Developing a Sustainability Credit Score System

Transcription

1 First draft. Please do not cite unless authorized by the authors. Developing a Sustainability Credit Score System Rodrigo Zeidan a, *, Claudio Boechat b, Angela Fleury b Abstract We present a credit score system based on sustainability issues to improve financial institutions lending policies. The Sustainability Credit Score System (SCSS) is based on the analytic hierarchy process methodology, and is used in loans to the agricultural sector in Brazil. The SCSS is developed through the following stages: analysis of the industry selected; definition of three different development paths for the average company in the industry: business as usual (BAU), sustainable business (SB) and future sustainable business (FSB); the variables related to the firms activities, in each of six sustainability dimensions: economic growth; environmental protection; social progress; socio-economic development; ecoefficiency; and socio-environmental development; the combination of all the information to obtain questions for the composition of the score system; and the weights for the analytical hierarchy process. We relate and discuss the implications of the integration of sustainability criteria into risk management practices. We argue that new internal banking practices may change, albeit marginally, the view that sustainability is a constraint on the profit function of firms towards one in which financial markets can promote sustainability because of its many linkages with the rest of the economy. Keywords: Sustainability; Risk management; Lending policies; Equator Principles; Commercial banks; Management practices; Corporate social responsibility a Fundação Dom Cabral and Nottingham University Business School China. * Corresponding author. rodrigo.zeidan@fdc.org.br. Address: Av. Princesa Diana, 760, Nova Lima/MG Brazil. b Fundação Dom Cabral. 1

2 Introduction The main goal of this paper is to present a new way to incorporate sustainability into banking practices by focusing on a credit score system to improve financial institutions lending policies. Many banks now use the Equator Principles as a framework for assessing environmental and social risks, but few integrate sustainability into more widespread credit products. In the present paper, we analyze the case of a multinational bank that creates a sustainability credit score (based on the analytic hierarchy process methodology) to be used in loans to the agricultural sector in Brazil. We contribute to the literature by discussing the implications of voluntary sustainability practices in a commercial bank s lending practices. There is a growing literature on the relationship between regulation and sustainability in the banking industry; for instance, Richardson (2009) argues that regulation must target the financial sector because it profits from unsustainable practices. However, if there is an eco-premium (e.g. Lubin and Esty, 2010), market mechanisms may be complementary to regulation in integrating sustainability and management practices. The current trend in the literature on sustainability and finance is shifting from the idea that sustainability is a constraint on the profit function of firms towards a vision that financial markets can promote sustainability because of its many linkages with the rest of the economy. Scholtens (2006 and 2009), for instance, argues that finance can promote socially and environmentally desirable activities through the credit channel and private equity activities. Adams and Frost (2008) find that companies are increasingly incorporating social and environmental KPIs into their strategic planning, but the issues raised by 2

3 management and the way in which those issues are integrated into operations vary considerably amongst their sample. There are two major trends in the literature relating to sustainability and the banking industry, which can be divided into external and internal practices. The external practices strand analyzes the relevance of sustainability to the communication of banks with shareholders and stakeholders, and how investors use it as a measure in achieving optimal portfolio allocation (e.g. Herzel et al., 2012; Konar and Cohen, 2001; Weber, 2005; Wright, 2012). The internal practices literature, more relevant to the present work, studies the integration process of sustainability criteria into risk management models and lending practices. Weber et al. (2008) and Weber et al. (2010) use sustainability as a predictor of future financial performance and argue that, because it is an important predictor, banks should use sustainability in their credit risk models. Another example is Thoumy and Vachon (2012), who show the relevance of sustainability to project finance in Canada. We focus, as do Singh et al. (2007), on the credit score as a decision tool for financial institutions, and present a case study in which a multinational bank applies the methodology to the sugar industry in Brazil. The Sustainability Credit Score System (SCSS) is developed through the following stages: Selection of the industry to be analyzed. Analysis of the industry: economic outlook; product life-cycle analysis; value chain; legislation and public policy; industry self-regulation; and innovation. 3

4 Development paths for the average firm: business as usual (BAU); sustainable business (SB); and future sustainable business (FSB). Definition of variables related to individual firms, in each of six sustainability dimensions: economic growth (EG); environmental protection (EP); social progress (SP); socio-economic development (SD); eco-efficiency (EE); and socio-environmental development (SD). Unveiling of the materiality issues pertaining to the average firm, plus vulnerabilities and opportunities regarding the sustainability of the industry. Combining the information on the steps above to obtain questions for the composition of the score system. Definition of the weights for the analytical hierarchy process. The final result is a credit score system that rates companies and is composed of six matrices for the six sustainability dimensions, each matrix ( ), in which { if if, and a weighting matrix for the six dimensions. For each dimension, A i is composed of 5 questions, and a final questionnaire of 30 questions is developed from the analytical model, giving us a final sustainability credit score that ranges from 0 to 1 and is used as a tool to assess the sustainability of a company in the selected industry. The rest of the paper is as follows. The first section analyzes the theoretical background that relates sustainability and lending policies; the second section presents the analytical methodology and relates its application to the sugar industry in Brazil; the third section introduces the sustainability credit score system; while the final section makes concluding comments. 4

5 1. Incorporating sustainability into commercial practices in the banking industry The current work presents evidence of the voluntary incorporation of sustainability indicators into a commercial bank s lending practices. As such, it is related to the CSR literature, as well as to the management practices of financial institutions. We know relatively little about the impact of CSR on management practices in the banking industry, both from the side of lenders and from the side of borrowers. There is some evidence that CSR affects the cost of capital of listed companies (El Ghoul et al., 2011) and that lenders react positively to CSR practices. Goss and Roberts (2011) show that firms with social responsibility concerns pay between 7 and 18 basis points more than firms that are more responsible (in a sample of over 3000 transactions with US institutions). However, this effect disappears for high-quality borrowers. CSR plays a role in financial institutions strategies (Jeucken, 2001; Jeucken. and Bouma, 2001). Weber (2005) divides the approaches to integrating sustainability into financial institutions into five models: event-related integration of sustainability, sustainability as a new banking strategy, sustainability as a value driver, sustainability as a public mission and sustainability as a requirement of clients. Weber (2005) argues that events usually trigger the incorporation of new management practices into the banking industry through event-related sustainability integration. Here we present a case in which a bank proactively develops a sustainability credit score system, a management practice that more closely resembles the model of sustainability as a value driver. 5

6 In this model, banks create strategies based on sustainability to generate value by developing new competitive advantages. Hu and Scholtens (2012) analyze the case of developing nations using a sample of 402 banks from 44 developing countries in They conclude that commercial banks in developing countries perform relatively well on social issues but are rather poor performers regarding environmental management, codes and responsible products. Filling this gap may result in competitive advantages for commercial banks in developing nations. The starting point for the present work is the idea that emerging issues regarding sustainability and ethics provide incentives for financial institutions to develop new strategies and incorporate them into their commercial practices for instance, the eco-premium (Lubin and Esty, 2010) is in itself an incentive that could change the way in which companies conduct business (Conley and Williams, 2011; San-Jose et al., 2011). Our paper is closely related to two works: Chih et al. (2010) and Nandy and Lodh (2012). In the first, the authors investigate a total of 520 financial firms in 34 countries, and find that larger firms are more CSR minded, even though financial performance and CSR are not related; firms act in more socially responsible ways to enhance their competitive advantages when the market competitiveness is more intense; and firms in countries with stronger shareholder rights tend to engage in fewer CSR activities. In the present case, the Sustainability Credit Score System is developed for an institution that closely resembles the characteristics reported by Chih et al. (2010): it is a commercial bank in a country with weak shareholder rights, and it is a large 6

7 institution that faces intense market competition. Hence, it is poised to have the proper incentives to develop innovative CSR policies. We try to build on Nandy and Lodh(2012), who find, for a sample of over 3000 lending transactions by banks in the US, that bank incorporates firms environment-consciousness into their corporate lending decision, and that more eco-friendly firms obtain a more favorable loan contract than firms with a lower environmental score. Nandy and Lodh (2012) argue that banks can reduce their default risk by considering firms environment-consciousness when determining loan contracts. However, most models (e.g. Goss and Roberts, 2011) usually assume in their hypothesis development that banks are socially neutral and are concerned solely with credit repayment. Here we argue that CSR practices, like the SCSS, may extend beyond credit risk to incorporate reputational risks and the development of potential competitive advantages that can be embedded into the core strategies of the organization. 2. The Industry in 2012 The Sustainability Credit Score System is developed to classify companies according to their sustainability practices, and is tested through application to the Brazilian sugar industry, which combines two main characteristics that make it suitable as a first adopter: it presents environmental, social and economic pressing issues (ethanol is considered a relatively clean source of energy) and is large enough to warrant a sustainability analysis by a commercial bank. The sugar and ethanol industry (referred to as the sugar industry from now on) output in Brazil totaled U$32 billion in the 2011/2012 crop season, approximately 7

8 2% of the Brazilian GDP, representing 50% growth compared with The industry employs about 4.5 million people and processes around 700 million tons of sugar cane to produce 38 million tons of sugar and 27 billion liters of ethanol annualy. Table 1 below reveals some data on the sector for the Brazilian economy. Relevant to the present work is the fact that the industry is composed of dozens of thousands of small producers and hundreds of industrial mills, which makes it costly to collect information to develop credit score systems. PLEASE INSERT TABLE 1 HERE. Brazil is the world s largest sugar cane producer, followed by India, Thailand and Australia. In the 2011/2012 crop season, sugar cane crops occupied an area of 8.1 million hectares: 0.95% of Brazil s territory and 2.5% of the country s cultivable land. The industry produces sugar and ethanol both for domestic consumption and for exporting. Recently, it has added the generation of bioelectricity from sugar cane bagasse. Of the total 2011 industry output, 45% was used to produce sugar and 55% to produce ethanol. Roughly two-thirds of the refined sugar output is exported. As for ethanol, the high domestic demand and competition from the USA have been forcing a decrease in exports since 2008, when sales in the international market reached a peak of 5.12 billion liters. Sugar cane production is concentrated in the South-Central and Northeastern regions of Brazil. In the state of São Paulo, sugar-cane-related activities are common in 60% of the 645 municipalities. The Southeastern region produces almost 70% of the national output, and São Paulo alone is responsible for more 8

9 than half (59.46%) of the country s production. The South-Central region, on the other hand, is the new frontier. It produces less but its productivity rivals that of the Southeast. It is also the new source of growth for the industry. A total of 432 mills are currently operating in the country as of 2012, of which 251 produce both sugar and ethanol and 162 are pure ethanol producers. They are all self-sufficient in the production of both thermal and electrical energy. São Paulo has the largest number of industrial plants, followed by Minas Gerais, Paraná and Goiás. Sugar-cane-related activities employ 3.85 million people and the formalization of labor relations reaches 79.6%. 3. Methodology for the Sustainability Credit Score System The idea behind the Sustainability Credit Score System is to measure each firm s potential contribution to sustainable economic production. Because sustainability is multidimensional and dynamic, there is no unique way to measure the impact of a single firm. For the present work, Figure 1 below summarizes the whole analytical process that generates questions for the score system. PLEASE INSERT FIGURE 1 HERE. The methodology is based on a bottom-up approach. First is the industry analysis, followed by the definition of critical issues regarding the industry and its long-term sustainable path. We then distill these issues into their environmental, economic and social aspects and relate them to the three main 9

10 paths for sustainable development: business as usual (BAU), sustainable business (SB) and future sustainable business (FSB). Due to the inherent uncertainty of dealing with forecasting, we adopt a generic conception of these development stages. BAU refers to the present stage in which the sector practices are directly related to past practices, which may or may not be sustainable. SB is a future stage (around 2020), the result of the adoption of new sustainable practices by firms. These are mainly derived from the emerging technologies, new commercial practices and evolving legislation. FSB is a future stage (around 2050) marked by the foreseen role of the sector in a sustainable path that would allow continuing economic, social and environmental development (WBCSD, 2010). From this relationship we deduce risks and opportunities, which are the main source of the credit score system. The main contribution of this methodology is that the resulting credit score system can help develop proactive short- and long-term commercial practices. We turn to this later, but a simple example of long-term commercial practices follows. By conducting a long-term analysis, we try to establish the possible future sustainability of the industry itself. For instance, let us assume that our analysis of the sugar industry shows that its long-term yield productivity is going to be low and that the only way for the industry to survive is to expand geographically into protected environments and/or displace other cultures, generating negative benefits for society. In this case, the FSB analysis would show that firms would only be able to achieve FSB practices if they change their core business by focusing on more promising products. This could result in the development of credit strategies for the bank in which loans would be given to 10

11 companies investing in changing their business model. On the other hand, it may be that the FSB is one in which firms are technological leaders and would be able to obtain much better yields by focusing on new crops and new techniques. In this case, directing loans to firms searching for those opportunities could be part of a proactive credit policy Sectoral Analysis The sectoral analysis methodology combines an in-depth examination of the industry practices with an analysis of the global challenges (WBCSD, 2010), and it forms the basis for all the subsequent analyses. The idea is that the global challenge analysis addresses the major issues that firms and consequently the sugar industry have to address in the coming decades. The variables that determine environmental, social and economic changes are many and the relationships among them are dynamic and complex. From the countless challenges and issues regarding sustainability (e.g. KPMG, 2012; OECD, 2012; United Nations, 2012; United Nations Environment Programme, 2011; WBCSD, 2010), among many others), thirteen are selected, either because of their global comprehensiveness (such as water and climate change issues) or because of their relevance to the industry (such as transportation and mobility). For each one, we try to identify the main possible sources of sustainability risks, but also some opportunities for the dynamic development of the industry. Table 2 shows the selected global challenges for the sugar industry in Brazil. 11

12 PLEASE INSERT TABLE 2 HERE. The next step is to relate these challenges to the sugar and ethanol industry. We achieve this by dividing the analysis into six topics: economic outlook; value chain; life cycle; public policies and legislation; industry self-regulation and programs; and innovation. Below we show some excerpts from each topic Economic Outlook Brazil is the world leader in the production of sugar and sugar cane. The demand for sugar will probably remain strong due to the emergence of new consumer markets. The sugar prices in the international market have risen in the last couple of years, but the supply is unstable due to the weather conditions in the producing countries. The industry in Brazil balances this volatility by alternating production between sugar and ethanol, but Brazilian ethanol productivity has been declining. The ethanol market both supply and demand is concentrated in two countries, Brazil and the United States, hindering ethanol commercialization and preventing it from becoming a global commodity. International competition is increasing, but Brazilian firms are well positioned. The industry faces three major economic issues in its effort to reach a sustainable future: Government regulation of fuel prices, which places ethanol in a less competitive position due to subsidies to gasoline and diesel; Insufficient investment in the construction of new mills; and 12

13 Lack of transparency and governance structures throughout most of the sector, making companies inefficient Value Chain The hurdles regarding the operating challenges and costs in the sugar and ethanol industry are in the primary steps of the value chain farming/growing and the logistics of harvesting and transportation. To enable the advance of sustainability in the sector, it is necessary to overcome the obstacles related to the expansion of agricultural land area, sugar cane varieties, higher productivity levels in growing sugar cane and in the harvested crop, and logistics, especially the transportation of sugar cane to the mills and of vinasse (a by-product). Issues related to the burning of leaves and legal deadlines to stop burning practices are already in place in most producing states. The major challenges related to the topic concern R&D especially regarding new sugar cane varieties that require less water, are more resistant to pests and offer better fixation of nutrients in the soil. New suitable varieties are a necessary condition for expansion into different kinds of soil, hence geographic expansion is tied to R&D Product Life Cycle The life cycle analysis shows that, in addition to being a renewable fuel, sugar cane ethanol is also the fuel with the smallest CO 2 footprint among its major competitors, such as gasoline and corn ethanol. Sugar made from sugar cane, when compared with its major beetroot competitor, is also more efficient. 13

14 However, there are some sources of inefficiency that can hinder the industry s long-term sustainable growth: the burning of leaves prior to harvesting, the use of machines and trucks powered by fossil fuels, and fertilizers and agrochemicals that may affect the soil and water and increase the emission of CO 2 and other pollutant gases. New techniques and varieties may mitigate those factors Public Policies and Legislation The legislation scenario concerning the sugar industry is fluid, with many new regulations arising regularly. One relevant policy is the Sugarcane Agroecological Zoning, which is an attempt to specify appropriate areas for sugar cane growth so as to avoid harming biomasss, water springs and hydrographic basins. It is interesting to note that despite the fact that the zoning prohibits sugar cane growth in many areas, it also states that 64.7 million hectares remain suitable for sugar cane cultivation Self-Regulation The industry has, in the last five years, established some important selfregulatory measures, which can be subdivided into programs, initiatives and formal commitments. They attempt to mitigate some of the negative externalities generated by the industry. Some of the initiatives are related to labor issues, such as labor productivity and minimum prices paid to producers. There is also an initiative for an international environmental standard, called Bonsucro Certification. This attempt by means 14

15 of production standardization to gain acceptance among international market players is especially important for ethanol because commoditization breeds market penetration Innovation Innovation is key to the development of the sugar industry, whichever development path it should take. There are many R&D initiatives regarding the development of new sugar cane varieties, but also relevant is innovation in terms of industrial flexibility in ethanol and sugar production. Particularly important is the development of second- and third-generation ethanol, which should be more efficient and less polluting than the current version on the market Critical Issues The results from the previous analyses indicate 70 issues relevant to the sustainability of the Brazilian sugar industry. On this set of issues, further analysis is carried out and 34 critical issues are selected. Those issues are organized in 8 categories. PLEASE INSERT TABLE 3 HERE. The next step is to give materiality to the groups of critical issues in Table 3. First, we divide the issues and relate them to the dimensions of sustainability, 15

16 as shown in Table 4. The purpose is to provide guidelines for the intra-sector relationship between firms and their relation to their stakeholders. PLEASE INSERT TABLE 4 HERE Business as Usual (BAU), Sustainable Business (SB) and Future Sustainable Business (FSB) We then proceed to separate the group of critical issues into a development path represented by three categories: business as usual (BAU), sustainable business (SB) and future sustainable business (FSB). Each one is defined as follows: BAU the average firm in the sector; SB the top tier of firms regarding sustainable practices; FSB the average sustainable future firm, in which innovations shape the sector according to sustainability requirements. There are two main paths for development: the dissemination of sustainable practices, in which the average firm turns to sustainable practices (from BAU to SB); and the innovation path, which leads firms from their present sustainable practices to future sustainable practices (from SB to FSB). We establish SB practices for the sugar industry, which form the basis of the credit score in the next section. We show examples of two sets of critical issues in Table 5. PLEASE INSERT TABLE 5 HERE. 16

17 3.4. Risks and Opportunities The last step before developing the credit score system is to determine which of the many potential risks and opportunities that we unveiled in the previous sections would be relevant to the strategies of a commercial bank. We filter the information through two development paths from BAU to SB and from SB to FSB. The risks and opportunities are divided into credit and reputational categories, and are presented in appendix Sustainability Credit Score System The analytical methodology in section 3 has one main goal: to support the development of a questionnaire that, when applied to the firms in the sugar industry, will reveal their creditworthiness based on sustainability issues. The Sustainability Credit Score System (SCSS) is based on an analytic hierarchy process method and is divided into two parts: structuring and evaluation. In the first part, we decompose the critical issues and risks from section 4.4. into a hierarchical structure. In the second, we define the relationship between the hierarchies. The AHP demands comparisons, in pairs, among criteria/alternatives that belong to the same hierarchical level. In this particular case, we have the following levels of comparison (always in pairs): 1) Comparison between the relative importance of eco-efficiency (EE), socio-environmental (SA), socio-economics (SE), environmental protection (PA), economic growth (CE) and social progress (PS). At the end of this phase, we attain a 6 6 comparison matrix. 17

18 2) Next, for each of the six previous dimensions, we compare the respective critical issues. For instance, for social progress, three questions are compared which, in turn, result in a 3 3 comparison matrix. 3) Finally, for each question, the level of development of the firm, relative to the sustainability criteria relevant to the sugar and ethanol industry, is established. In this case, for each question, the possible answers are classified as below business as usual (nbau), business as usual (BAU), sustainable business (SB) and potential future sustainable business (FSB). The resulting matrices are presented in appendix 2, alongside the AHP methodology used to create the SCSS. The main result is that the credit score, which ranges from 0 to 1, ranks firms in terms of their sustainability and creates information to allow a bank to develop commercial strategies such as: lending practices; short-term strategies based on local branches, for instance the funding of new projects related to R&D or the transportation of vinasse; longterm policies such as the funding of research centers and lending to companies in frontier regions; and reputational exposure to the sector and specific firms. Most of these results can be achieved by a detailed analysis of the industry, but the advantage of the SCSS is that by distilling all the information into a questionnaire that results in a comparable number for each firm, financial institutions are free to incorporate it into their more established credit models. 4.1 Using the SCSS We show the development of a rating system that is proactive in establishing sustainability criteria to determine lending practices. However, using the SCSS 18

19 means developing a questionnaire to be completed by branch and account managers with private information regarding firms in the sugar industry. There are two necessary conditions for the SCSS to be effective: information has to be created and the system has to be incorporated into the decision-making process. There is no hard evidence that the SCSS is actually efficient in classifying firms based on sustainability issues, and it can easily be discarded if an organization feels that it is not accomplishing its main goal. Unless it has internal ramifications, the commercial bank will be stuck in its BAU mode, even though the idea is to move towards a future sustainable business. However, if used well, it can change the criteria used to make loans and to establish portfolio allocation. It fits well into the framework of Weber (2005) and can bring forth concrete information on how banks value the CSR practices of borrowers (as in El Ghoul et al., 2011). There is precious little information on banks management practices regarding CSR, but if the firms in the industry start adopting mechanisms similar to the SCSS, sustainability may be driven voluntarily instead of being forced by regulation, a scenario that would generate positive externalities for society. The present case shows an example of a bank that is trying to act in a more socially responsible way to enhance its competitive advantage, which corroborates the result of Chih et al. (2010). Final Comments In this paper, we describe the development process of a Sustainable Credit Score System (SCSS), which is evidence of the voluntary incorporation of sustainability indicators into a commercial bank s lending practices. The development of the SCSS consists of the following stages: selection of the 19

20 industry to be analyzed, with corresponding analysis of its economic outlook; product life-cycle analysis; value chain; legislation and public policy; industry self-regulation; innovation; development paths for the average firm: business as usual (BAU), sustainable business (SB) and future sustainable business (FSB); definition of variables related to individual firms, in each of six sustainability dimensions: economic growth (EG); environmental protection (EP); social progress (SP); socio-economic development (SD); eco-efficiency (EE); and socio-environmental development (SD); unveiling of the materiality issues pertaining to the average firm, plus vulnerabilities and opportunities regarding the sustainability of the industry; combining the information on the steps above to obtain questions for the composition of the score system; and finally definition of the weights for the analytical hierarchy process. The system is first applied to the sugar industry in Brazil, which is particularly suitable because it is a large industry in economic terms and its by-products represent relatively cleaner energy than other energy sources. We present the step-by-step development of the score system its main input is a questionnaire that follows the main aspects of sustainability of firms in the sugar industry in Brazil. The goal of the SCSS for the bank is to rank firms in the industry based not on their creditworthiness, but on their sustainability impact. Firms that rank low on the SCSS would be denied credit, even if they are financially sound. The SCSS is a CSR policy but also tries to build a competitive advantage for a financial institution by reducing the bank s long-term exposure to reputational risk. It seems that the SCSS may be a response to an ecopremium (Lubin and Esty, 2010), and if so, future research should generalize 20

21 such policies to determine the extent to which voluntary CSR policies can have an impact on long-term sustainability. There are many implications and future avenues of research. The first is to try to gain a better understanding of how new management practices that rely on CSR relate to building competitive advantage. Are market mechanisms relevant to the financial industry or should more regulation promote lending policies that are based on sustainability? Also, more direct evidence of new practices, such as the SCSS, may help us understand how the financial industry is evolving regarding CSR. 21

22 Table 1 Industry Data on the Brazilian Sugar Industry 2005 and US$ billion Industry value-added (sugar cane, refined sugar, U$20 billion R$42 billion ethanol and bioelectricity) Value-added as a % of GDP 2.35% of GDP 2% of GDP Employees (direct and indirect jobs) 3.6 million 4.5 million Number of independent sugar cane producers 72,000 farmers 70,000 farmers Sugar cane output (in millions of tons) Refined sugar output (in millions of tons) Ethanol output (in billions of liters) Refined sugar exports (millions of tons/us$) 14/US$4 billion 20/US$14 billion Ethanol exports (in billions of liters /US$) 2.5/US$1 billion 2/US$1 billion Tax revenue (US$ billions) R$6 R$7 Current investments (US$ billions) U$2 billion/year U$4 billion/year Included (number of sugar mills and distilleries) Projects in progress Sources: IBGE (2012) and Jornal da Cana (2012). 22

23 Table 2 Global Challenges and the Brazilian Sugar Industry Selected Impacts on the Sugar Industry Challenges 1 Climate Change This global challenge may have negative impacts, for instance on the biodiversity of agricultural land to produce sugar cane and on the amount (reduction) of water available to irrigate crops in the Cerrado region, but, on the other hand, it may allow for new frontiers for production. Also, changes in the energy matrix may create a demand for ethanol and energy from biomass as cleaner alternatives to oil and gas. 2 Wealth, Economy and Consumption This challenge may represent an increase in the labor cost, as well as migration from this to other industries. 3 Biodiversity The decline in biodiversity and in ecosystems may compromise sugar cane productivity and lead to the reduction of agricultural land, in order to preserve threatened biomes. 4 Energy For the sugar and ethanol sector, which generates its own energy, regulatory measures issued by the Government may be a concern, but the possibility of an increase in demand may point in the direction of increased business and new consumer markets. The sector shows high potential to contribute to changes in the energy matrix, not only supplying ethanol for transportation, but also producing electricity from sugar cane bagasse. One promising new product, for instance, is aviation kerosene produced from ethanol. 5 Cities This global challenge may represent, on the one side, opportunities to increase the demand for urban mobility products and, on the other side, disputes over scarce resources such as water. 6 Water This global challenge may represent an increase in the demand for food products but, on the other hand, it may provoke heated disputes over the raw materials necessary for industrial output. 7 Food The demarcation and the allocation of land for agricultural production intended to limit deforestation demand major productivity improvements in the areas destined for sugar cane cultivation. This requires investment in research on new varieties, with higher sucrose content. 8 Forests and Deforestation Mechanization of the sugar cane harvest is a consequence of the need to avoid burning its residues but also to improve labor productivity. However, one of its consequences is the elimination of low-skilled workers. Also, increases in ethanol production under new processing conditions may add green jobs to the economy, not only in Brazil but also in other countries. 9 Jobs and Green Jobs The impact of this challenge on the sugar and ethanol sector may affect the ethanol production costs and create pressure on the ecosystem used to produce biomass. 10 Shortage of Inputs The impact of this challenge on the sugar and ethanol sector may affect ethanol production costs and create pressure on the ecosystem used to produce biomass. 11 Transportation and Mobility The use of machines and equipment and the transportation of sugar cane to the mills and from there to the market require fossil fuels, which in turn increase CO 2 emissions. At the same time, ethanol represents an important source of clean energy and contributes to reducing the utilization of fossil fuels. 12 Population Growth Population growth may affect the industry as the increase in the consumption of renewable forms of energy results in higher demand for ethanol, and hence greater demand for land. However, new technologies may counterbalance this effect. 13 Organizational Governance Corporate governance issues may result in more professional companies, especially as family-owned companies evolve. Better governance should bring transparency and ethical and better self-regulation. The commoditization of ethanol may require compliance with global regulations related to sustainability matters. 23

24 Table 3 Critical Issues of the Brazilian Sugar Industry Group of Issues Group 1 Geographical Occupation Group 2 Productivity/Sugar Cane Variety Group 3 Clean Energy/New Products from Ethanol Group 4 Mechanization of Production Group 5 Legislation and Relationship with the Government Group 6 Chemical Inputs/Fertilizers Group 7 Governance/ Competitiveness Group 8 New Technologies Description Aspects related to the area planted with sugar cane in Brazil: not only the area already planted both in regions where the crop is traditional and in the already expanded frontier but also its future expansion to new unexplored frontiers, in search of increased production of sugar cane to respond to a growing demand. The future of the sugar and ethanol sector (market, new frontiers, survival against climatic changes, etc.) depends on the development of productivity (sucrose obtained/ton), a goal that may be achieved especially by means of the new sugar cane varieties now being researched in the country. Ethanol and bioelectricity from sugar cane may be accepted as clean sources of energy as long as their impacts on the environment are mitigated by means of research and by replacing some of the practices in use today. Ethanol (as a fuel), bioelectricity and new products from ethanol may be highly valued in the world energy matrix. The tendency to mechanize sugarcane plantations, especially during the harvest, lead the sector to a new relationship with labor. Workers need to be requalified and relocated. New technologies tend to improve productivity. The sugar and ethanol sector, as with the whole agricultural segment, has to comply with laws, norms and regulations that are increasingly more demanding. The relationship with the state includes compliance with legal regulations and sectoral initiatives, both aimed at conformity with the major requirements of sustainability. Fertilizers and chemical inputs are among the major environmental impacts of sugar and ethanol production. The sector needs research and innovation targeted at reducing the use of these resources in order to achieve sustainability. Firms in the sugar industry present low levels of governance, due mainly to the lack of professional management, decreasing competitiveness. Innovation in the sugar and ethanol sector depends on new technologies that may transform the industry. Products may contribute to a cleaner and more sustainable energy matrix in the world. 24

25 Table 4 Classification of Critical Issues, Global Challenges and the Dimensions of Sustainability for the Credit Score System Groups of Critical Issues Global Challenges Dimensions of Sustainability 1. Geographical Occupation 1. Climatic Changes 3. Biodiversity 6. Water 7. Food 8. Forests/Deforestation 2. Productivity/Sugar Cane Variety 3. Clean Energy/New Products from Ethanol 4. Mechanization of Production 5. Legislation and Relationship with the Government 1. Climatic Changes 6. Water 7. Food 1. Climatic Changes 4. Energy 5. Cities 11. Transportation and Mobility 12. Population Growth 13. Organizational Governance 2. Wealth, Economy and Consumption 9. Jobs and Green Jobs 2. Wealth, Economy and Consumption 3. Biodiversity 6. Water 8. Forests/Deforestation 9. Employment and Green Jobs 13. Jobs and Green Jobs 6. Chemical Inputs/Fertilizers 1. Climatic Changes 3. Biodiversity 6. Water 10. Shortage of materials 7. Governance/ Competitiveness 2. Wealth, Economy and Consumption 13. Organizational Governance 8. New Technologies 1. Climatic Changes 2. Wealth, Economy and Consumption 4. Energy 10. Shortage of Materials 11. Transportation and Mobility 12. Population Growth Eco-efficiency Environmental Protection Socio-environmental Economic Growth Eco-efficiency Environmental Protection Eco-efficiency Socio-environmental Socio-economics Environmental Protection Social Progress Socio-economics Socio-environmental Environmental Protection Economic Growth Economic Growth Social Progress Economic Growth Socio-economics 25

26 Table 5 Examples of Firms Practices in the Brazilian Sugar Industry 1. Geographical Occupation BAU SB FSB The sector complies with the Forest Code and creates its own legal reserves or in association with others. The sector currently carries out geographical occupation according to the Sugarcane Agroecological Zoning and to licenses granted to single firms. The sector has not yet expanded as necessary to respond to the current demand for sugar and ethanol. Although new fully mechanized plantations are being developed, the sector still occupies a large area (mainly in the Northeast) where declivity is higher than 12%, rendering the burning of leaves necessary. The sector competes with food production in areas where farmers may alternate between sugar cane and other crops, such as leguminous crops, depending on the market value of each crop. Climatic changes still do not impact on current plantations and most of the sector seems not to be concerned with anticipating what may happen to its enterprises. The sugar and ethanol sector s carbon footprint increases due to the use of fossil fuel to power sowing and harvesting machines and vehicles that transport goods between farms, mills and points of internal commercialization and exportation. Adequate expansion, in areas large enough to respond to the demand for ethanol and sugar, preserving biomes, water springs, hydraulic basins and biodiversity. All plantations are in areas with declivity below 12%, fully mechanizable and free from the burning of leaves. The sector occupies areas where it does not compete with food production or, whenever there is competition, crops are alternated in an efficient way. The sector invests in research on climatic changes, identifying new and adequate areas for sugar cane cultivation. There is a balance between planted and preserved areas, owned by either enterprises or by suppliers, regardless of the biome where they are, ensuring local biodiversity and protecting water springs and hydrographic basins. The sector does not need to expand anymore, since its productivity is sufficient for responding to the market demand for products. The soil of occupied areas is thoroughly researched, as well as water availability, biodiversity and adequate sugar cane varieties, enabling the development of an agriculture of precision. Short cycles of different crops in the same area enable three to four complementary and different crops a year and help improve soil productivity (for instance sugar cane, beans, peanuts and forage). Occupation of new areas, selected according to climatic changes, without impacting on biomes and biodiversity. 3. Clean Energy/New Products from Ethanol BAU SB FSB Gradual replacement of vehicles and equipment powered by fossil fuels in favor of biofuels and machines equipped with more efficient engines. The sector is under the influence of an erratic policy dictated by the Brazilian Government in regard to both taxes and stimulation of the production of ethanol (control over gasoline prices) and bioelectricity (the price of biomass energy does not reach attractive numbers in auctions). Ethanol from sugar cane is still not competitive with ethanol from corn. Influence on public policies to stimulate production and commercialization of ethanol and bioelectricity, aiming at the reduction of CO 2 emissions. Research on second- and thirdgeneration ethanol and on engines powered by biofuels is at an advanced stage, making sugar cane ethanol more competitive and accepted, especially in relation to fossil Transportation during planting, harvesting and commercialization is carried out with minimal carbon emission (vehicles and machines are powered by biofuels and technologies such as alcohol ducts). Ethanol and bioelectricity are important components of both Brazilian and global energy matrices, together with public policies and incentives adequate for the society s high demand for clean and renewable forms of energy. Ethanol s traceability increases its value in the international market. 26

27 Bioelectricity from sugar cane bagasse makes mills selfsufficient, but only 25% of the mills sell energy to public utility companies due to the high cost of infrastructure. Incipient research on alcohol chemistry and bioplastics, as well as on sugar cane fuel for aviation. fuels, which incorporate the mitigation costs of social and environmental damage. Incentives for the production and commercialization of bioelectricity by construction of adequate distribution infrastructure. Alcohol chemistry products, ethanol aviation fuel and bioplastics are commercially available, but still on their way to becoming sustainable products. Bioelectricity from sugarcane bagasse has lower production costs and higher market value. Expanded portfolio of alcoholchemical products, bioplastics and fuel for aviation widens the market for the sugar and ethanol sector. Table 6 Sustainable Business Practices for the Sugar and Ethanol Sector 1. Expansion of sugar cane production in compliance with both the Forest Code and the Agroecological Zoning, including the preservation of biomes, hydrographic basins and biodiversity, abandoning the practice of burning and without interfering with areas destined for food production. 2. Participation in consortia aimed at research on transgenics and new sugar cane varieties that may be cultivated in current and new-frontier areas including areas of relocation due to climatic changes with increased productivity, measured as TES/ton (total extracted sugar/ton of sugar cane crushed). New varieties must capture higher amounts of CO 2, require less water and show self-defense properties against pests. 3. Optimization of ethanol production as a clean energy to achieve global goals of reduction in CO 2 emissions; investment in second- and third-generation ethanol; reduction in the use of fossil fuel in the agricultural and commercialization phases; co-generation of bioelectricity both for self-sufficiency and for sale to public utilities; expansion of the relationship with the Government in order to establish policies to valorize ethanol. 4. Mechanization of sowing and harvesting activities; elimination of burnings; reduction in the emission of pollutant gases and of impact on public health. Requalification of workers to operate machines and equipment according to the new profile required by the sector and consequent retention of employees by means of greater benefits. Gradual machine renovation to improve efficiency and reduce soil compaction. Compliance with current social (good labor practices) and environmental legislation (waste, water, licensing, legal reserve, Forest Code), protecting the company s good reputation and paying attention to future national and international legal contexts. Foment the formulation of public policies aimed at valorizing ethanol. 5. Reduction in the use of agrochemicals in plantations (fertilizers, compounds for soil correction, pesticides and herbicides), replacing them with a correct and efficient fertigation with vinasse and filter cake, avoiding soil and groundwater contamination. Investment in genetic research on sugar cane varieties to reduce the need for agrochemicals. Investment in research to substitute agrochemicals in sugar production for other non-toxic compounds. 6. Adhesion to and effective implementation of sectoral programs and initiatives that generate benefits for the sector. Research on international standards of governance and management, ensuring information transparency, product competitiveness and perennation of enterprises. 7. Creation of knowledge partnerships aimed at research and evolution of technologies and products. Incorporation of existing technologies to make agro-industrial processes more sustainable. Better use of funding for innovation, both domestically and abroad. Permanent attention to innovations that affect the sector, including new products and the creation of new markets. 27

28 Figure 1 Analytical Methodology for the Sustainability Credit Score System 28

29 Appendix 1 Risks and Opportunities for a Commercial Bank in Relation to the Brazilian Sugar Industry CREDIT RISKS 1. Companies displaying the characteristics, or risk factors, listed below may present credit risks to banking operations: Non-compliance with legislation. Use of sugar cane varieties inappropriate for the region. Operation in an area where the water supply is compromised. Low productivity. Limited capability to manage the product mix. Sugar cane planted in areas of declivity higher than 12%. Manual harvesting is not replaced by mechanized harvesting and burning of leaves is not abandoned. Labor practices inadequate for retaining the agricultural labor force. Inadequate use of water. Contamination of soil and groundwater by fertilizers and agrochemicals. Inadequate fertilization of plantations. Inadequate managerial and governance practices. Use of obsolete equipment throughout the production process. Non-use of technological improvements such as new sugar cane varieties, sorghum, direct planting, precision agriculture, generation of electrical power, etc. Failure to obtain environmental licenses. Inappropriate contracts with sugar cane suppliers. Negligence in tracking the impacts of climatic changes. Co-responsibility in lawsuits filed against companies of the sector with regard to socioenvironmental issues. REPUTATIONAL RISKS 29