Why central banks need to consider deforestation and land conversion risk

Deforestation and land conversion are major drivers of nature loss and climate change and present financial risks that central bankers should be aware of. As WWF’s Greening Financial Regulation Initiative Introductory Guide shows, failing to address deforestation and land conversion may expose the financial sector to economic risk.

Forest ecosystems are home to a vast majority of terrestrial biodiversity but are jeopardised by a persistent trend of loss. Global deforestation reached 6.6mn hectares in 2022. At the same time, deforestation contributed to most of the average 13% of total carbon emissions attributed to forestry and other land uses between 2007 and 2016.

Deforestation and conversion are sources of financial risks that directly and indirectly affect the economy and the financial system. Banks and investors who fail to address deforestation are exposed to various financial risks, including physical risk from the degradation of nature and loss of ecosystem services, transition risk from a misalignment of actions to protect, restore and/or reduce negative impacts, and systemic risk.

More critically, the financial system itself also contributes to the destruction of these natural ecosystems by financing the production, processing, and trade of agricultural commodities. This is particularly the case for supply chain products such as beef, leather, palm oil, cocoa, coffee, pulp and paper, soya, and timber, with production taking place mainly in the tropical and subtropical regions.

Given the crucial role financial stakeholders play in enabling the economic activities driving these issues, and how this affects the global financial system, central banks, financial regulators and supervisors can complement existing policy and regulatory frameworks to mitigate the associated risks.

Double materiality, double opportunity for action

The financial system supports the production, processing, trade and retailing of commodities associated with deforestation and land conversion through the provision of credit and investments.

According to the latest Forest 500 annual report, since 2022, 150 financial institutions provided US$6.1tn to 350 companies exposed to tropical deforestation risk commodities. For example, JBS S.A. and Marfrig Global Goods, the two largest beef processors, received $26bn from creditors, while nearly $4.4tn was invested in palm oil buyers through loans, bonds, and shares.

The aggregation and accumulation of the impacts caused by deforestation and land conversion can often lead to physical risks which affect the economy and the financial system, disrupting supply of food and raw materials, and increasing supply chain costs. For example, the hot and dry summer of 2023 caused poor harvests and increased prices of several commodities worldwide, including cocoa, olive oil, rice and soyabeans. Such events reduce the profitability and solvency of companies that depend on these commodities, with potential effects on banks’ revenues, asset valuations and creditworthiness.

Moreover, regulations addressing deforestation and land conversion can also have direct effects through increased costs and reduced supply throughout supply chains, with knock-on effects on financial institutions. These transition risks include regulations, such as the EU’s regulation on deforestation-free products, which forbids certain products that play an important role in deforestation from entering the EU market.

Banks and investors are uniquely positioned to tackle deforestation through their engagement across value chains, financing decisions and encouragement of best practice and transparency among their clients.

However, financial institutions do not seem to recognise or acknowledge these risks, nor their opportunity for action. Existing commitments are only voluntary and have not been enough to achieve the global goal to eliminate deforestation by 2030, let alone the biodiversity and climate change goals. This is why they must be supplemented by mandatory measures, complementary policies and regulations from both the public and private spheres.

A shared responsibility

Central banks, financial regulators and supervisors are not meant to replace any governmental action but they can complement existing policies and regulatory frameworks in important ways. By using the policies and tools they have at their disposal, regulators play a crucial part in addressing the risks posed by forest and non-forest natural ecosystem conversion and degradation.

A handful of central banks and financial supervisors have started to take action on deforestation. Such is the case of the Bank Negara Malaysia, whose value-based impact assessment framework helps financial institutions integrate environmental considerations in relevant sectors, such as palm oil. Another example is De Nederlandsche Bank (DNB), which offers a guide with tools which financial institutions can use to mitigate deforestation risk. And the Banco Central do Brasil which has implemented an agricultural sector-specific policy on rural credit, and whose central bank agenda contains a sustainability dimension.

However, this handful of efforts are far from enough to drive systemic change within our financial system.

Regulatory support with a focus on a precautionary approach

Central banks and financial supervisors must take pre-emptive measures and implement policies that aim to halt the financial system´s contribution to deforestation and conversion.

Some of the measures financial supervisors can already take include issuing clear expectations for financial institutions to integrate deforestation and land conversion-related risks in risk assessment management, and integrating these within their due diligence on climate and nature. Additionally, central banks can already start assessing their contributions to deforestation and land-use conversion through their monetary policy portfolios, and account for the associated risks within tools such as refinancing operations and reserves tiering.

Ending the loss of forest and non-forest natural ecosystems in the face of financial risks associated with climate change and nature loss is in the best interest of central banks and regulators if they are to fulfil their mandates. The less the financial system is prepared to adapt to regulations and preferences that aim to halt deforestation and ecosystem conversion, the more difficult it becomes to prevent financial instability.

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