Note: Last month, Root Capital published our inaugural issue brief on the emerging business case for financial institutions to conduct due diligence on the social and environmental practices of their borrowers and investees.
This is the fourth and final installment in a series that goes deeper on that social and environmental due diligence, addressing questions such as: What do we look for in the business we lend to, and why? How do we go about it? And how do smallholder producers and agricultural businesses in Africa and Latin America benefit, as well as upstream exporters, processors, retailers, and consumers worldwide?
In previous posts, we have described what we look for in our social and environmental due diligence: a mutually beneficial relationship between agricultural businesses, smallholder farmers, and the natural environment. We conclude our four-part series by beginning to discuss how lenders, corporate buyers, and others can identify whether, and how, this mutually beneficial relationship exists in a particular rural community.
The challenge for financial institutions in identifying the mutually beneficial cycle between an agricultural business and its affiliated farmers is that they typically interact only with the business. Financial institutions typically do not survey farmers or measure ecosystem health, because to do so would be prohibitively costly and time-consuming – on the order of thousands or tens of thousands of dollars per survey.
If the agricultural business has achieved a certification such as organic, Fair Trade, or Rainforest Alliance, then lenders can leverage the work that has already been done. Certifiers typically conduct extensive surveys of farmers to ensure, for instance, that farmers are receiving a certain price, or that they are appropriately managing the soil. In these cases, financial institutions need only understand the requirements for each certification, and then address any remaining issues that are of interest but are not covered by the relevant certifications. Achieving certification also requires significant organizational capacity on the part of the business, and thus can serve as a proxy for managerial capacity.
Some businesses that are not certified have adopted sustainable agricultural practices and are supporting the livelihoods of smallholder farmers. If we are to address poverty and environmental degradation on a global scale, we need to reach these businesses and these farmers, and we need to be able to do so without conducting long surveys of large numbers of farmers or environmental measurements ourselves in every community in which we operate. As an example, Root Capital does conduct such extensive surveys with a number of rural communities each year, but could not do so with all of the 200+ agricultural businesses that borrow from Root Capital every year.
While comprehensive, farmer-level audits may not be practical for financial institutions to conduct, lenders can look for a set of practices, of the business and of the farmers, which can reasonably be expected to lead to the socio-economic and environmental outcomes we desire.
We call this approach ‘practices as proxies.’ For instance, if the business is offering improved seeds and paying a higher price than other local buyers for farmers’ harvests, we have reason to believe that those practices are improving farmers’ incomes, all else equal.
To be sure, practices are not proof of impact. To the extent that individual lenders’ mandate is to achieve certain social or environmental impacts, those lenders may implement deeper impact evaluations and case studies to demonstrate that impact. Root Capital conducts such evaluations, which can be found on the impact page of our website.
More generally, lenders must rely on professional researchers for experimental studies to connect the adoption of sustainable agronomic practices to desired social and environmental outcomes. In areas where researchers have generated a strong evidence base, lenders can leverage it to inform their choice of practices to look for. Root Capital’s social and environmental due diligence is based on our own review of this evidence base. Where the evidence is weak or ambiguous, lenders can play a role in calling attention to the need for further research to inform practice.
Only a minority of lenders will conduct independent impact evaluations or engage with the research agenda around social and environmental practices. But all lenders to agricultural businesses can employ the lessons of this research to use conduct social and environmental due diligence to focus their capital where it will have the greatest impact, and to inform better business decisions.
For more detail on the specific indicators that Root Capital uses to look for the mutually beneficial cycle, please see pages 9-21 of our Social and Environmental Due Diligence Methodology Guide, as well as the Social and Environmental Scorecards themselves.
We hope that by sharing our social and environmental due diligence methodology, we lower the barrier for other financiers to incorporate social and environmental concerns into their own due diligence. We invite other organizations to share their own approaches and contribute to the emerging standards and best practices around social and environmental due diligence, thereby enabling the social finance sector to focus its lending and investment on the businesses that will generate the greatest impact on the 2.5 billion people living on less than $2 per day and on the natural environment upon which we all depend.