Wednesday, 11 May 2022

Nature Emerges as a New Asset Class

 

By Akram Alami, Partner and Middle East ESG Lead, Bain & Company and Dale Hardcastle, Partner, Bain & Company

It is the world population’s duty to protect the planet, its environment and natural resources. The entire Gulf region has set a prime example in reducing carbon emissions by 2030.  Natural climate solutions (NCS) are ways to sequester carbon through conservation, restoration, and improved land management of the world’s forests, grasslands, and wetlands. Given their potential to abate greenhouse gas emissions, their comparatively low marginal costs, and their ability to deliver other benefits, NCS are expected to be a key component of any pathway that limits global warming to well below 2 degrees Celsius above preindustrial levels.

NCS could account for 37% of total mitigation efforts—about 11 gigatons of carbon dioxide out of the net 30 gigatons that need to be abated each year—while also delivering economic and social benefits, such as restoring ecosystems and securing the transition to low-carbon livelihoods for communities that depend on natural resources.

NCS also represent a new source of potential growth for investors. Today, only about 2% of the $632 billion deployed globally each year in climate capital goes toward natural solutions. The main reasons are that investors are unfamiliar with this asset class and unsure about the returns given the volatility of carbon prices. We expect that to change over the next few years, and it seems likely that the entry of institutional investors will help mature this asset class and bring it into the mainstream.

 

 

Several other trends indicate that the market is poised to grow and become more manageable for investors. Although NCS may not have received the attention from private capital that they deserve, several trends suggest that this is changing.

  • Growth of voluntary carbon markets: Carbon credits have been on an upswing in recent years, in terms of both price and traded volumes. Volatility in carbon markets over the past few months, however, has crimped volumes and prices, although some higher-quality credits, such as nature-based restoration credits, have sustained price levels.
  • Progress toward shared standards: For years, the global carbon markets have been hampered by the lack of consistent standards with which to measure carbon emissions. The Institute of International Finance’s Taskforce on Scaling Voluntary Carbon Markets is working on legal principles and contracts for carbon trading as well as a global benchmark for carbon credit quality.
  • A flourishing ecosystem of players: New infrastructure, systems, and actors (including marketplaces, brokerage services, and technical service providers to measure, verify, and report on carbon and cobenefits) are developing globally.
  • Growth in technological innovation: Technological advancements afford NCS projects greater transparency, accountability, and therefore trust—the lack of which had limited the growth of carbon offset markets. For instance, improved forest monitoring allows for more accurate baseline assessments and monitoring while reducing setup and operational costs.

 

Private capital is pouring into NCS

Investment funds are growing rapidly, and private investors are showing more confidence in this asset class. Three types of NCS funds are emerging with different sources for returns and target investors:

  • Sustainable product funds focus on greening supply chains for those with net-zero and sustainable sourcing commitments.
  • Nature+ funds invest directly in NCS to provide financial and nonfinancial returns for long-term investors.
  • Carbon pure play funds secure carbon credits from NCS investments within a broader carbon sequestration portfolio.

 

Five considerations for investors

A supply crunch is looming. Existing NCS projects have limited scalability, and many proposed projects either have long lead times (up to four years) or never pan out at all. In this seller’s market, with many buyers scouting for high-quality projects, investors should take several actions to improve their ability to obtain high-quality credits.

  • Form a proactive investment strategy that includes strong partnerships. Many investors have taken an opportunistic approach to credits, reacting when opportunities present themselves. A more effective approach is to establish a comprehensive origination strategy tailored to the local environment. They should evaluate partnerships based on their track records and their relationships with governments and local communities.
  • Use technology to speed up high-quality projects. The sector would benefit from comprehensive early-stage project registries and automated assessment tools to quickly score projects based on their carbon and cobenefits potential.
  • Engage the community. Poor community engagement is the primary reason for project failure. Success is more likely when local communities are properly consulted, participate voluntarily, and receive an equitable share of benefits. Investors that obtain such guarantees from project developers can better mitigate their risks.

 

Low correlation between price and quality

The nascent NCS market does not yet price risk and quality well despite a general understanding of the four criteria that determine their quality. The lack of a consensus standard can result in some low-quality credits being priced above high-quality ones. As standards coalesce and the risks become clearer, investors can consider several strategies to ensure the quality of credits.

  • Engage large funds. Large funds give investors more engagement and control over the selection of projects, enforce minimum standards and guidelines for projects, and assist with the selection of implementation partners, providing quality assurance for investors in an uncertain market.
  • Work with third-party tech providers. Specialty companies use technology and data to get a better picture of the quality of carbon credits, assessing their additionality, permanence, and potential for leakage. Using these third-party platforms for due diligence allows for the swift assessment and procurement of reliable projects.

 

Moving forward

The global net-zero imperative has never been more present, and NCS has an irreplaceable role to play. Private financing is waking up to the economic and environmental value of nature as an asset class. Whatever their risk profile and needs, pioneering investors can moderate their involvement from a range of participation models. If investors are mindful of the supply limitations, quality variance, cobenefits uncertainty, trade infrastructure developments, and regulatory risks, financial and nonfinancial returns beckon.

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