The Indonesian financial sector faces sizeable reputational, regulatory, and financial risks if it continues to support non-sustainable palm oil companies. As such, it should join actions advanced by the Indonesian government, the global community, palm oil buyers, and international banks and investors in managing the detrimental environmental and social impacts caused by non-sustainable palm oil practices.

Such stakeholder actions are increasing, and include the Indonesian government’s moratoriums on development in primary forests, peatland, and on further expansion of palm oil. They also include a commitment by European countries to purchase 100 percent certified sustainable palm oil by 2020. Further, many companies in the palm oil supply chain have committed to producing and sourcing only from areas and producers that comply with No Deforestation, No Peat, and No Exploitation (NDPE) requirements. These companies are also building traceability and monitoring systems and aiming for full implementation of their NDPE policies by 2020, a fast-approaching target.

Taken together, these measures translate into constraints on long-term growth prospects for the sector and increasing risks for palm oil companies that have not yet adopted sustainable practices. An estimated 75 percent of the land previously reserved for future palm oil growth cannot be developed under the present market and regulatory circumstances, as it is located in forest areas or peatland.

Traders, refiners, and consumer goods manufacturers may suspend their procurement contracts if the plantation companies they buy from cannot comply with sustainability policies. This may affect revenues, while costs may increase simultaneously, due in part to fines applied for the use of fires or other non-sustainable practices.

For banks financing Indonesia’s palm oil sector, these developments imply an increasing risk of non-performing loans (NPLs). At the same time, the value of collateral - often in the form of undeveloped land - falls, meaning that outstanding loans to this sector are in general underpriced. Regulatory pressure on banks to integrate sustainability criteria into their lending decisions is also increasing, and their continued exposure to sustainability issues in the palm oil sector may tarnish their reputation among both domestic retail clients and foreign investors. This will make it more difficult for banks to attract sufficient funding and meet solvency requirements.

Banks have benefited from the steep growth in the Indonesian palm oil sector. Indonesia is now the global leader in palm oil exports, which accounted for 12 percent of Indonesia’s 2016 export value, and loans supporting the development of palm oil have yielded healthy returns for banks. The sector continues to grow and is a major driver of local economic development and poverty alleviation, directly employing approximately 5.6 million people.

However, these economic benefits come with high environmental and social costs, including the conversion of tropical forests and other areas with significant biodiversity into palm oil plantations. The devastating forest fires in 2015, estimated to have caused more than 100,000 premature deaths in Indonesia, Singapore, and Malaysia, emphasize the importance of healthy forests and peatland in our ecosystems. The hundreds of land rights conflicts between palm oil plantations and local communities across Indonesia are also drawing increasing attention, as is the potential corruption and the low tax compliance ratio of the palm oil sector, highlighted by the Indonesian Corruption Eradication Commission (KPK).

Major stakeholders are taking measures to manage the sustainability risks, and this new environment is creating significant reputational, regulatory, and financial risks for Indonesian banks exposed heavily to the palm oil value chain, in particular to upstream production. Possible steps for banks to manage these risks include screening their portfolio, developing their own sustainability policy, and engaging with palm oil clients to support transformation. It is time for the Indonesian financial sector to join the growing ranks of those heading towards sustainability and secure for itself a stable and prosperous future.

This paper consists of three chapters and follows the structure in Figure 1, which explains how the actions of governments and the private sector to address unsustainable palm oil production could translate into financial risks for palm oil producers, and consequently for their lenders. Chapter 1 examines the risks in the unsustainable palm oil sector for companies and financiers, and Chapter 2 highlights the benefits of investing in sustainable palm oil. Chapter 3 closes this brief by providing practical recommendations for banks intending to address the looming risks of their exposure to unsustainable palm oil.