Building Investor Confidence in Nature-based Solutions
The perception that nature-based solutions are a high-risk investment is preventing the deployment of capital at the scale needed.
Investors are coming under increasing scrutiny over how far their activities support a pathway to net zero emissions and provide measurable benefits to the environment and society. Such scrutiny has been enabled by initiatives which are driving improvements in reporting of climate and nature-related financial information.12
Many investors are committing to long-term targets to decarbonize their assets and rethinking their portfolio allocation strategies to achieve this. In November 2021, the Glasgow Financial Alliance for Net Zero, for example, announced that investors worth over $130 trillion, or 40 per cent of global financial assets, had rallied around a net zero emissions target.3
Aligning investments with long-term decarbonization goals is a challenge that cannot be delayed. At COP26, it was announced that UK financial institutions will have to set out detailed plans for how they intend to hit climate change targets by 2050 in the next 24 months.4
Meanwhile, the rise of the environmental, social and governance (ESG) investment sector, which is expected to have grown by 39 per cent in the last 12 months alone, and wider impact investments, with annual financial flows tripling to $715 billion between 2017 and 2019, are both signals of investors tackling the implementation challenge.56
In a context where investors are exploring options to meet the demand for green impact investing, nature-based solutions – approaches to protect, manage or restore ecosystems so that they can remove carbon, provide biodiversity benefits and support social wellbeing – have gained momentum.7
The momentum behind nature-based solutions provides a window of opportunity to scale much-needed financial flows to these activities given that it’s estimated that at least trillions of dollars are needed up to 2050 in order to reverse biodiversity degradation and combat climate change.89
Forests: a key nature-based solution
Forest landscapes are an essential part of nature-based solutions along with grasslands, peatlands, wetlands and natural infrastructure in urban areas.10
Forests serve multiple functions. They support biodiversity, provide ecosystem services and regulate sustainable carbon, water and soil cycles. Finding ways to ensure that standing forests are not converted, as well as to reforest formerly forested areas, represent the two largest landscape-based carbon mitigation options.11
Forests also sustain local communities and can provide feedstock for forest-product industries such as energy, pulp and paper and cross-laminated timber.12
In providing these resources, forests directly generate an estimated 86 million jobs while supporting the livelihoods of many more.13
Forest landscapes exist on a continuum from intact natural forest to industrial plantations. Between these two, there is a spectrum of forest management approaches that provide a range of functions in different ways. These include low-impact forest management, reforestation, plantations with diverse tree species and agroforestry.14
The momentum behind nature-based solutions is an opportunity to direct more finance to those types of forested landscapes that deliver sustainability across these multiple functions. The ultimate result of investment should be a diverse set of forest landscapes that deliver both direct and indirect benefits to people and planet. Importantly, additional sources of finance can help mobilize landscape management towards this state, but first, some challenges must be overcome.
Overcoming challenges to scaling investment in nature
While there is an upswell of financial capital looking for green investments, a range of barriers are stopping it being channeled into nature-based solutions.
These barriers differ depending on the type of investor. Institutional, retail, public, impact and seed investors all have different risk appetites, a willingness to invest long-term and ways of prioritizing the kinds of impact they seek to deliver. In this way, different nature-based projects, each with unique cashflows as well as impacts, will be more aligned with certain investors’ risk and return expectations.
Currently, more risk-tolerant investors, including some development finance institutions and philanthropists, are more likely to invest in longer term outcome-focused activities in frontier regions of emerging markets compared to more risk-averse mainstream actors such as institutional investors.
These investors are establishing a track record for new regional markets in conservation, community-forestry and restoration, exemplified by the partnership between CDC Group, Finnfund, Norfund and New Forests, which aims to raise $500 million for landscape investments in sub-Saharan Africa.15
While the range of potential nature-based solutions will need to be carefully matched with the right investors, some steps can be taken to overcome general hurdles for most types of investors.
One key action is to increase investor confidence that nature-based solutions can deliver desired outcomes. Mainstream investors tend to see nature-based investments as high risk, in part due to a lack of institutional experience investing in these activities, limited examples of scalable success and currency risks.
Since most of the opportunities for nature-based solutions are found in frontier regions, currency risk is a real issue. To attract private finance into climate solutions, whether they are nature-related or not, innovative blended finance approaches need to be developed with international development institutions to manage these risks.
Lessons can be drawn from how currency risks for renewable energy investments have been managed such as the Long-Term FX Risk Management project. This was backed by the International Finance Corporation and The Currency Exchange Fund and funded renewable energy investment in Africa by guaranteeing long-term fixed inter-currency swaps, loan repayments and taking on high potential credit risk.16
Three further actions could help lower risk perceptions and provide more certainty of cashflow for nature-based solutions across established and emerging markets. These are to:
- Collate and share expert knowledge among investors new to nature-related projects.
- Understand how robust nature-based projects can provide more cashflow certainty for investors.
- Implement policies that provide long-term certainty by creating aligned end-markets for products and services.
Reducing perceived risks
Systematizing and sharing existing knowledge, as well as building consensus on guidelines, standards and frameworks, can help to address the lack of knowledge which is a barrier for mainstream investors.
Institutional investment in forest-landscapes has traditionally been through timberland as an asset class which currently totals $100 billion compared to over $4 trillion in private equity.17
These investments in timberland have often been part of a diversification strategy away from equity due to forest assets’ weak correlation to performance of the stock market and characteristically strong hedge against inflation.18
Even in timberland investments, where institutional investors are more active, investments are often made through a specialist intermediary such as Timberland Investment Management Organizations (TIMOs)19 or forest-owning trusts.20
As investing in forests is still niche, mainstream institutional investors often lack in-house knowledge on forest ecosystem functions, which can lead to a higher perception of risk.
Often, the expert knowledge required to operationalize investments in nature is concentrated in specialist organizations, such as TIMOs, or impact-based nature investment vehicles.
But mainstream investors are beginning to partner with individuals or organizations who can provide this expertise such as established forest landscape investors, indigenous groups and local forest communities who can help to identify strategies for sustainable forest practice.
These groups can provide invaluable lessons, not just on technical aspects of forest management, but also on the local socio-political context and how projects may affect communities on the ground.21
Knowledge on innovative nature-based solutions may currently be in development, or only trialed on small scales, and will take time to develop a track record.
Risk-averse investors seeking a high certainty of financial yields, for example, will be less likely to allocate capital to projects at the cutting edge of ecosystem services provision.
As many of the more sustainable approaches, such as polyculture plantations with native species, are only now being commercialized, it will take years to perfect the silviculture practices that achieve high productivity benchmarks.
Measurement of on-the-ground-benefits of innovative nature-based solutions can help to spread lessons from pilot programmes and disseminate new practices quickly thereby reducing the time to scale up.
To date, measurability, verification and standardization have been limited by a number of factors including the prohibitive cost of employing workers to conduct such measurements, lack of technology to automate measurements, difficulties in standardizing outcomes between boutique projects and a lack of incentives linked to cashflow to do so.
However, new innovations in technology, such as biodiversity monitoring through DNA sequencing and increased satellite surveillance capacity, can help to remove many of these barriers.2223
The creation of guidelines, standards and frameworks for nature-based solutions are needed to help systematize this evolving body of knowledge and support the transition to a sustainable bio-based economy. These tools can help create a common language to define what investment in robust nature-based solutions looks like.
Initiatives to build a multi-stakeholder classification of nature-based solutions, led by academics, sustainable landscape management actors and expert civil society organizations, representing the entire globe and spectrum of natural capital endowment, can drive this process forward.
Reducing cashflow uncertainty
Diversifying investments in different sustainable forest activities and combining novel technologies alongside mature investment models can help investors to diversify risks while also delivering additional benefits.
The likely cashflows and outcomes of the most mature forest-related activities, conservation and plantations are well understood by investors. Plantation forests generate financial returns primarily through the selling of timber and non-timber forest products and the appreciation of the real estate value of land while conservation yields financial return through easements and impact-related bonds.2425
Investing in only one type of forest activity will deliver specific benefits while more innovative forest management practices, or landscapes that combine a number of types of forest management, can provide a whole suite of functions and deliver multiple socio-economic outcomes.
But uncertainty over cashflow is currently limiting willingness to scale up investments in the most innovative nature-based approaches. Three key strategies could help to alleviate this uncertainty and provide a transition pathway:
Creating investments with pre-arrangements between the project and buyers to purchase or sell portions of the project's upcoming services and goods.
Integrating investments explicitly delivering natural benefits, such as restoration or conservation, into established portfolios for forests, agriculture and infrastructure can reduce the direct risk exposure of new cashflows with existing known payments.
The development of new valuation and business models that explicitly drive cashflows for the provision of a wider selection of benefits.
While pre-arrangement for the purchasing and selling of goods and services and integrating natural benefits into existing portfolios can be activated, new business and valuation models will take time to develop and public policies will be important to scale these new valuation and business models in the future.
Policies to increase investor confidence
Current policies on investment in nature-based solutions are fragmented although promising examples exist. Policies designed to nurture a circular bioeconomy, for example, can provide an opportunity to increase financial flows to nature-based solutions. Indeed, the development of bioeconomies will be critical to nurturing certainty in cashflow for investments that lead to positive outcomes.
Public policy that influences investor actions can incentivize investments in nature-based solutions. These include expanded disclosure requirements and the development of green taxonomies such as the EU Taxonomy,26 Association of Southeast Asian Nations Countries (ASEAN) Taxonomy27 and a China green standard, in co-operation with the EU.28
However, investor regulation must also be connected to policies that encourage finance to flow to a diverse range of forest projects in both established and frontier markets. This will require increasing investors’ confidence that they can generate financial and impact-oriented returns in emerging markets.
But investor confidence will depend on a number of factors including valuation and demand volatility of products and services, the status of land ownership, counterparty risks29 and capital liquidity.
Currently, international policy packages that reduce cashflow risks connected to the provision of forest-related benefits are fractured. Without wider efforts to introduce national or international policies designed to implement new valuation models, investments may only be channeled to hyperlocal or established high-confidence markets and not generate benefits in more frontier regions with higher risks.
Promisingly, there is a patchwork of existing jurisdiction-specific examples that can provide a blueprint for scalable regulatory solutions to provide security of cashflows in ecosystem services. The California cap-and-trade policy, for example, which guarantees the floor price of carbon year on year, has channeled funding from credits into planting more than 125,000 urban trees and restoring over 650,000 acres of land.30
Similarly, the New Zealand Emissions Trading Scheme, recently adjusted in 2020, caps the total greenhouse gas emissions allowed in the scheme at five year intervals, providing more long-term certainty of the price of buying and selling local carbon credits and the level of decarbonization they must achieve.31
These policies have helped to channel money to the planting of trees but they must be underpinned by accurate measurement of actual carbon savings to ensure any benefits of the investment are additional and that it does not cause harm to local communities.
Policies driving the development of sustainable bioeconomies can boost the flow of finance to forests. They provide a soft signal to investors of consistent, long-term assurances of an end-market stability.32 Indeed, there is a growing momentum to connect forest products and services to end markets through formalizing bioeconomies and, in 2020, 19 countries dedicated bioeconomy strategies while nearly 60 had strategies under development.33
Cohesive supply-chain policy signals are needed to drive capital towards a common goal of sustainable forest use. Demand-side policies, such as mandates, procurement and emissions reduction incentives, provide certainty in cashflow for end markets while end-market procurement of products and services should be twinned with supply-side land-use planning policies, such as subsidies, taxation and land titling rights, that provide long-term incentives or regulation to create landscapes that sustainably align with end markets.34
Across value chains, robust transparency and certification can increase investor confidence that the assets they invest in, do deliver additional positive outcomes and thereby reduce reputational risk.35
Building investor confidence in nature-based solutions, whether though knowledge-sharing, market measures or policy implementation, can only be achieved through collaboration between a wide-ranging stakeholder group. This collaboration should occur:
- Within the finance sector. Collaboration between more experienced nature-based investors and counterparts in the mainstream retail or institutional sectors can reduce risk perceptions.
- Across varied and inclusive stakeholder groups. Partnerships between a broad stakeholder group involved in natural capital financing, including primary investors, nature-based asset managers, project developers, local communities, indigenous groups and civil society actors, is needed to ensure that the benefits of nature-based projects are realized.
- International policy. Policymakers working internationally can align, and reinforce, supportive policy development across supply chains from the source of finance to end markets.
Building investor confidence across the interconnected layers of knowledge, markets and policy will be critical to moving large pools of capital into nature-based solutions over the long term.
While different types of investor will have different approaches, reducing the risk and normalizing forest finance for new investors can help to channel capital to diverse landscapes that deliver for people and planet.