Sources of investment for forestry: preventing flows of finance to illegal activities

Discussion paper written on behalf of the Sustainable Development Programme of the Royal Institute of International Affairs

August 2003

Jan Willem van Gelder (Profundo)

Wolfgang Richert (AIDEnvironment)

Eric Wakker (AIDEnvironment)

Acknowledgements

The authors would like to acknowledge the valuable inputs by Duncan Brack and Jade Saunders of the Sustainable Development Programme of the Royal Institute of International Affairs. This paper was written with the financial aide of the RIIA.

Contents

Chapter 1Introduction

1.1Aims of this paper

1.2Why financial institutions?

1.3Illegal activities and forest management

Chapter 2Economic sectors affecting forest ecosystems

2.1Relevant economic sectors

2.2Timber industry

2.3Pulp and paper sector

2.4Agribusiness

2.5Mining sector

2.6Infrastructure projects

2.7Conclusion

Chapter 3The role of financial institutions

3.1Introduction

3.2The financing of companies

3.3Types of financial institutions

3.3.1Private financial institutions

3.3.2Public and semi-public financial institutions

3.4Categories of financial services

3.5Financial institutions and forest-related sectors

3.5.1Timber industry

3.5.2Pulp and paper sector

3.5.3Agribusiness

3.5.4Mining sector

3.5.5Infrastructure projects

3.5.6Downstream financing

3.6Conclusion

Chapter 4Options for action

4.1Introduction

4.2Scope for possible options

4.3Existing approaches

4.3.1The do-no-harm approach: minimum criteria

4.3.2The pro-active approach: towards sustainability criteria

4.4Existing regulatory framework

4.4.1Financial market regulations in EU-countries

4.4.2Basel Capital Accord

4.4.3Regulations against Money Laundering and the Financing of Terrorism

4.4.4New policy initiatives

4.5Lessons from other policy fields

4.6Options for action

4.7Conclusion

Annex 1Illegal practices in the forestry sector

Annex 2Notes

Chapter 1Introduction

1.1Aims of this paper

This paper was prepared for the international workshop on “Sources of investment for forestry: preventing flows of finance to illegal activities”, organized by the Royal Institute of International Affairs (RIIA). The workshop is to be held in London on September 5, 2003.

This paper broadly reviews the main economic sectors that contribute to illegal forest destruction worldwide and assesses the main sources of (public and private) financing for each of these sectors. We subsequently explore policy options to prevent flows of finance to illegal activities in forest related sectors.

1.2Why financial institutions?

In the past five years, increasing attention has been paid to illegalities in forest related sectors, notably in the logging and timber industry. This attention went along with a series of studies, high level workshops, campaigns and policy initiatives debating on the roles of forest users, trading companies and governments. Just recently, at the end of July 2003, the United States State Department Secretary, Colin Powell, for instance launched the “Global Initiative to help stop Illegal Logging”.[1]

The role of financial institutions, notably those that are privately owned, has been given relatively limited attention in the debate so far. Yet financial institutions are as critical to natural resource extraction as are (commodity) trading companies and retailers (see for a schematic representation Figure 1).

Figure 1: The role of financial institutions in natural resource trade cycles

Financial institutions enable the companies involved in natural resource extraction, as well as those involved in processing, trading and retailing natural resource-bases products, to establish themselves and expand. Financial institutions provide these companies with a range of services including loans, working capital facilities and trade credits to share and bond issuances, trust management and other services. In fact, many developments in forest areas would not be possible without the services provided by financial institutions such as commercial and investment banks, Export Credit Agencies, development banks and fund managers. This is especially valid for the non-timber trade sectors discussed in this paper (pulp and paper, agribusiness, mining and infrastructure) which are rarely fully self-financed.

As governments and NGOs, as well as forerunners in various industrial sectors are beginning to address legality and sustainability issues in the forest related sectors, the strategic role of financial institutions emerges naturally. Governments, NGOs and other stakeholders have experienced that companies are not always responsive to legislation or softer policies. Considering the real or perceived influence that financial institutions have over their clients, these stakeholders hope that financial institutions can and will help shift the power balance.

In a traditional culture of financier-client confidentiality and, sometimes, explicit denial of responsibility for the clients actions, many financial institutions have initially shrugged off such requests for support. However, financial institutions have become increasingly responsive because they are, or aim to be perceived as, responsiblecorporatecitizens, an image that does not match with poor legal, environmental or social performance of the financial institution or its clients.

Another reason for financial institutions to consider external stakeholders’ issues is that financial institutions have begun to realise they expose themselves to various types of risk when they are involved in financing criminal or destructive activities. Risk officers, upper management or shareholders may not accept such risks.

1.3Illegal activities and forest management

Numerous studies have pointed out that illegal logging and trading activities are commonplace in various regions in the world and that these have rampant impacts on forests and their ecological, social and economic functions. These studies commonly refer to laws and decrees that clearly provide provisions to protect forest resources (see Annex 1 for an overview). Although no internationally accepted definition of illegal (forest) practices exists, such cases are relatively straightforward as they address bad forestry and trading practices that are also against the law or at least fail to meet certain policies that aim to protect forest resources. In this paper we will concentrate on illegal practices of this type.

However one a priori remark needs to be made. Unfortunately, existing laws and policies can not always be blankly relied on as a reliable reference cadre for forest protection or sustainable forest use. There are situations in the forestry sector where the legally required practices are actually not considered sustainable or equitable. In Russia and the Baltic States, for example, clearcutting is required by law and when sustainable forestry pilot projects were introduced to these countries, the initiators realised that selective logging, which is considered to sustain more biodiversity values, was in fact an illegal practise.

Similarly, donor organisations or financial institutions wanting to sponsor community forestry projects in Indonesia may find that such projects are illegal because community land claims are not recognised by Indonesian law. In other cases complex or overlapping laws make it virtually impossible to determine what is legal, and what is not. “Legality” can also be a poor reference framework when a government enables (mega) projects with harmful impacts by overriding existing laws. It is thus important to realise that probably in quite a few instances insisting on legal compliance may not be effective in achieving sustainability. Sometimes it may even be harmful to forests, people and businesses.

Chapter 2Economic sectors affecting forest ecosystems

2.1Relevant economic sectors

Apart from the logging and timber industry there are several other sectors that undertake activities in forest areas and are affecting forest ecosystems.[2] These economic sectors are listed in Table 1.

Table 1: Economic sectors affecting forest ecosystems
Sector / Sub-sectors
Forestry / Logging and timber industry
Pulp and paper industries
Agriculture and aquaculture / Plantations
Large-scale commodity farming
Cattle raising
Shrimp farming
Extractive industries / Mining
Oil and gas
Infrastructure projects / Roads, railways, waterways
Oil and gas pipelines
Power transmission lines
(Hydropower) dams

In the following paragraphs we will explore the impacts on forest ecosystems of the most important of the sectors listed in Table 1, as well as their involvement in illegal activities.

2.2Timber industry

  • Description of the sector

The timber industry comprises those industries that are involved in logging and/or processing, trading and marketing solid wood products, such as logs, sawn wood, plywood, Oriented Strand Board (OSB), Multi-Density Fibre Board (MDF).[3]

The logging sector itself is not very concentrated, with many small companies operating only on a national level and a few larger, multinational companies. The timber processing and trading sector is concentrated in the hands of a limited number of large integrated industries.

This is especially true for the tropical timber trade, which represents 15 percent of the global timber trade. Timber companies from Malaysia (such as Rimbunan Hijau, Samling and Innoprise), Indonesia (such as Barito Pacific Timber and Alas Kusuma) and Europe (such as Rougier, Danzer and Sonae Indústria) are also major forest concession holders in terms of total areas under concession in tropical forest areas in Asia, Africa and Latin America. But these companies, as well as the timber traders without forest concessions of their own, also buy for a large number of smaller logging companies. State forestry departments and state corporations are also major players in some countries (e.g. Malaysia, Indonesia).

  • Geographical spread

The main forest countries are European Russia, Siberia, Russian Far East, Eastern Europe, Canada, Central America, South America (notably Amazon region), West and Central Africa, Southeast Asia and Pacific. The main market countries are to be found in Europe and Northern America. Brazil, Japan and China are emerging markets.

  • Impact on valuable forests

The timber industry remains highly dependent on primary or previously unlogged natural forests as the source of roundlogs. Logging in such forests is not illegal in most countries, but nevertheless subject to public debate. In the tropics around 80 percent of all log production depends on these forests, whereas this figure is as high as 90 percent for the world's largest wood producer, Canada. Primary forests are becoming increasingly scarce on a global scale. According to FAO data, only 166 million hectares of economically accessible undisturbed forest remains outside the former Soviet Union.[4]

Table 2: Estimates of primary forest logging as a share of total logging, wood pulp and timber production(1980s-1990s)[5]
Country / Overall share of logging in primary forest / Wood pulp from primary forest / Timber from primary forest
Russia / n.a. / 76% (c) / n.a.
Brazil / 40% (b) / 4%(c) / 93% (a)
Canada / 90% (e) / 70%(c) / n.a.
Indonesia / n.a. / 58 -80% (c,f,g.) / 86% (a)
Papua New Guinea / n.a. / - / 93% (a)
Chile / 5% (b) / 0% (c) - 10% (d) / n.a.
Cameroon / n.a. / - / 89% (a)
Gabon / n.a. / - / 93% (a)
Surinam / n.a. / - / 94% (a)
Guyana / n.a. / - / 91% (a)
Malaysia / n.a. / 79% (c) / 85% (a)
Bolivia / n.a. / n.a. / 71% (a)

N.a. = not available; - = no production

As the area of accessible primary forest declines, the relative share of logs from secondary (previously logged) forests and plantations is beginning to grow. On the longer-term, the timber industry will be less reliant on natural forests and increasingly rely on plantation forestry (not taking into account further expansion of the sector). But plantation forestry is not necessarily considered a more sustainable forestry strategy and often triggers persistent criticism from non-forestry stakeholders (environmental and social rights NGOs, local communities).

  • Illegality

The most commonly reported legality issues, in the tropics and other regions, related to the timber sector are:

  • Illegal practices in or around the forest area.
  • Log purchases from illegal sources and illegal trading practices (see for a detailed list of common illegal practices Annex 1).

World Bank estimates place the annual revenue loss to governments from failure to collect taxes from forest concessions at over US$ 5 billion. In addition, the annual market value of losses from illegal cutting of forests is placed at over US$ 10 billion.[6]

In the past five years, a large number of reports have been published highlighting illegal practices in the forestry sector. Some estimates of the share of illegal logging compared to total production at the country level include:

  • Indonesia88-90%
  • Brazilian Amazon80-90%
  • Colombia42%
  • Cameroon50-60%
  • Russia20-50%
  • Cambodia94%
  • Canadavarious cases[7]

It must be noted that the figures presented above are indicative estimates only.

2.3Pulp and paper sector

  • Description of the sector

In this paper, we refer to the pulp and paper industry as those industries that process, trade and market tree fibre based pulp and paper products, including rayon. Many pulp and paper mills are also involved in forestry.

In terms of log consumption, the pulp and paper sector is concentrated in the hands of a limited number of large integrated industries. The most important are:[8]

  • International PaperUnited States
  • Georgia-PacificUnited States
  • WeyerhaeuserUnited States
  • Stora Enso Finland
  • UPM-Kymmene Finland
  • Nippon Unipac Japan
  • SCA-Svenska Cellulosa Sweden
  • MeadWestvacoUnited States
  • M-realFinland
  • SappiSouth Africa
  • DomtarCanada
  • Norske SkogNorway

The largest pulp mills in the world are operated by:[9]

  • Indah Kiat Pulp & PaperIndonesia2.0 million MT/yr
  • Riau Andalan Pulp & PaperIndonesia2.0 million MT/yr
  • Aracruz CeluloseBrazil1.9 million MT/yr
  • Geographical spread

Main forest countries are to be found in European Russia, Siberia, Russian Far East, Scandinavia, Canada, South America (including Chile), Southeast Asia, China. Main market countries are to be found in Europe, North America, East Asia.

  • Impacts on valuable forests

Modern pulp and paper mills consume vast amounts of raw logs. Log supply does not necessarily depend on the forests surrounding the mill; logs and pulp are traded and transported globally.

Globally, the pulp industry is still significantly dependent on old grown forests as a source of fibre. This is mainly due to the world's biggest global pulp supplier - Canada - which continues to depend heavily on old growth and primary forests. According to estimates from the Canadian Ministry of Environment in the mid-1990s, approximately 90 percent of total production originates from such forests.[10]

Another country that relies more heavily on its natural forest is Indonesia, whose pulpwood processing capacity increased almost fourfold to 5 million tonnes between 1993 and 2000. During this period, about 92 percent of all pulpwood was cut in tropical forests.[11]

For Russia, Wood Resources International estimated the original forest content of wood pulp at 76 percent in 1993. Assuming that these percentages apply to the woodpulp traded from just these three countries (Canada, Indonesia and Russia) in the year 2000, then about 35 percent of all wood pulp traded internationally originates from old growth and tropical forests.[12]

Table 3: Estimated original forest content of internationally traded pulp
Exporter / Total pulp exports / Estimated share from original forests / Volume from original forests / Share of total volume
Canada / 11,878 / 90% / 10,690
Russia / 1,646 / 76% / 1,251
Indonesia / 1,361 / 92% / 1,252
Others / 22,952 / N.a. / N.a.
Total / 37,837 / 13,193 / 35%

As the area of accessible unlogged forest declines, the relative share of logs from secondary (previously logged) forests and plantations consumed by pulp and paper companies is beginning to grow. On the longer-term, the pulp and paper industry will be less reliant on natural forests and increasingly rely on plantation forestry (not taking into account further expansion of the sector) as well as recycled fibre.

But plantation forestry is not necessarily a sustainable forestry strategy in forestry terms and also triggers persistent criticism from many NGOs who work with communities affected by these 'forests'. Human Rights Watch has reported outright human rights violations in Riau, Indonesia, in relation to plantation development for pulp and paper companies.[13] Similar cases are reported by World Rainforest Movement e.g. in Southern Brazil.[14]

  • Illegality

With some exceptions few in-depth studies have highlighted illegal practices in the pulp and paper sector. The most commonly reported legality issues, in the tropics and other regions, related to the pulp and paper industry are:

  • Illegal practices in or around the forest conversion or plantation area
  • Log purchases from (potentially) illegal sources
  • Log demand exceeds legal and sustainable supply

Log shortages are considered to be a major drive in illegal logging in the Indonesian pulp industry. A study for the UK-Indonesia Tropical Forest Management Program in 1999 revealed major gaps between the legally available wood volume and the actual processing capacity of the pulp industry in Sumatran provinces (see also figure 2).[15]

The research institute CIFOR has estimated that Indonesian pulp producers may have obtained as much as 40 percent of the wood they consumed between 1994 and 1999 from illegal sources. Heavy debts create added pressures to keep mills operating at their full capacity: the projects are simply "too big to let fail".[16]

Figure 2: Long-run supply and demand imbalance for pulpwood in Sumatra

In Scandinavia, the pulp and paper sector is struggling with illegal log supplies from Russia and the Baltic States. According to WWF Sweden and Taiga Rescue Network (TRN), many roundwood and pulp traders and consumers in Scandinavia that apply strict FSC standards for production of their domestic raw materials rely on government enforcement of the Russian Forest Code for their Russian roundwood and pulpwood supplies. This Code is not being enforced as 70 percent of timber produced in the Russian Far East region of Primorye and 80 percent of forestry production in the Lake Baikal region are from illegal origins. The Code also is often contradictory with other (local) civil, criminal, administrative and tax codes.[17]

While few claim that illegal logging in Canada is widespread there are reports that suggest that regulations on illegal logging are insufficiently enforced. For example, British Columbia has one of Canada’s most sophisticated legal regimes designed to ensure sustainable forestry. The law is known as the Forest Practices Code of British Columbia Act. The code allows for fines up to C$ 1 million a day to penalise poor forestry practices but despite this, the reported total in tickets and penalties collected under the code in a three year period (June 1995 - July 1998) amounted to C$ 2.3 million only. In comparison, during this same period, the Vancouver Public Library collected C$ 3.5 million in library fines.[18]