The EU Deforestation Regulation – turning a blind eye to the role of EU banks and investors?
When the EU Commission presented its proposal for a Regulation on Deforestation Related Commodities, financial institutions were omitted from the text. This was deemed unnecessary considering the already existing EU initiatives in sustainable financing. As this story further unfolds, Roos Kolkman assesses the fitness of the EU initiatives to address the deforestation impacts of the financial sector.
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Introduction
In 2021, the world witnessed a 22% rise in deforestation in the Brazilian Amazon, which is now at a tipping point between carbon sink and carbon source and EU banks play a major role. In November of that same year, the European Commission (Commission) published its proposal for a Regulation on deforestation-free products (EUDR).
The EUDR sets mandatory due diligence obligations for organisations that import forest-risk commodities to the EU. Surprisingly, the proposal explicitly omitted financial institutions from its package of measures. The Commission reasoned that existing initiatives in the area of sustainable finance would be sufficient. Specifically, the EU Taxonomy Regulation, Corporate Sustainable Reporting Directive and the Corporate Sustainability Due Diligence Directive.
The amendments proposed by the European Parliament (Parliament), on the other hand, advocated for all financial institutions’ banking, investment and insurance activities to be included in the EUDR. The amendments introduced detailed measures for financial institutions. Most notably, Parliament introduced an obligation for financial institutions to establish that there is “no more than a negligible risk” that their services directly or indirectly support activities that contribute to deforestation, forest degradation or forest conversion before they may offer their financial services. Nevertheless, after months of lobbying, the provisional agreement solely mentions financial institutions to the extent that their inclusion will be reassessed no later than two years after the entry into force (expected in May/June 2023).
As this story further unfolds, it is important to assess whether the existing initiatives in the area of sustainable finance would indeed be sufficient to ensure that banks and investors can no longer profit from deforestation. Or, if the exclusion of financial institutions would instead undermine the aims of the EUDR.
Current sustainable financing initiatives
Is it enough? Spoiler alert - not quite.
EU Taxonomy Regulation (Taxonomy)
The Taxonomy offers a framework to identify ‘sustainable economic activities’ and aims to establish a common language for investors and participants in the financial market to promote sustainable investment decisions. With the starting pistol having fired on 1 January 2023, approximately 4,000 large companies are now required to report on their activities.
The Taxonomy does not ban investments that are not labelled green, rather it limits which investments can be called climate-friendly. In doing so, it prevents greenwashing and acts as a carrot for financial institutions to invest in environmentally friendly activities.
As such, deforestation-related activities are classified as non-climate-friendly, but the taxonomy does not actively prohibit investments that support such projects.
Corporate Sustainable Reporting Directive (CSRD)
As of 14 December 2022, the CSRD came into force and introduced more detailed reporting requirements for companies. The expansion of sustainability information should ensure that information is reliable, relevant and comparable to support more investments being re-directed to endeavours less harmful to the planet and its people. In this way, the CSRD aims to incentivize financing of the green and social transition. The CSRD offers more transparency of businesses’ impact on the environment and empowers consumers with information about the footprint of companies.
While the CSRD will ensure that more financial institutions need to report on the sustainability of their businesses, the Directive also does not specifically prevent or ban such institutions from investing or engaging in environmentally or socially harmful practices.
Corporate Sustainability Due Diligence Directive (CSDDD)
In February last year, the Commission shared a legislative proposal for a CSDDD – an initiative also known as ‘sustainable corporate governance’. The proposal lays down an obligation on Member States (MS) to ensure that companies conduct human and environmental due diligence and includes deforestation in its scope of application.
When it comes to financial institutions, however, the proposal is under pressure. Financial lobbying against financial coverage has been significant. For instance, the Dutch Fund and Asset Management Association (DUFAS), calls for the removal of investee companies from the Directive. The Dutch Banking Association NVB argues that banks should be exempted from civil liability. So far, their lobbying push has been successful. On 1 December 2022, the Council adopted their negotiating position for the CSDDD, including a compromise that it should be left to the individual MS to decide whether financial institutions will be included in the scope of the national transposition. One of the reasons raised is that legal responsibility to manage environmental risks is not suitable for the financial and investment sector.
While we have to wait and see which way the cat jumps – it seems that we cannot rely on the new CSDDD to offer the legislation needed to hold financial institutions accountable for their involvement in adverse impacts. Besides, the Directive will not be transposed any time before 2025.
Considerations
We do not have time to wait and see which way the cat jumps. In the midst of the negotiations on the proposal for the EUDR, the Forests and Finance Coalition in collaboration with 9 other NGOs published a very timely report that further highlights the role of financial institutions in global deforestation. The report summarises that from 2016 until September 2022, “banks have provided USD 267 billion in credit to just 300 forest-risk commodity companies operating in the world’s three largest tropical forest regions”. This is equivalent to the annual GDP of all of Finland.
Credit trends in tropical forest-risk sectors 2016-2022
It is evident that the EU financial sector significantly contributes to deforestation globally and that their actions need to be regulated to effectively halt further destruction. The current EU legislative framework to address this seems to have a number of loopholes, however.
Only carrots, no sticks
While the legal initiatives addressed earlier in this blog post do provide incentives that should steer investments away from deforestation, they do not strictly prohibit investments in the very activities that will be banned under the EUDR. In short, there will be many carrots for sustainable financing but no sticks that effectively stop financial institutions from contributing to deforestation.
A collection of studies conducted in recent years indicates that this might not be sufficient. For example, in the Netherlands, ING, Rabobank and ABN Amro are the three largest banks. In 2019, all three of these banks endorsed the Dutch Climate Agreement – the Intended Nationally Determined Contributions (INDC) of the Netherlands – and they also have sizeable documents on their sustainability ambitions. Nonetheless, these banks have collectively injected at least €3.1 billion in loans to forest risk products and activities between the adoption of the Paris Agreement and 2021.
“We manage the most relevant environmental and social risks while fostering the protection of biodiversity and human rights across all of our relationships.” – ING
This view is also supported by Triodos bank and 11 other financial institutions in the EU. In an open letter to the EU Commission, they urged MS and the Commission to stand with the Parliament and support the inclusion of the financial sector in the EUDR. The letter points to the failure of companies’ voluntary commitments to actively stop investments in practices linked to deforestation and stresses that the amendments provided by the Parliament on the inclusion of financial institutions would ensure that “the EU’s action to halt EU-driven global deforestation is not undermined by allowing the financial sector to continue financing the very same companies whose products would be anyway covered under the Deforestation Regulation”.
From this perspective, the rationale for including financial institutions in the regulation is straightforward: if companies are not allowed to profit from deforestation, then banks shouldn’t either. The CSRD and Taxonomy cannot actively guarantee this.
CSDDD in shambles?
A second concern is the potential watering-down of the CSDDD. There is now serious doubt that the financial sector will be covered by the Directive at all. In any case, the Directive will, not be transposed before 2025. The compromise text proposed by the Council and strong financial lobbying efforts indicate that a weakening of the CSDDD’s application to financial institutions is likely. One particular example of the potential ramifications for deforestation is the Council’s position to leave it up to MS to decide whether to include pension institutions in the scope of the Directive because they are considered social security schemes. Even though, these funds also contribute considerably to deforestation. For example, two pension funds in the Netherlands have invested in Brazil’s top three meatpackers – an industry known to be the main driver of deforestation in the Amazon. This means that if a MS decides not to include these corporations in the transposed CSDDD, and they are also excluded from the EUDR, there will be no EU regulation that can hold them accountable for grave environmental destruction.
No time to waste
Lastly, many things can be said for no longer stalling the implementation of the EUDR. At the same time, however, investments in activities have had such significant contributions to deforestation that their actions need to be regulated quickly and efficiently. Only this would ensure that EU financial institutions are covered by EU legislation in a way that effectively halts their investments into forest risk commodities whether these are imported into the EU or not. Waiting two years before a review is too long. By that time, we may have come to find that the CSDDD is entirely diluted in its obligations to financial institutions. Meanwhile, the institutions can continue to profit from the very same commodities that are protected under the EUDR.
Some have already described the EUDR as a paradigm shift for deforestation by moving from voluntary policy initiatives towards mandatory legislation for forest-risk commodities. While this indeed is applaudable, the many loopholes currently present for financial institutions and their contributions to the sector are concerning. It seems that the Taxonomy, CSRD and CSDDD don’t seem to be as suited as the Commission suggested they would be in addressing the deforestation impacts of the finance and investment sector. Rather than only creating incentives to transfer financial flows towards sustainable projects, the EUDR could offer an effective means to also drive investments away from deforestation-related activities and provide MS with the necessary enforcement mechanisms.
Global deforestation and its relation to climate change and biodiversity loss is an urgent challenge. The EUDR offers a perfect opportunity to quickly ensure that EU financial institutions are also covered by the forest protection regime of the EUDR.
This article was originally written by Roos Kolkman as a blog post assignment for the master Law and Sustainability in Europe (EU Climate Protection) 2022-2023, which is organised by the Utrecht Centre for Water, Oceans and Sustainability Law.