved in the production of ‘dirty stuff’, i.e. commodities associated with deforestation and social problems,” he said.

This can have a very direct financial cost, said Coralie David, policy analyst on investment in agriculture at the OECD.

A study of 39 large-scale agri-business investments by the World Bank and the UN Conference on Trade and Development showed “that the most prominent adverse impacts were disputes over access to land. Companies often underestimate the costs of conflict with affected communities,” David said.

She also quoted a study by the Shift Project in 2014 in which one company estimated the potential costs of the non-technical risks of its various projects at more than USD 3 billion per year, representing a double-digit percentage of its profits.

Reputation is also a key factor here, said David, as NGOs are quick to relay knowledge of unsustainable production to increasingly conscious consumers in developed countries.

While institutional investors such as pension funds are usually remote from the companies they finance in frontier markets, private equity funds directly participate in their capital.

“They are closer and have a responsibility to identify and mitigate risk,” she said.

“If they are funding an agri-food company that expropriates local communities, they are exposed to reputational risk.”

Reputation is important for large companies, but industry standards offer less of an incentive to smaller domestic producers: their risks are different

She noted that major agri-food companies, including Coca Cola and Pepsico, had made strong commitments to limit adverse impacts on local communities in order to reduce that reputational risk to their brands.

CONSUMERS AND SOCIAL MEDIA

Several of the sessions at the Global Landscapes Forum meeting on investment in London on 10 June will address risk-based approaches to investment in tropical landscapes.

One of them will discuss the role of the insurance industry: if poor sustainability constitutes a risk, could investors insure themselves against it and insurance companies put a market value on it?

CIFOR’s Lawry said awareness of sustainability requirements has already translated into general risk management by the financial industry.

“As an impact investor put it to me: if you want to produce dirty stuff, we will loan you the money – but at a higher interest rate to reflect the higher risk associated with increased consumer scrutiny,” he said.

Lawry believes that this shift is part of a wider movement in the management of tropical landscapes: after 200 years of state ownership of forests and agricultural land, the rise of consumers, media (especially social media in recent years), and investors agitating for sustainable production has reduced the role of traditional government regulation.

“A growing proportion of commodities are now produced under non-state governance agreements” such as certification schemes or voluntary industry initiatives, he said.

Lawry’s colleague Sophia Gnych has studied the motivations of companies applying such voluntary market-based standards.

“Risk is key,” she said. “This is about self-preservation.”

But, she said, not all stakeholders in tropical commodities supply chains see it the same way.

“Reputation is important for large companies, but industry standards offer less of an incentive to smaller domestic producers: their risks are different,” she said – especially in view of the high costs associated with the mitigation of sustainability risks.

One asset management company putting this new approach into practice is US-based Calvert, whose chief executive John Streur spoke at a panel discussion organized by CIFOR as part of last March’s World Bank Conference on Land and Poverty .

Streur said Calvert managed $13.5 billion in investments in companies that properly address “environmental, social and governance” risks in their operations.

The firm conducts a “traditional investment analysis” on them, Streur said, as well as assessments on environment, indigenous peoples’ rights and other sustainability criteria.

As an impact investor put it to me: if you want to produce dirty stuff, we will loan you the money – but at a higher interest rate to reflect the higher risk associated with increased consumer scrutiny

The financial sector can contribute to “a sustainable systems approach to de-risk supply chains,” said Streur, by creating tools such as “zero-deforestation/zero-degradation indices to benchmark performance” or “prohibiting the use of child and forced labor and development on High Carbon Stock, High Conservation Value, and peat lands”.

Once committed investors have a stake in companies exposed to those risks, Streur said they should “engage with them in the boardroom” to monitor and improve their practices.

INTERNATIONAL STANDARDS

To help investors find their way through the maze of existing international standards on responsible investment, the OECD and the United Nations Food and Agriculture Organization have developed a Guidance for Responsible Agricultural Supply Chains that will be published shortly after June’s Global Landscapes Forum.

This guidance “narrows the list down of standards to the ones that are widely recognized through inter-governmental processes,” said Coralie David.

These include the OECD Guidelines for Multinational Enterprises to which 46 countries adhere and which includes a grievance mechanism to sort out disputes; and thePrinciples for Responsible Investment in Agriculture and Food Systems developed by theCommittee on World Food Security.

The World Bank’s global coordinator for land governance assessment framework, Thea Hilhorst, said that analysis of inventories by national statistical agencies of all investment projects for which land was assigned by governments to both local and international investors, could generate data and benchmarks needed by governments to screen incoming companies.

“Who of the investors is actually farming and what is land use and productivity? What are the benefits for local communities in terms of employment and other spillover like technology on smallholder farming? Are ground rents and taxes being paid?” were among the questions she said should be documented.

“Giving governments this data can help them assess the risks associated with new projects and design a policy for failed investment. If existing ones are not performing, this land could be reallocated to new projects rather than open new forests,” Hilhorst said, but warned that screening all investment projects against sustainability criteria was labor and knowledge intensive and requires capacity.

And as trees continue to fall in the forest, CIFOR’s Lawry said that scientists are interested in measuring the impact of initiatives driven by the non-government sector.

“If zero-deforestation industry pledges are implemented, will they have more impact than REDD+, which is a state-centric model?” he asked.

“We’re focusing on this – and we are excited about it.”