Regulatory risks
Guiding Definitions
Future risk: The potential negative impacts caused by the lack of preparedness for changes in laws, regulations, self-regulatory organization rules, and codes of conduct.
Present risk: The potential negative impacts caused by the violation of current laws, regulations, self-regulatory organization rules, and codes of conduct. Also known as “compliance risk.”
Background
In the past few decades, the world has seen an increase in environmental, social and governance (ESG) regulations, touching on issues ranging from indigenous rights to biodiversity protection. Companies and investors must now comply with a myriad of rules related to the protection of citizens and natural resources, including specific norms on deforestation, land degradation and human rights in production and supply chains. The number of climate change regulations alone has grown from 72 in 1997 to 1,500 globally in 2018.
Many nations , along with international bodies such as the European Union, are stepping up to the plate with regulatory measures affirming the need to stop deforestation, with particular attention being placed on products originating from areas with high deforestation rates. In addition, markets are increasingly requiring compliance with extra-governmental sustainability policies, including different supply chain standards such as No Peat, No Deforestation, no Exploitation policies and the voluntary Brazilian Soy Moratorium.
The lack of compliance with existing regulations can result in grave negative outcomes, from significant fines to orders to cease operations. Furthermore, for lagging companies, the uncertainty around possible legal and regulatory changes increases risk and highlights their need to prepare for compliance. For leading companies, these potential changes provide incentives for sustainable sourcing practices.
Examples of consequences
- Fines for lack of compliance with environmental and human rights legislation within supply chains.
- Suspension of certification due to violation of standard requirements.
- Stranded assets due to failure to anticipate stricter deforestation regulations.
- Financial losses because of additional time needed to adapt the business model to more rigorous labor laws.
Business Risks - Regulatory Examples
Illegal Logging
In 2016, Lumber Liquidators, the largest hardwood flooring retailer in the U.S., was criminally charged for importing hardwood flooring from China made of illegally-sourced timber, in violation of the Lacey Act. Lumber Liquidators made false declarations about the timber’s species and country of origin, and imported wood flooring products manufactured by Chinese suppliers out of timber originally harvested in Russia and Myanmar, making part of that timber illegal.
The company was required to pay a $13 million criminal fine, a $1.2 million community service fine, and forfeit assets related to illegal deforestation. It was also put on a five-year probation in which it had to fund independent environmental audits to verify its compliance with both a new environmental plan and the Lacey Act.
Illegal Fires
The Government of Indonesia has been increasing its efforts to penalize companies responsible for forest fires, including publicly traded companies producing palm oil. For example, in August 2016 Indonesia fined Sampoerna Agro $81 million for 2014 forest fires on 3,000 hectares on its concessions in Riau Province. The $81 million fine was slightly less than Sampoerna Agro’s revenue in the first six months of 2016.
In January 2019, the Indonesian Supreme Court upheld a $69 million decision against PT National Sago Prima, a sago-producing subsidiary of Sampoerna Agro, for forest fires in Riau in 2015. The ruling set a legal precedence for similar damage cases filed against other companies. In October 2019, the court in Palangkaraya ordered palm oil company PT Arjuna Utama Sawit to pay the equivalent of $18.6 million in fines and damages for fires that destroyed 970 hectares of forests in the Central Kalimantan province.
In September 2019, Indonesian authorities sealed off at least 29 palm plantations after fires were detected in their concessions, firmly enforcing the law to create a deterrent effect.
Illegal Deforestation
United Cacao used to operate the largest cocoa plantation in Latin America, and in 2014 it started pursuing an ambitious growth strategy that relied on rapid expansion of cocoa plantations in the Amazonian Loreto Region of Peru. The company raised capital through equity and debt markets, including an initial public offering (IPO) on the London Stock Exchange’s Alternative Investment Market.
This aggressive expansion, however, violated environmental regulations. As environmental groups publicized satellite images showing that primary forests had been cleared for the new plantations, the Peruvian Environment Investigation Agency scrutinized the illegal deforestation tied to United Cacao’s operations. One of United Cocoa’s subsidiaries was ordered to cease operations over illegal deforestation concerns. These issues violated the London Stock Exchange’s commitment to the U.N. Sustainable Stock Exchanges Initiative, and resulted in United Cocoa’s delisting from the Alternative Investments Market in 2017. The company declared insolvency the same year, and equity and debt investors lost an estimated $42 million.
Stranded Land
The increasing adherence of buyers to No Deforestation, No Peat, No Exploitation (NDPE) policies has made the expansion of palm oil plantations into existing forests and peatlands economically unattractive, since it carries the risk of exclusion from substantive markets.
Around 28% of existing oil palm concessions is thus considered a stranded asset for the purpose of palm oil expansion, imposing significant economic burden on the owners of these concessions. In addition, in September 2018, Indonesia adopted a presidential resolution putting a 3-year moratorium on new licenses for oil palm plantations on existing forests and peatland, and a review of oil palm licensing data.
Stricter Regulations
In July 2019, the European Commission adopted an E.U. communication on stepping up E.U. action to protect and restore the world’s forests. One of the action plan’s priorities is to reduce the E.U. consumption footprint on land and encourage the consumption of products from deforestation-free supply chains in the E.U. Among other initiatives, this plan launches an assessment of possible new regulatory measures, including stronger certification schemes for deforestation-free products and possible demand-side legislative measures. These forthcoming policies might significantly affect the importing of deforestation-risky products into the European Union.
France also launched its own national strategy to end the “importing of deforestation” by 2030. Its 17 goals include launching a zero-deforestation label for consumers and implementing a zero-deforestation policy for public purchases