Deforestation risk and due diligence

Deforestation as a systemic risk

Deforestation poses significant threats to ecosystems, biodiversity, human rights, and financial stability. Financial institutions (FIs) face material and reputational risks through exposure to clients involved in forest-risk commodities such as soy, palm oil, and timber, which contribute to over two-thirds of tropical deforestation. Regulations such as the EU Deforestation-Free Regulation (EUDR) and the UK Environment Act require stricter compliance, with timelines starting from late 2024 and mid-2025 for SMEs under EUDR. FIs must prepare for potential inclusion in these regulatory frameworks.

Deforestation regulations and mandatory due diligence

The EUDR mandates geolocation-based due diligence and risk assessments, with penalties for non-compliance including fines of at least 4% of EU-wide turnover. Similar regulations are in development in the US and other jurisdictions. While FIs are currently excluded, the EUDR requires a mid-2025 review to consider the inclusion of FIs in mandatory obligations. This guidance aligns with these developments, providing practical steps to mitigate deforestation risks.

Scope and target audience of this guidance

The guidance targets commercial lending, investment banking, and asset management. It emphasises the integration of deforestation due diligence into broader ESG frameworks. FIs are urged to ensure due diligence covers all business relationships exposed to deforestation risks, from producers to financiers.

Addressing gaps in data availability

Significant data gaps remain in supply chain traceability. Public tools like Global Forest Watch, Trase Finance, and Forest 500 are recommended for assessing deforestation risks. Examples such as NBIM’s 45 engagements on deforestation in 2022 highlight the role of collective action. Institutions are encouraged to prioritise high-risk exposures and demand improved client disclosures, using mechanisms like grievance reporting to identify gaps.

Integrating deforestation due diligence into existing risk management

Deforestation considerations should be embedded into existing processes such as loan assessments and ESG policies. ING Group exemplifies this integration through its Environmental and Social Risk Framework, which evaluates deforestation risks during credit evaluations. Tools like geospatial datasets and third-party platforms enhance due diligence capabilities.

Risk-based deforestation due diligence for financial institutions

Embed deforestation due diligence in existing policies

FIs are urged to integrate deforestation due diligence into governance structures and decision-making processes. This includes recognising deforestation as a financial risk and holding senior leaders accountable for rigorous implementation. An example is Allianz’s ESG framework, which assesses deforestation in sensitive sectors.

Identify and assess risk of deforestation, conversion, and human rights abuses

The guidance outlines a decision tree approach to identify and assess deforestation risks. Key steps involve evaluating clients’ involvement in high-risk commodities, production in deforestation hotspots, and policy commitments. For example, clients sourcing high-risk commodities from hotspots are flagged for enhanced due diligence. The Forest 500 scores provide a benchmark for assessing policy robustness.

Prevent and mitigate risks; monitor and remediate adverse impacts

FIs should engage clients to strengthen policies, improve supply chain traceability, and implement remediation plans. Failure to comply may result in terminated relationships or financial penalties, as seen in sustainability-linked loans where interest rates are tied to traceability progress. Institutions like Grieg Seafood use green bonds to fund deforestation-free supply chains. Monitoring through tools like Global Forest Watch ensures ongoing compliance and transparency.

Track, report, and disclose for accountability

Transparency through public disclosures signals commitment to deforestation-free finance and boosts stakeholder confidence. FIs are encouraged to report client engagement outcomes, risk categorisations, and progress on mitigation plans. Reporting formats should align with existing sustainability and ESG disclosures, as demonstrated by Aviva’s public voting policy against non-compliant directors.