Will Amazon deforestation finally lead to a financing drought?

In January 2020, Brazil’s delegation to the World Economic Forum in Davos, populated by senior bankers, chief executives and headed by the country’s economy minister, Paulo Guedes, arrived in confident mood. The country had recently passed pensions reform that, along with the still-new fiscal ‘ceiling’ legislation, addressed international investors’ longstanding concern about the country’s precarious fiscal situation.

The Brazilians arrived sure that investors would be beating a path to their door to discuss investments in the country. Where else in the world was there such a large market, with the rule of law and such a dizzying array of investment opportunities being promoted by a new market-friendly government? “We were going to be in reality what Argentina under Macri had tried to be – only bigger,” says one delegate who was present.

It was, therefore, a huge surprise to many (and an unpleasant reminder for a few) in the Brazilian delegation when, instead of being the sensation of the conference, interactions proceeded warily.

“Again and again, conversations began with question about the Amazon and never really got constructive from there,” he explains.

For all the solid work that had been done on improving the country’s macroeconomic framework, the approach towards the Amazon of Jair Bolsonaro, president of Brazil since the previous January, was running the country very strongly against the prevailing environmental, social and governance (ESG) tide. Deforestation rates were up, enforcement of protective forestry regulations was down and Bolsonaro had become a very clear source of encouragement to those driving the waves of illegal penetration deeper into the Amazon rainforest.

Frustrated and chastened, the Brazilians returned from Davos disappointed. Later that year, in September 2020, the country’s three largest private-sector banks – Bradesco, Itaú and Santander Brasil – announced a tripartite agreement to address Amazon deforestation and promote sustainable economic activity in the region, with what was called the Amazon Advisory Council and is now called the Plano Amazonia. At the time, the then chief executive of Itaú, Candido Bracher, admitted to feelings “close to humiliation” that it took foreign investors and companies pushing for greater effort on sustainability for local banks to take action.

“The World Economic Forum [in 2020] was a great trigger, but there was already a collective awareness that something needed to be done,” says Carolina Learth, head of sustainable business development for Santander Brasil. Sponsored by their respective chief executives, the banks created an advisory board to develop a plan that would align their banks to support environmental conservation, encourage investment to “develop the bio-economy” and sustainable infrastructure, and improve the lives of Brazilians living in the Amazonian biome.

There was also the quietly spoken underlying objective to counter the growing ESG critique of companies operating unsustainably in the Amazon and the banks that finance them. International capital flows were rapidly becoming sensitive to financing that came with any such negative externalities.

Environmentalists had long tied the Amazon’s future to the world’s sustainability – it was the planet’s green lung – and now Brazil under Bolsonaro was seen as almost wilfully destroying large swathes of this vital natural resource. Deforestation in 2020 hit a 12-year high (over 11,000 square kilometres). Add in increasing climate change events and the exponentially larger flows to ESG-mandated portfolios and the external financial pressure seemed to be bearing fruit.

That global pressure is important and continues to build. Organizations like the Planet Tracker, the Investors Policy Dialogue on Deforestation and Forest and Finance continue to mobilize international investors to pressure Brazil to end rampant deforestation. However, local environmentalists see greater cause for optimism from a rapidly changing local appreciation of the impact of national climate change.

Despite the global warnings that the Amazon is reaching a tipping point where existing tree mass would no longer generate sufficient cloud-cover and rainfall, sending the forest into a ‘savannization’ death spiral, becoming hotter, dryer and less diverse, it’s the developing science – and experience – of hydrological change that is focusing minds throughout Brazil.

Paulo Barreto, associate researcher at Institute of People and the Environment of the Amazon (Imazon) says that: “Even within agribusiness there is growing dissent” against the recent high rates of deforestation. “Some of this is from business with international exposure – reacting to those pressures – but increasingly there is just an awareness from the local farmers. They are seeing what’s happening with rainfall and what that means to their crops. Brazil’s agribusiness sector is in big trouble because of the climate crisis.”

Recent research shows a very direct link to deforestation in the Amazon and changing rainfall to the south of the rainforest, where much of this agribusiness is located. For example, a study in Nature, called ‘Deforestation reduces rainfall and agricultural revenues in the Brazilian Amazon’, showed a direct correlation between forest loss and the mean long-term trend rainfall in nearby areas. According to the study, even when assuming a purely commercial basis for analyzing deforestation: “Widespread deforestation results in a negative sum-game where total reduction in rainfall outdoes local gains.”

The farmers and politicians don’t need to read Nature – Brazil is suffering its worst drought in 91 years. The impact is clear and goes far beyond agriculture. Brazil is famously a clean-energy country, with around 83% of power generated by hydroelectric dams and some river-flow generation. Low levels at reservoirs and rivers mean more expensive energy as thermal back-up power plants are switched on. This is part of the reason why inflation is now above 10% and it is also hampering economic recovery, as industry nervously looks at the growing likelihood of power rationing.

Organizations like Planet Tracker are using this hydrological weakness to pull the local and international threads together. It recently released a report, No Rain on the Plain, that looks at how deforestation reduces ‘evapotranspiration’ – the source of localized rainfall in the Amazon region – which in turn makes the country’s agriculture more fragile.

Peter Elwin, director of fixed income, head of food and land use programme at Planet Tracker (previously deputy head of European equity research for JPMorgan), points out that the farms in this region depend on two crops per year, which in turn depends on a stable climate with consistent rainfall and temperatures. With deforestation destabilizing returns, the country’s large agricultural export sector – primarily soy – is at risk.

Ultimately, Elwin’s aim for the report is not only to get investors in these sectors to assert pressure for policy change on deforestation but also to reach a wider range of investors – even institutional investors in Brazilian sovereign debt. For example, the report argues that export revenues could fall by $2.1 billion a year by 2050, equivalent to 6% of Brazil’s total export revenues for soy and maize in 2018.

“We want to use sovereign bond investors as one of the leaders to effect change, because it’s in their self interest because their portfolios are more at risk [from the negative economic impact of deforestation] than they were even three years ago – and that risk will continue to step up as deforestation continues,” says Elwin. “The other challenge is – and we haven’t modelled this yet – but my guess is that it’s not a linear progression. It will be a curve and there is a potential tipping point: if you turn the Amazon into a savannah, then that’s going to have a dramatic impact on climate in Brazil.”

Elwin concedes that some investors have investment horizons that are too short to factor in such analysis. However, he believes these will be the minority. “Generally speaking investors are still looking at a bond portfolio of at least five to eight years and it could feed into that kind of duration. Also, there are a growing number of investors who have their own ESG or sustainability policies – and that is beginning to seep through into [bond pricing].”

For this reason Elwin says that he thinks a sustainability-linked bond from the sovereign that is linked to deforestation targets would be a potentially good tool for Brazil. However, it is unlikely there would be sufficient faith among investors to agree to such structures with the current administration in power.

Sovereign bond investors are already getting involved. The Investors Policy Dialogue on Deforestation represents 55 financial institutions with approximately $7 trillion in assets under management. On January 29 the group spoke with Brazil’s vice president, Hamilton Mourao, to highlight to the administration the financial risks from deforestation. Mourao tweeted about the meeting and there were positive words exchanged between the groups, but deforestation rates have remained high.

Planet Tracker has focused on the soy industry because it generates more export dollars and is more sensitive to the changing hydrological profile of the southern Amazon. However, for environmentalists, the most problematic industry is the beef industry, which remains the biggest driver of deforestation. While soy often establishes itself upon deforested land, the primary driver of deforestation in the first place remains cattle farming.

Barreto says that far from trying to prevent the beef industry from expanding its territorial coverage in the Amazon rainforests, the state and its banks continue to subsidize these protein companies. He says that in 2020 the state provided $9.5 billion in credit to cattle ranching activities in all the northern states plus Mato Grosso – areas that have suffered most from deforestation.

According to Barreto there is a now a toxic mix of non-enforcement of existing forest protections and continued availability of subsidized financing for companies responsible for much of the deforestation. While Bolsonaro is responsible for a spike in illegal deforestation, he points to a 2012 decision effectively legalizing farmland that was the product of illegal forest seizure as a large cause of the problem. The remaining legal protections are also enforced slowly, with courts painfully slow to make judgements and open to delays and lengthy appeals. Meanwhile, state banks like BNDES have adopted internal rules that restrict loans to beef companies that source cattle from illegally occupied land, but these rules are being ignored.

“I talk to forest rangers and one of them told me that the illegal loggers believe that Santa Claus is coming – meaning they can deforest illegally and grab public lands because Bolsonaro is Father Christmas and he’s coming to legalize it all,” says Baretto. “So we are seeing a preemptive deforestation and land grab – and if there is a legal response, they ultimately believe Bolsonaro will go against the judiciary.”

Barreto has no faith in the current administration changing tack and becoming a force against deforestation. However, he feels that rather than excusing other participants, such as the private-sector banks, from blame for the deteriorating situation, it places even greater responsibility on the private sector.

“When you look at the past, deforestation is driven by policy and the market,” he says. “When policy is strong – even if the market is driving prices [of beef] up – deforestation is controlled and farmers invest in increasing the productivity of the under-utilized pastures we have. When policy is weak, then the market needs to react to push this process by refusing to finance activities that are directly leading to deforestation.”

Data from non-profit organization Forests and Finance shows that the leading three banks haven’t reduced financing for the most sensitive industries active in the region. Nor are they pushing such companies to accelerate their commitment to sustainability. For example, the slaughterhouses that operate in the area have committed to full traceability of cattle in the area by the end of 2025. Today cattle ranches that supply cattle to the slaughterhouses need to be registered, but there is little or nothing in the way of tracking of cattle before they arrive at those registered operations. This leads to ‘cattle-washing’, where illegal or unregistered farms supply slaughterhouses cattle via registered farms.

Is should also be noted that, combined, the financing by the three private banks behind Plano Amazonia is equivalent to roughly 50% of that by state-controlled Banco do Brasil, which didn’t respond to Euromoney’s requests for an interview.

The technology to prevent cattle-washing – and thereby prevent illegal deforested operations generating revenue – exists. In 2019 Euromoney visited Pecsa, a company that could guarantee the validity of the cattle on the farms it manages in the Amazon from conception to slaughter. Barreto points out that the deadline of 2025 is both unambitious and dangerous: at current deforestation rates the situation in the Amazon will be precariously worse in four years time.

Why then are the banks that created the Plano Amazonia not pushing their client companies for quicker adoption of such policies?

Marcelo Pasquini, Bradesco’s head of sustainability, says the problem is complicated. “We have been working with specialists in the region to see how we can do this. It is a very fragmented industry and you do not have a large concentration in the hands of a few players. If you take the top three frigerifocos [meat processing companies] they have a market share of only about 30% to 35%. And so a little bit of learning about the region is needed here.

“As you tighten the rules for some slaughterhouses, more and more is done on the sidelines [of the industry] and that can lead to even worse practices. So we need a balance and we need to ensure that we can trace the entire chain and that there are no hidden escape valves – it is important that we do this in a way that really works.”

Santander’s Learth agrees. “It’s a highly complex chain with many suppliers and we need to be able to manage the entire chain, which isn’t a simple thing. There’s no one more interested in getting these chains to adjust as quickly as possible than the banks, though, you can be sure of that.

“Companies such as JBS are receiving a lot of pressure, but the banks are receiving double that pressure; but we have listened to the meat producers and understand the complexity. This is not to say that nothing will happen until 2025. On the contrary, this year we are already implementing KPIs [key performance indicators] with these protein companies that we will monitor, starting from next year and then adjusting them in the coming years.”

But environmentalists aren’t convinced that the complexities warrant pushing back full compliance until the end of 2025. They point to the beef industry’s rapid adoption of full cattle licensing in 2001. In order to take advantage of the UK’s absence from the beef export market following the outbreak of foot-and-mouth disease Brazil needed to ensure all its cattle were vaccinated from the disease.

Previously its herd was for domestic consumption and there was a low rate of vaccination. However, with the carrot of export dollars the industry formalized full vaccination registries and saw a jump in annual exports, which were worth $8.5 billion in 2020. If full documentary history of cattle for vaccination purposes was possible 20 years ago, it is reasonable to ask why full cattle histories can’t be achieved in a similar timeline with the added advantage of 2021 technology?

Barreto argues that the banks involved in the Plano Amazonia could be powerful drivers of change by bypassing the federal government and working directly with municipal governments. He says that today satellite imagery can show the areas of highest deforestation, almost in real time, and the banks could say that they would pull out financing from these regions unless the local governments stopped deforestation within six months. He argues that even as a pilot experiment – targeting a few of the worst cases – such a policy could have a powerful effect on deforestation rates.

However, such aggressive enforcement strategies lie outside the scope of the Plano Amazonia. In fact, the banks are increasing their investment in the Amazon, albeit directed to sustainable retail, micro and small and medium-sized enterprise loans. Bradesco is the leader of the three banks in terms of this type of finance. It has operations in all 722 Amazonian municipalities with more than 1,000 service points and 3,600 banking correspondents – including a boat that travels 1,600km along the region’s rivers and, according to the firm, provides banking access for 250,000 people. Meanwhile, Santander is planning to expand its branch network in the Amazon to 58 from 27 and Itaú’s head of sustainability, Luciana Nicola (who responded to questions by email) says that the bank is developing targets to improve financial inclusion and entrepreneurship in the region, with a focus on financing micro, small and medium companies.

Sergio Leitao, executive director of Instituto Escolhas, a non-profit organization that promotes environmental sustainability, welcomes this extension of sustainable credit and thinks that Plano Amazonia is a positive development. However, he believes that as long as the three banks are financing any of the industries that cause deforestation – or financing infrastructure in the region that enables further deforestation to take place deeper into the rainforest – the negative impact of the banks’ financing will outweigh the positive commitment to improve sustainable businesses in the region.

If the focus of the Plano Amazonia underwhelms environmentalists, it has generated a more positive response among financial peers. For example, a report from Credit Suisse says that in its view Brazil’s large-cap banks: “Have taken the leading position in the ESG scene within the region, which was reinforced last July with the launch of the Amazon Plan by the three private banks in this segment, strengthening more specifically on the ‘E’ and ‘S’ fronts.”

Like beauty, progress on sustainability is in the eye of the beholder. The Plano Amazonia will have almost certainly help to shift the perspective of future attendees of World Economic Forums in Davos. It’s unlikely to make much of an impact on those attending the 2021 United Nations Climate Change Conference – COP26 – but, then again, those delegates look more to Brazil’s government than its private banks. And that is a problem that no one but the Brazilians going to the ballot box in 2022 can solve.