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April 22, 2022

The EU Deforestation Proposal: are key sectors ready?

Kachi Nwanna
Moody's ESG Solutions
VIEW REPORT

Deforestation and forest degradation are two of the major contributors to biodiversity loss and climate change. The United Nations Framework Convention on Climate Change has set out that forests act as a net carbon sink accounting for about 20% of the estimated annual carbon emissions. The Task Force on Natural-related Financial Disclosures, which recently launched a disclosure prototype, has identified deforestation as a driver of nature loss and a significant source of carbon emissions. According to the World Resource Institute (WRI), deforestation was responsible for approximately 8.3 gigatonnnes of carbon emissions between 2001 and 2020. The WRI also states that the major causes of forest cover loss are large-scale forestry operations, wildfires, shifting agriculture, and commodity-driven deforestation. Commodity-driven deforestation entails the permanent conversion of forests for commodity production including agriculture, mining, and oil & gas production, and it is associated with 103 million hectares of forest cover loss between 2001 and 2020. Products associated with deforestation are finding their way into end markets. A 2020 study found that 20% of soya exports and 17% of beef exports from the Amazon and Cerrado to the EU were likely to be “contaminated with illegal deforestation”.

Recognition of the need for action has been increasing globally. SDG 15 aims to protect forests, reverse land degradation and halt biodiversity loss. Forest management certifications such as the Programme for the Endorsement of Forest Certification (PEFC) and Forest Stewardship Council (FSC) have been developed to ensure forests are being managed in a sustainable way, preserving its biodiversity and mitigating climate change impacts. For stakeholders involved in palm oil, The Roundtable on Sustainable Palm Oil (RSPO) aims to transform the market in order to produce Certified Sustainable Palm Oil. Beyond that, the RSPO created a joint steering group, “No Deforestation Joint Steering Group”, which is a collaboration with the High Carbon Stock Approach to ensure requirements around No Deforestation are aligned and harmonized. Elsewhere, in 2017, a number of investors came together with global brands in a statement of support for the Cerrado Manifesto to halt deforestation and incentivize sustainable land management in the Brazilian Savannah. Governments and lawmakers, though criticized by environmentalists around Europe for lack of activity on this topic, are also beginning to take action. For example, at COP 26 leaders representing over 85% of the world’s forest pledged to halt and reverse deforestation and land degradation by 2030.

In November 2021, the EU published a legislative proposal which aims to tackle global deforestation and forest degradation by preventing the import of commodities linked to deforestation from certain countries which highly contribute to global deforestation (see Figure 1). The specific commodities mentioned in the proposal are beef, palm oil, cocoa, coffee, wood, and soy as well as derived products such as leather, chocolate, and furniture.

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This proposal is in line with the EU Commission’s commitment to “assess additional demand side regulatory and non-regulatory measures to ensure a level playing field and a common understanding of deforestation free supply chains”. The proposal recommends establishing a benchmarking system to identify countries presenting different levels of risk of producing commodities which are not deforestation free. This system will determine due diligence requirements; simplified for low-risk countries and enhanced for high-risk countries. In addition, it also proposes a partnership with producer countries to “address root causes of deforestation” and international cooperation with major consumer countries to “promote the adoption of similar measures”.

Key sectors that will be most impacted by the proposed upcoming regulation are likely to be food & beverages, luxury goods & cosmetics, pharmaceuticals & biotechnology, biomass energy generation, home construction, paper, and other forest products. Companies in any of these sectors may be labelled producers, traders or retailers as defined by the proposal, depending on their interaction with the relevant commodities in their value chain. They are likely to face potential market access risk, reputational and legal risks when the new legislation comes into force. For example, companies involved in producing paper products may encounter problems with sourcing raw materials essential for serving their markets, and luxury goods companies may face public backlash regarding the origin of the leather used in their products.    

Moody’s ESG Assessment data allows us to examine the preparedness and resilience of key sectors to the impact of any potential regulation on deforestation. Figure 2 below shows results of our analysis of three sectors at risk: Beverages, Food and Forest Products & Paper.  

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We see uneven performance in commitments companies make towards the promotion of sustainable agriculture and prevention of forest degradation. As of March 2022, 80% of companies in the forest products & papers sector have published such commitments compared to 47% and 53 % of the beverage and food sectors respectively.

     


Example: Mondi Group discloses targets alongside its deforestation commitments

Mondi Group, an integrated paper and multi-packaging solutions provider, published policies that commit to maintain zero deforestation in their wood supply by sourcing from healthy and resilient forests. The company also committed to responsibly sourcing 100% of its fiber with 75% FSC- or PEFC- certified fiber by 2025.


Article 10 of the EU legislative proposal outlines risk assessment and mitigation steps to be undertaken by companies on relevant commodities and products placed in the market. In general, Moody’s ESG Solutions assesses the risk mapping and the environmental impact assessment that companies carry out to determine the impact of overall operations on biodiversity. Given rising scrutiny, we should expect to see an improvement in the disclosure and quality of disclosure of the environmental impact assessment carried by these companies in the coming years. However, at present, lack of action by certain key sectors suggests a large gap to improve overall practice. For example, currently only 22% of companies in the food sector disclose the presence of environmental impact assessment or risk mapping within their own operations.

We also see that despite the high share of companies in the forest products and paper sector publicly committing to preventing forest degradation and deforestation, they lag behind significantly in disclosing steps taken to do so. None of the sectors highlighted have a majority of the companies disclosing the specific means put in place to prevent deforestation or promote sustainable agriculture within their business activities and supply chain. These means may include implementation of sustainable agricultural practices and the procurement of certified forest products in its supply chain.

 


Example: Danone Group and certification of forest products

Danone Group reports that 95% of its palm oil sources were certified by the Roundtable on Sustainable Palm Oil (RSPO). In addition, the company reports that 98% of its paper and board packaging are made of recycled fiber or virgin certified fibers (Forest Stewardship Council, Programme for the Endorsement of Forest Certification, Sustainable Forestry Initiative). Danone also reports on conducting environmental impact assessments and deforestation risks mapping. Danone communicates on a risk map for all its commodities, conducted with the help of an environmental consulting agency and a list of high-risk countries of sourcing has been developed with NGOs/consulting agencies.


Furthermore, the proposal specifically mentions due diligence requirements on relevant commodities and products supplied by each supplier. This implies that companies will have to perform an audit of their suppliers on deforestation risks. Our ESG Assessment covers the presence and the quality of dedicated environment audits in the supply chain. Across the major sectors that are exposed to the relevant commodities and their derivatives, few companies carry out such dedicated audits (Figure 3). Less than 30% of the companies in the pharmaceuticals & biotechnology, home construction, food, and beverage sectors disclose that they carry out dedicated supplier audits. Disclosure in the luxury goods & cosmetics sector (intensive users of soy, cocoa, palm oil in cosmetic products as well as leather for luxury goods) is slightly higher, at 37%. But overall low prevalence of dedicated environmental audits reflects a lack of understanding of supply chain deforestation risks and impacts.

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Our analysis finds that the key sectors at risk under the upcoming EU rules on deforestation lack the appropriate management and reporting frameworks to meet potential requirements to address deforestation risks despite overall better reporting on commitments to the issue. Addressing this imbalance and building further capabilities will be important, not least because the potential regulation may include more specific reporting requirements, such as reporting on geo-location coordinates of all land where the commodities and products are produced. To sum up, the proposed EU legislation highlights the need to fight inaction, expose poor practices and reward those who have taken steps to define and identify key material information that may be necessary to assess and mitigate inherent deforestation risks across business activities.  

Moody’s ESG Solutions provides insights and analyses on ESG themes and multi-stakeholder performance, climate-related risks and opportunities and global sustainable finance trends.

For more information, visit esg.moodys.io/esg-measures