Major new EU regulations on deforestation are being introduced that will force companies to trace their input materials. These rules are a firm step in the right direction towards protecting biodiversity, and will create more transparency for equity and bond investors. More broadly, the economy must transition to a more sustainable footing, and this means opportunities for innovation directly linked to the regulations and indirectly in tangential industries such as automation and efficiency tools.
  
Between this year’s International Day for Biodiversity on 22 May and next year’s, we will see some major new EU regulations on deforestation. From December 2024, companies trading in the EU will have to demonstrate that the import and sale of commodities linked to deforestation, including timber, palm oil, soy, and beef, do not contribute to deforestation or forest degradation. This means companies are going to have to trace their input materials, which is not an easy process.

While we have questions about the detail of the regulations and potential loopholes, the rules are a firm step in the right direction in helping companies and investors understand and manage both risks and opportunities. These regulations will have an increasing impact on equity and bond investors over time. As an asset manager, we are engaging with companies about the key deforestation-risk commodities. More broadly, the economy must transition to a more sustainable footing, and this means opportunities for innovation directly linked to the regulations and indirectly in tangential industries such as automation and efficiency tools.

A deforestation-free market

The EU is implementing new regulations aimed at addressing the environmental impact of deforestation. Under these regulations, companies must ensure that the commodities they import or sell in the EU market comply with certain sustainability criteria, particularly around deforestation. EU states consumed products contributing to an estimated 19% of global tropical deforestation between 2008 and 2017. These regulations are intended to combat deforestation by promoting sustainable practices and encouraging the use of certified sustainable commodities.

Under the EU deforestation regulation (EUDR), from 30 December 2024 (or 30 June 2025 for micro or small businesses), it will be prohibited to place certain deforestation-related products on the EU market or export them from the EU, unless they are:

• 'deforestation-free' (relevant products were not produced on land that was converted from forest to agricultural use, whether legal or illegal, after 31 December 2020)
• produced in accordance with the relevant legislation of the country of production,
• covered by a due diligence statement indicating no more than a negligible risk of non-compliance.

The last point is key because it mandates companies to prove compliance, so they will have to trace their inputs to the original plot of land that was used to cultivate the raw materials using precise geolocation data with GPS coordinates. This makes the regulations challenging but potentially effective as it encourages traceability of supply chains.

The laws relate to numerous commodities including palm oil, soy, wood, cattle, cocoa, coffee, rubber, and derived products (for example, leather, chocolate, tyres, and furniture). According to one independent report, these imports and exports account for €85 billion in trade, and the law covers around 60% of all EU agricultural imports.

EUDR targets commodities with highest contribution to deforestation

While the main requirements of the EUDR will apply from December, the impact is being felt today. The obligations will affect the ability of companies to market relevant products because businesses must ensure that items entering the EU market did not originate from land that has been deforested or exposed to forest degradation since 31 December 2020.

The exact framework for breaches is still unclear, but the EU can fine companies with the most significant and consistent breaches more than 4% of their EU turnover. These companies can also be temporarily excluded from public procurement and funding schemes and made to use the more stringent due diligence process. Penalties for non-compliance will also be laid down under national law.

Traceability is key

Proving compliance with the EUDR is the most difficult part of fulfilling the obligations for companies. Supply chain traceability was already important for companies for managing their own operations, but the new regulations make this even more relevant.

Some commodities are relatively easier to trace to the farm level than others, but the line of sight to the farm level is unusual for most commodities. This means new and evolving solutions to traceability are being developed. There are some emerging technologies that use DNA tracing to track where products come from. However, this is much easier for rare commodities like mahogany, for example, than for more common commodities such as pine.

There are certification systems in place to assess and certify commodity environmental credentials, but coverage varies by commodity. The definitions of certification systems also make a difference. The chain of custody in supply chain management - the process of following materials through each stage of the value chain - generally follows either a ‘segregated model’ where certified commodities are kept physically apart from uncertified ones, or a ‘mass balance’ approach that mixes certified and non-certified commodities somewhere in transit or production. Mass balance certifications will struggle to meet the EU’s deforestation regulation.

For example, certified palm oil is often mixed and shipped with uncertified palm oil. Leather is tougher to trace beyond the tannery level today, although some major European companies such as Kering are making good progress towards their 100% leather traceability targets to the farm level. The Textile Exchange - the major apparel/fashion industry group - is pushing for broader target setting for traceability. Beef bought and sold in Europe is more likely to come from within the region and tends to be easier to trace to the farm level.

Corporate deforestation commitments increasing, but varies considerably by commodity

Impact on companies

The EUDR marks a clear step up in biodiversity and deforestation-related regulation. Companies will have to invest in traceability to produce geolocation data to the farm level, adding a cost throughout the supply chain; a one-off cost for establishing traceability mechanisms, risk assessments and due diligence, and ongoing maintenance costs.

At a global level, the EUDR may change trade patterns, with fewer EU imports from countries with greater deforestation risks. An undesirable effect may be that non-certified commodities are supplied outside the EU, which could push the problem out of sight rather than stop it. The regulation could also have other knock-on effects including adding to overall inflationary pressure in economies.

The EU estimates the new rules could cost companies based in the EU and importing to the EU €175 million to €2.6 billion, which is around 0.3-4.3% of company input costs. This means the costs could be significant but are also uncertain. It’s also not clear how these costs will be managed and to what degree they will be absorbed by companies or passed on to end customers. Costs will also vary by industry and position in the supply chain. For example, smaller farms with less bargaining power could be lumped with disproportionately high charges, affecting local wages and lifestyles.

Another question is around enforcement. The EU has a structure of penalties in place, but we will need to see how compliance is determined and its frequency, and how the law is interpreted and applied.

One important repercussion of the new regulations is the soft deterrence it provides to companies. Reputational damage from breaching the EUDR could be potentially severe, and most, if not all, major companies will recognise the importance of compliance. For example, in September Nestle dropped Brazil’s second largest food processor, Marfrig Global Foods, as a supplier due to allegations of illegal land acquisitions from indigenous groups.

Opportunities for investors

Investors on both the debt and equity sides must be cognizant of the risks facing companies that do not prepare adequately for the new EUDR regulations. As Marfrig shows, investors should be cautious about exposure to companies that could be challenged about their sustainability practices. These companies could damage their reputations and lose business, hurting their stock and bond prices. Given that the EUDR promotes supply chain transparency, investors will be better able to understand how companies source their materials and manage their supply chains, as well as hold companies to account. But investors should also research each link in the supply chain and where risks lie within operations and with external suppliers.

Companies with traceable supply chains and more evolved supply chain tracking systems will be better placed to meet the regulatory timeline. Bigger companies with more resources, capabilities and financing will have an advantage here.

Companies that provide traceability platforms and mapping tools, including real-time satellite monitoring and remote sensing solutions should see more demand. Companies that offer products to improve agricultural productivity such as Deere and Trimble may indirectly benefit over time as deforestation efforts mean farmland must be used more optimally. Deere and Trimble provide solutions to enable farmers to enhance agricultural yields and reduce resource use, for example through smart technology, autonomous equipment, water management systems, and monitoring and data analysis. 

There could also be more innovation in alternatives to commodities with high deforestation risks. Biotech companies and start-ups are researching sustainable methods to produce alternatives to palm oil for example. These companies will need to collaborate with large-scale, established producers in the supply chain such as L’Oréal and Unilever.

Biodiversity regulation will only increase over time

We can’t know the exact effects on industry as a result of EUDR given we need more detail around the level and strictness of implementation required by the EU and national governments, as well as how the knock-on effects will play out. But while there is uncertainty in the short term, the long-term direction of travel is clear; the EU is actively addressing biodiversity risks.

Indeed, the European Commission is due to review the legislation by June 2025, with a potential for expanding the regulations to more commodities including biodiesel and maize and extending the ecosystems the rules apply to such as savannahs and wetlands. In the UK, there is legislation being introduced to stop many commodities linked to deforestation, although the laws aren’t as strict as the EUs. In the US, the FOREST Act is working its way through Congress.

The EUDR follows the Corporate Sustainability Reporting Directive (CSRD), which came into force in January 2023 and considerably expands the scope of social and environmental sustainability reporting requirements. The Corporate Sustainability Due Diligence Directive (CSDDD) is moving through the EU legislative process and if adopted would require companies to mitigate the potential impacts of their activities on the environment and human rights. Companies and investors should only expect more biodiversity regulation over time.

Companies are under pressure to trace and modify operations to protect forests, and equity and bond investors play a role in holding them to account. In 2022, we widened the scope of our existing palm oil thematic engagement to create a programme covering the key forest-risk commodities: palm oil, soy, beef and leather, and pulp and paper. This ongoing engagement prioritises companies with weak practices that are materially exposed to potential deforestation risk.

The economy must transition to a more sustainable footing and that means opportunities for innovation directly linked to the regulations and indirectly in other industries such as automation and efficiency tools. Ultimately, as a global community, we must feed and clothe 8 billion people while at the same time preserving our biodiversity for future generations. This can only be done by being more efficient, effective, and resourceful in our commodity production and supply chain management.

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