Palm oil is an inexpensive and highly versatile oil derived from the fruit of the oil palm tree, a native of West Africa's tropical forests. It is found in half of all consumer goods on the shelves today in Western grocery stores, from chocolate, ice cream, and baked goods to soaps, lotions, and detergents. Palm oil is also used as a petroleum substitute (a biofuel) to power vehicles, heat homes, and manufacture plastics. Palm oil plantations produce more useful oil per unit of land than any other crop. Due to its high yields and many uses, palm oil is the most actively traded edible oil in the world, with 90 percent of its global production traded on the world market.
With reported scores of 2,000 to 3,000, the Pollution Standards Index (PSI) in Palangkaraya, Central Kalimantan, went off every official charts from palm oil production fires. In Singapore, a PSI of 300 is rated hazardous (Un-manipulated photo, credit: Bjorn Vaughn)
And with annual sales of $50 billion, palm oil is big business. Indonesia and Malaysia have expanded their plantations and tripled production over the past 15 years, and today they account for 85 percent of global production. In Sub-Saharan Africa and Latin America, large-scale palm oil production is growing rapidly and cash-strapped countries are jumping on the bandwagon, as demand is expected to grow.
For decades, however, the palm oil business has been criticized for its links to corruption, social injustice, and deforestation. In Southeast Asia, government officials award oil palm growers legal rights to clear forests, often in exchange for bribes, and generally without regard for the customary rights of the people living within affected areas.
Companies exploit confusing, contradictory, and unclear regulations related to landownership. To make way for plantations, palm oil companies often force indigenous peoples and other forest dwellers off their land, and sometimes use slave and child labor. In 2012, 59 percent of the Indonesia's 1,000 palm oil companies were linked to land conflicts with local communities. Forest clearing for palm oil, including in peatlands, has pushed iconic species like Bornean orangutans and Sumatran elephants and tigers to the brink of extinction, and has added hundreds of millions of tons of carbon pollution to the atmosphere.
To the extent that the palm oil industry paid attention to concerns about deforestation or the exploitation of vulnerable communities, it responded with mostly cosmetic measures. Occasionally, some companies did the right thing. But mostly, business as usual moved plenty of money into the pockets of well-placed palm oil executives, bankers, and corrupt officials. Governments promoted or tolerated this "collateral damage" in the name of economic development. Yet - contrary to public opinion - in Indonesia the entire plantation sector contributes only 2 percent of gross domestic product, despite massive public subsidies.
But change is on the horizon. In the past two years, the palm oil sector has experienced unprecedented progress. Since 2014, a number of major multinational agricultural powerhouses, led by some of the most unlikely converts - collectively controlling roughly 60 percent of global palm oil trade - have made unprecedented commitments to break the link between palm oil and deforestation, while also protecting the rights of local communities. As Paul Polman, chief executive officer of Unilever, has said: "It only takes a handful of sizable companies to reach a tipping point and to transform markets."
Palm Oil Financial Risks: Case studies
While the palm oil plantation sector may be half a world away, industry-wide third-party certification and associated financial implications are relevant to procurement directors anywhere. Certifications, such as the Roundtable on Sustainable Palm Oil (RSPO), often provide corporate buyers assurance and demonstrate buyer preference. Certified palm oil often have higher margins and higher product quality. Likewise, publicly traded companies associated with deforestation are now at times being removed from institutional investors' portfolios. Finally, public procurement preference is beginning to be given to corporations whose products are not linked to deforestation as currently over 300 corporations globally have made zero-deforestation commitments core to their day-to-day procurement policies.
As an example of some of the key issues in the palm oil sector, financial analysis has shown that if firms do not meet buyers' procurement policies, they may lose buyers.
IOI Corporation: Case Study
For IOI Corporation (IOI:MK) - a large publicly traded plantation company - not meeting its buyers' procurement policies - according to Chain Reaction Research - has meant losing these buyers.
In Q1 2016, IOI stock price was on the rise, reaching a high of MYR 5.00 year-to-date. Then in March, after the Roundtable on Sustainable Palm Oil (RSPO) temporarily suspended IOI due to its clearing of forests in violation of RSPO's policy, its shares fell 18%, hitting a year-to-date low by mid-May of MYR 4.12. IOI then announced it would sue RSPO over its decision. As a result, Moody's Investors Service stated it would "review for downgrade" IOI's corporate debt, potentially negatively impacting IOI's cost of borrowing.
After considering these market signals, IOI changed its approach. On June 6th, 2016, IOI withdrew its lawsuit against RSPO and instead announced it would focus on improving its sustainability profile to achieve buyers' No Deforestation, No Peat, No Exploitation (NDPE) commitments, and zero-deforestation commitments. IOI also stated that they would planned on achieving RSPO's stringent RSPO Next certification for its plantations by Q4 2016. IOI's equity price recovered slightly reaching MYR 4.31.
IOI's share price decrease because of their RSPO non-compliance resulted in over a $1 billion loss of equity value to shareholders.
Simply put, IOI had two historical land bank issues it had the chance to resolve over the previous five years but choose not to (see sidebar description of both RSPO complaints).
IOI sells about 750,000 metric tons of certified sustainable palm oil (CSPO) annually, about 96% of its palm oil sales. With its suspension, global CSPO supply is reduced 6%, from 12.5 million metric tons to 11.75 metric tons annually. Other CSPO buyers saw their prices increase, resulting in global margins between CSPO to CPO increasing. Anecdotally, other regional producers have increased their margins on CSPO vs. crude palm oil (CPO) significantly from $25 to $35 a metric ton.
IOI is not the first company suspended, or threatened with suspension, by RSPO - but its aggressive legal response is unprecedented. Many other companies have successfully worked with RSPO to arrive at mutually beneficial outcomes, including Wilmar, Genting, and Bumitama. Other companies have voluntarily removed their memberships from RSPO to improve their operations and then returned to RSPO at a later date.
In the first half of 2016, 26 large corporate buyers, from Bunge to Unilever, have suspended purchases from IOI because IOI was determined by RSPO to have clearcut forests and peatland contrary to and against RSPO's voluntary policies.
As a result of IOI's suspension from RSPO because of these complaints, IOI's former buyers are now looking elsewhere to lock-in forward purchases of CSPO.
The market has now shown that as these forward purchases increase, sellers are likewise increasing their CSPO margins, making it more expensive for buyers to achieve their zero-deforestation commitments yet giving buyers greater supply chain stability, decreasing contract by contract procurement costs. This demand for CSPO pricing stability in the spot and forward markets has resulted in increasing margins for CSPO contracts and greater reliability by buyers allowing them to more easily achieve their zero-deforestation commitments.
For example, as reported by Kuala Lumpur Kepong Bhd. (KLK:MK), due to IOI's temporary suspension KLK is now selling its CSPO palm oil with greater premiums. KLK's premiums have risen about 50% from estimated $20-$25 to $35-$40 a metric ton. KLK produces about 750,000 metric tons of CSPO.
As described earlier, IOI's suspension from RSPO impacted their share price as it decreased almost 20% after the suspension was announced. Also, in May 2016, Moody's Investors Service stated it would "review for downgrade" IOI's corporate debt, potentially negatively impacting IOI's cost of borrowing because of their suspension.
Felda Global Ventures: Case Study
Similarly, on May 3, 2016, Felda Global Ventures (FGV:MK) withdrew their RSPO certificates from 58 of its 71 Malaysian mills. FGV's move does not influence their ongoing RSPO Supply Chain Certification System (SCCS) certificate of its kernel crushing plants and downstream refineries.
By withdrawing mills from RSPO certification, FGV increases its reputation risk while putting pressure on its margins as they choose to temporarily exit the RSPO market. The self-imposed action, however, is widely assumed to be a preemptive move by the company, possibly tied to seven ongoing Malaysian court cases over fresh fruit bunch oil extraction rate price manipulation. Other sources suspect FGV withdrew because they were clearly shown to have deforested 880 hectares of identified High Conservation Value peatlands.
Whatever the reason, the withdrawal gives FGV time to improve its operational risk management processes and does not appear to reflect that FGV is losing faith in RSPO. The RSPO market is rapidly growing - increasing 165% year over year - while uncertified palm oil market growth is stagnant or declining as many buyers switch to less expensive soymeal oil.
Analysts were sharply negative on the withdrawal. FGV's RSPO sales are 7% of their revenue while IOI's RSPO sales are 51% of their revenue, reported Kenaga Research. BIMB Research found that the company faces potential premium sales losses from its inability to supply certified palm oil, and BIMB Securities reduced FGV's FY2016 to FY2017 earnings by 3% to 2.8%. Public Investment Bank said the company may lose their RSPO premium of about US $25 per ton, and Kenanga Research thinks the move could decrease 2016 FGV revenue by $4.2 million, reducing the company's fiscal year 2016-2017 earnings estimates by 7% to 10%. TA Securities Holdings Bhd also said that FGV's lack of CSPO premium sales going forward would impact their bottom line.
IOI and FGV case studies: Two approaches to similar problems
IOI's response to sue the RSPO following its temporary suspension may be an attempt to manage its reputation risk by suing RSPO. IOI violated RSPO principles and criteria at the plantation level, which in turn is jeopardizing firm-wide reputation and goodwill, and putting cash flow at risk. As a result, more than 20 major buyers, including Unilever, Mars, Kelloggs and Nestlé have cut back on the palm oil they buy from the company.
FGV, under similar circumstances, is choosing to mitigate is reputation risk through removing its mills from certification. This proactive model gives FGV three years to fix its operational risk management culture - from its plantation manager to its Board. While FGV's decision in the near-term may have a negative impact on cash flows, FGV's decision "does not does not affect Felda Group's RSPO Supply Chain Certification System (SCCS) certificate of its kernel crushing plants and downstream refineries." By doing this, FGV will mitigate its reputation risk while giving it time to improve its firm-wide risk culture.
Palm Oil Revenue at Risk: Case studies
It is clear from the evidence above and other analysis that failure to meet buyers' procurement policies can also occur lost revenue.
50% to 60% palm oil traders and producers have established No Deforestation, No Peat, No Exploitation (NDPE) policies. Palm oil growers that choose not to meet these standards may lose revenue and are putting potential future revenue at risk.
According to Chain Reaction Research report Palm Oil Revenue at Risk: Failure to Meet Buyers' Procurement Policies Results in Lost Revenue, published in June 2016, Austindo Nusantara Jaya (ANJT:IJ), Sawit Sumbermas Sarana (SSMS:IJ), and Provident Argo (PALM:IJ) are all growers that have not chosen to achieve buyer NPDE requirements, and as a result, each company is facing buyer turnover, loss, as well as an increasingly less diverse buyer base.
Applying a Monte Carlo simulation technique to determine 2016 quarterly revenue at risk for three selected palm oil producers, based on buyers continue to suspend purchase, all three companies lost revenue due to non-compliance with buyers' policies, failing either to identify the risk potential of their non-diversified buyer portfolio or to undertake timely action to mitigate, transfer or avoid it.
Austindo Nusantara Jaya (ANJT:IJ): 2016 35% quarterly revenue at risk based on Q4 2015 actual revenue losses of 10% when ANJT did not meet buyers' NDPE.
Sawit Sumbermas Sarana (SSMS:IJ): 2016 42% quarterly revenue at risk based on Q4 2015 actual revenue losses of 0% to 5% when SSMS did not meet buyers' NDPE
Provident Agro (PALM:IJ): 2016 37% quarterly revenue at risk based on Q4 2015 actual revenue losses of 15% when PALM did not meet buyers' NDPE
Government of Norway: Case study
Similarly, the Government of Norway has announced a ban on public procurement of products, services and goods that directly cause tropical deforestation. The new policy impacts an estimated $60 billion in annual procurement by the nation's central and sub-central governments. The Norwegian Parliament's Standing Committee on Energy and Environment recommended the ban in their report to parliament.
Norway's announcement comes in support of the New York Declaration on Forests, which was launched during the 2014 Climate Week in New York City. The Declaration is the first global timeline for cutting and totally ending deforestation, and was supported by developing and developed nations, businesses and NGOs.
According to the Organisation for Economic Co-operation and Development (OECD), an organization of 34 leading global democracies, Norway spends an estimated 12% of its GDP on public procurement and its share of total government expenditures is estimated at 27%. Both are less than the respective OECD weighted average for member countries. Likewise, because of Norway's centralized government procurement policies, Norway may be able to achieve their zero-deforestation procurement policies in an economically efficient manner.
This spring, the Government Pension Fund of Norway - the world's largest sovereign wealth fund - published their investment portfolio. An analysis by Rainforest Foundation Norway found that the fund had divested from RSPO members Indofood Agri's parent-company First Pacific (142:HK) and Kulim Malaysia (KUL:MK). The Government Pension Fund of Norway's May 2016 assets under management were $873 billion, making it one of the largest pensions funds in the world.
In fact, RSPO membership may not appear to be an adequate guarantee of inclusion in the Government Pension Fund of Norway's portfolio. Likewise, RSPO membership also may not appear to guarantee that companies do not cause unacceptable environmental damages.
The loss of buyers for company products and services can lead to changes in behavior for companies and shows the potential impact of forest certification at the global scale. Many companies also want to demonstrate that they are good land stewards and are not only interested in maintaining access to markets but want to be recognized as being as corporations that care about the global environment and their local communities.
This evidence shows that it may be important for plantation owners to understand their buyers' certification and sustainability criteria. If not, these plantation owners may lose their clients due to their inability to manage their buyers' No Deforestation, No Peat, No Exploitation (NDPE) and zero-deforestation procurement policies and requirements.
Thousands of hectares on fire in Muara Kendawangan, West Kalimantan Oct 16-24, 2015
Gabriel Thoumi, CFA is Senior Fellow at Climate Advisers where provides global financial analysis for mitigating systemic climate risk while advising on "greening" capital markets for clients and coalitions. Previously, he worked globally for 15 years leading green finance initiatives for Morgan Stanley, USAID, Calvert Investments, and others. He has a MBA and MSc from the University of Michigan.