ISS ESG Highlights Deforestation Risks And Investment Insights

ISS ESG, the ESG investment business of ISS STOXX, has published its first report from the Natural Capital Research Institute, launched in 2024. Titled The Root Cause of Nature Loss: Forests, Why They Matter, and How to Assess Deforestation Risk in Investment Portfolios through Nature-Related Data, it discusses how crucial forests are in current efforts toward global sustainability and the financial risks hidden in deforestation. It also identifies opportunities for institutional investors to mitigate these risks while promoting environmental resilience.

According to the report, tropical forests are critical ecosystems that act as carbon sinks and biodiversity hubs. They contain 70% of the world's forest carbon sinks and 67% of terrestrial biodiversity, and they regulate the climate of the planet and support life on Earth. However, deforestation upsets critical systems and brings cascading effects ranging from soil degradation, water scarcity, to loss in biodiversity, thus intensifying climate change, creating environmental instability, and threatening the long-term survivability of industries dependent on natural resources.

Mirtha Kastrapeli, Global Head of Natural Capital at ISS STOXX, highlighted the issue's complexity when discussing deforestation risks. "This flagship study shows that mitigating deforestation risks in public equity portfolios will be a dynamic journey," she said. "Data around nature-related dependencies and performance are expanding, alongside practices like regenerative agriculture and sustainable land management.

The report categorizes deforestation risks into three types: physical, transition, and systemic. While physical risks may include environmental changes such as land degradation, transition risks are sourced from regulatory misalignments like the EU Deforestation Regulation, which requires a more stringent level of supply chain disclosures by 2025. Systemic risks, on the other hand, refer to big destabilization events, such as desertification, that can send shockwaves throughout ecosystems and economies.

Transition risks are especially critical as regulatory frameworks such as the EUDR put increasing pressure on institutional investors to ensure transparency in supply chains and to conform to sustainable practices. Companies failing to adapt could face reputational damage, market exclusion, and reduced profitability.

To mitigate these risks, the report calls for a high level of ambition in nature-related data. Three types of data, according to ISS ESG, are fundamental in assessing the risk of deforestation: dependencies data, impact data, and performance data. Dependencies data look at the dependency of companies on forest ecosystems as far as the operational and financial performance is concerned. Impact data evaluate the intensity of their activities in contributing to forest degradation. Performance data highlight mitigation policies and innovations such as regenerative agriculture that promote sustainable land management.

According to Kastrapeli, the most critical enabler of informed investment decisions is advancements in data architecture. "Nature data architecture at the asset level is advancing, enabling investors to make informed decisions," she said. Tools such as ISS ESG's Biodiversity Impact Assessment and Corporate Rating systems help investors evaluate the ecological impacts of portfolio activities and identify investment opportunities aligned with ESG principles.

The report contains case studies that depict the practical use of nature-related data in portfolio management. For example, in the analysis of the Nature Action 100 Portfolio, it was discovered that more than 50% of its revenue relied on climate regulation and erosion control, and 33% relied on surface water. Moreover, the study established that land transformation accounted for more than 90% of biodiversity loss, and the highest impact was felt by the food and beverage sectors.

Another method mentioned in the report is the "funnel method," through which investors can screen companies with higher risks at sector, region, and specific activities levels. Such a data-driven approach would further facilitate focused engagement to help investors work with companies to reduce the risk of deforestation and get them on the path toward sustainability.

Looking forward, the report draws attention to nature-related disclosures and technological improvements in geospatial data and related technologies in enabling supply chain transparency and, ultimately, a determination of the associated investment risk. Institutional investors have the means and tools with such integration that may help minimize risks associated with deforestation, taking advantage of opportunities for natural solution-based practices.

This report is a guide for investors ready to embark on the journey of incorporating nature-related data into their investment frameworks," Kastrapeli concluded. Improved data systems, innovative strategies, and emphasis on sustainable practices in the financial sector will play a crucial role in fighting deforestation and promoting a resilient, biodiverse future.