Alvaro Vivanco, Head of EM and ESG Macro Strategy at NatWest Markets, explains why a sustainability-linked bond tied to level of Amazon’s deforestation (with adjusted coupon to annually upwards or downwards of deforestation) would provide the right incentives for Brazil and investors alike to tackle this major priority in the fight against climate change and biodiversity loss. 

Sustainability-linked bonds deforestation

The election of President Lula is expected to lead to significant changes to Brazil’s environmental policies. Crucially, this could create new opportunities for global investors to help finance the reversal of damage done to the Amazon.

A lot is at stake, but a lot can be done

The Brazilian rainforest absorbs vast amounts of carbon dioxide and is vital if the world is to reach its climate targets. From the outset of his latest bid for the presidency, Luiz Inácio Lula da Silva – popularly known simply as Lula – pledged to eliminate deforestation by using every tool at his disposal, including spending more money and appointing officials to enforce more stringent environmental regulations. 

While there is untapped money available in the form of the Amazon Fund, which contains around $560 million to be spent on protecting the rainforest, this alone is unlikely to be enough. Lula has officially asked major donors to expand the fund, but this will take time. 

Assuming financing is available, the question then becomes what to do with the additional funds?Reviving previous environmental and forest protection codes will be crucial, as will recruiting more staff for enforcement agencies and park services. However, Lula’s promises could be compromised by the need to fund other social causes and accelerate economic growth, which could be boosted by agricultural expansion in the Amazon. The president will have to manage his domestic and external political priorities carefully.

Sustainability-linked bonds deforestation

Why a sustainability-linked bond?

There are several financing options for green projects, including grants, green bonds, carbon credits and sustainability-linked bonds (SLBs). There are a number of reasons why we believe that a properly defined and monitored SLB should play a critical role.

An SLB can directly address any sustainability-linked key performance indicator (KPI) that is measurable and easy to monitor, and directly related to mitigating climate change. Given that the administrative costs of protecting the Amazon are not particularly large (the entire budget for Brazil’s Environmental Ministry is about $325 million), an SLB could serve as an important signalling mechanism for both Brazil and investors. As Brazil embarks on a new environmental policy, an SLB could solidify and safeguard Lula’s plans. 

How might the SLB work in practice? One possibility is that Brazil commits to an aggressive path of deforestation reduction (similar to its previous plan in 2003) and is rewarded or penalised by lower or higher coupon payments based on the results. Investors get to participate directly in efforts to protect the Amazon while benefitting from a sizeable sovereign spread. 

SLBs are preferable to the other financing tools available, in the view of NatWest.

Regular sovereign bonds, for example, have been shown to have a limited correlation with environmental outcomes over the medium term. While some investors have excluded investments in countries such as Brazil on environmental grounds, the actual effects (measured in terms of underperformance relative to peers) have been rather short-lived. 

Likewise, for NatWest, a green curve is not the best way of dealing with the preservation of the Amazon directly. Green bonds could certainly play a role in incentivising other environmental and social goals, but the Amazon is in a different category given its global importance. 

Carbon credits could be also cumbersome given the size of the Amazon, as monitoring costs would be substantial. Legally, the Amazon is already protected, so it would fail to qualify as a project available for new credits, which generally aim to create additional impact from efforts that would otherwise not receive financing. While technicalities could be tweaked and carbon credits could be structured to protect the areas at highest risk of deforestation, we believe this approach would fail to deliver the scale that is needed to protect the Amazon rainforest over the long term. Similarly, small grants could help finance some of the costs around monitoring and policing but are unlikely to provide a large enough incentive for Brazil to act quickly. 

Sustainability-linked bonds deforestation

Markets want transparent, simple, measurable targets with an impact on climate

A well-structured SLB targeting deforestation in the Amazon basis could have a profound impact on climate change while delivering on important policy and investment objectives domestically and outside Brazil. 

Significant global impact: directly focusing on Amazonian deforestation as the first key sustainability indicator for a Brazilian SLB would align it with both its importance to the world and the ability of local policy action to affect its outcome. 

The degree of deforestation in Brazil has been very closely linked to previous presidential terms. This is not the only factor at play – agricultural prices matter as well – but we think that the reversal of the current policy stance could make a substantial difference in terms of reducing deforestation rates relatively quickly. 

Also, compared with SLBs for corporate and other sovereign issuers, the size and visibility of the Amazon should prove extremely appealing for investors looking to allocate to (perhaps for the first time) a sustainability product. 

Continuously measurable ndicators: The Brazilian government already collects data on deforestation rates with a short lag and relatively small margin of error using satellite-based systems. Annual assessments of the targets (and repricing of the coupons) would add a crucial sense of urgency to the issue.

Structure to incentivise outperformance: we believe a coupon step-up and step-down is the most appropriate way to provide the right incentives for both the issuer and investors. The principle we have in mind is that underperformance or outperformance of already demanding targets should be directly reflected in coupons on an annual basis. This would be an innovation that enhances transparency and incentives to reach the target as soon as possible.

What an Amazon SLB could look like

An SLB addressing Amazonian deforestation could include the following characteristics. First, it could focus on a single and direct KPI: the area of deforestation of the legal Amazon. 

Deforestation fell significantly between 2004 and 2014 (from 27,000km2 per year to about 5,000km2) but has increased since 2018 to about 13,000km2 per year by 2021 under the Bolsonaro administration. 

Using 14,000 km2 as an illustrative starting point, bringing deforestation to zero by 2030 would require an average annual reduction of 1,750km2. We believe that ending deforestation by 2030 should remain the goal as it sends an important message to everyone involved. 

Second, if actual deforestation deviates from this path, the bond’s coupon could be adjusted annually upwards or downwards to reflect the actual area of excess deforestation relative to the target path. The effects of early underperformance or outperformance of targets compound over time: higher deforestation in one year needs to be made up subsequently to avoid higher coupons. For NatWest, this sends the right signal that meeting targets is urgent.

A way forward for the Amazon – and global governments

A new sovereign bond with special but simple characteristics would signal Brazil’s progress in environmental protection through an effective financial instrument. This makes sense for all parties – the government, investors, and the Amazon. Crucially, it could also set the pace for other global governments looking to mobilise global funding in the fight against climate change.

Sustainability-linked bonds deforestation

Source: NatWest