Alexandra Pinzon, Nick Robins and Gabriel Thoumi explore how investors in sovereign bonds can take action to confront the risks of deforestation.
2020 could well go down as the year that marked a new phase in investor engagement on deforestation, with the focus extending from the companies they own to the governments whose sovereign bonds they hold. The focus has been on Brazil, where a sharp increase in deforestation over the past year has been matched by a surge in investor dialogue with key government authorities. This has already generated results, but further action is needed to ensure that deforestation is eliminated, not only to protect the environment and the rights of indigenous peoples, but also to underpin the long-term health of sovereign bonds from natural capital-rich countries such as Brazil.
A deteriorating situation
Deforestation in Brazil has worsened for the past 13 months and is likely to reach levels not seen since 2008. According to data from the Brazilian Institute of Spatial Research (INPE), deforestation expanded by 12 per cent in May 2020 compared with May 2019. Between August 2019 and May 2020, INPE’s monitoring system has produced deforestation alerts for 6,499 square kilometres in the Amazon, with an increase of 78 per cent relative to the same period last year. The increased deforestation rate means that, while the world as a whole is seeing a reduction in greenhouse gas emissions as a result of shutdowns in response to COVID-19, Brazil could see a rise.
Compounding the situation is the new provisional measure proposed to legalise rural properties and settlements of up to 15 fiscal units[1] in Brazil, replacing a pre-existing rule that is expiring. The two main requirements to regularise these settlements are: first, that the Environmental Rural Registry (CAR in Portuguese) is active for the rural settlement and second, a declaration that the land has been occupied since before 22 July 2008. There is widespread concern that the new bill opens the door for further deforestation in the Amazon, with severe consequences for climate, biodiversity and natural capital goals. In response, more than 40 European companies have warned of their plans to boycott Brazilian products should the bill pass.
Leading investors also believe that the proposed law for rural settlement regularisation could result in more deforestation and undermine the continuing access of companies operating in Brazil to international commodity markets. Deforestation presents a risk not only to companies but also to Brazil’s future macroeconomic performance and thus the holders of the country’s sovereign bonds. As a result, it is imperative that the Brazilian government and investors consider these sovereign health risks and make the necessary changes in public finance and policy to protect the country’s natural capital, which underpins both the achievement of the Sustainable Development Goals (SDGs) and the country’s debt-paying capacity.
Investors step up the pressure
Investors are increasingly involved in addressing deforestation, engaging with meat and soy producers and traders and some are even disinvesting from companies that deviate from investment guidelines. Last year, the forest fires in the Amazon prompted a group of 251 investors with US$17.7 trillion in assets to sign a statement led by the UN-backed Principles for Responsible Investment and the sustainability non-profit organisation Ceres to call for the elimination of deforestation in the supply chains of companies operating in or sourcing from Brazil. Deforestation and its impacts on climate, together with concerns about Brazil’s credit quality, led to Nordea Asset Management suspending Brazilian sovereign bond purchases for its Emerging Stars Bonds Fund. This suspension remains in place.
This year’s increase in the rate of deforestation has now triggered a call by more than two dozen financial institutions for the Brazilian government to halt deforestation, highlighting the uncertainty that this brings to their investments in the country. As a result, a group of investors with over US$4.6 trillion in assets, including Norway’s largest pension fund, KLP, Nordea, Storebrand and other investors, have engaged with Brazil’s government and central bank to discuss more robust and predictable policy frameworks to protect nature.
Following the first high-level meeting of this group, the Brazilian government issued a temporary fire ban in the Amazon. The first meeting was evaluated as positive by investors but they emphasised their intention to continue assessing Brazil’s progress in five areas: reducing deforestation rates, enforcing the Forest Code, strengthening the capacity of environmental and human rights agencies to carry out their work, preventing forest fires in or near the Amazon, and boosting transparency on deforestation, forest cover and supply chain traceability data. This engagement by international investors has also prompted Brazilian companies to issue statements calling for the halting of deforestation.
Making the links with sovereign bonds
Deforestation also has implications for Brazil’s sovereign health, in other words its capacity to issue debt and repay it in a manner consistent with achieving the SDGs. Currently, few market participants are pricing the value of sustainability for sovereign bonds.
In our February report The Sovereign Transition to Sustainability, we concluded that the preservation and regeneration of natural capital needs to be fully incorporated into the issuance, management and analysis of sovereign debt, particularly for countries such as Brazil who rely so heavily on nature for their prosperity. The continuing deterioration of the forestry situation in recent months underscores the need for governments to recognise and incorporate their dependencies on natural capital in macroeconomic policy and public finance strategies. Natural capital risks affect sovereign performance on institutional, economic, external and hazard factors, which in turn amalgamate in their fiscal performance.
The perceived weakening of environmental regulation enforcement in Brazil is the first area to address to strengthen the policy and institutional pillar. The current trends in deforestation combined with the provisional rural settlement regularisation bill are particularly worrying ahead of the 2020 fire season.
In a context of wider economic uncertainties, Fitch recently revised Brazil’s Ratings Outlook to ‘negative’, maintaining its Long-Term Foreign Currency Issuer Default Rating at BB- because of political uncertainties, lower oil prices, and a weak balance sheet as it enters in a recession. Latin America’s largest economy deficit is forecast to achieve 13 per cent of GDP, which is almost twice the ‘BB’ country median of 6.8 per cent, due to the economic recession. Its five-year credit-default swap is now at its widest since 2016.
Continued forest loss threatens Brazil’s ability to continue its agribusiness production and export leadership into the future. The materialisation of these natural capital risks would cast a shadow on Brazil’s future debt-paying capacity. The clear interest from the Brazilian Ministry of Agriculture in attracting international finance to support the sustainable development of the sector with a pipeline of projects reaching US$163 billion so far, and its willingness to engage with international investors is a very welcome step. These efforts can be built upon at the sovereign level. Promoting sustainable development is of critical importance now that Brazil’s government debt burden is forecast to increase from 75.8 per cent of GDP in 2019 to 89.4 per cent of GDP in 2020, and the IMF is forecasting Brazil’s GDP contracting by 9.1 per cent in 2020.
A turnaround in Brazil’s environmental performance, notably through a credible pathway to zero deforestation, is not only urgently needed to protect the country’s natural capital and the human rights of indigenous peoples: it is needed also to underpin the country’s long-term attractiveness as an investment, both in terms of its companies and its sovereign bonds. In the weeks and months ahead, sovereign investors can make a real difference in connecting these two agendas in their continued engagement with government bodies.
Alexandra Pinzon and Nick Robins at the Grantham Research Institute, with Matt McLuckie and Gabriel Thoumi at Planet Tracker, are authors of The sovereign transition to sustainability: Understanding the dependence of sovereign debt on nature, which has won the 2020 Sustainable Investment Award for ESG research innovation of the year from Environmental Finance magazine.
[1] Depending on the region, a fiscal unit varies from 5 to 110 hectares
