Financing Nature as an Infrastructure asset class
Our evolutionary journey from Natural Infrastructure to Built Infrastructure
The idea of nature as an infrastructure in the recent literature can be traced back to the 1800s or before. However, as eloquently laid out by Erik Berglof in his piece last year for millennia, natural infrastructure – such as river systems, wetlands, coastal plains, sand dunes, and forests – have supported the development of human civilization. Our ability to harness such infrastructure, for everything from food and drinking water to storm-surge protection and flood mitigation, has been central to our success as a species. With rapid urbanisation, "grey" took over "green" giving way to cables, concrete and steel. "Natural infrastructure" gave way to "Built infrastructure".
Today, we reserve infrastructure as a term exclusively to refer to the built environment. This industry attracts significant investments globally across the public and private markets. As per McKinsey & Company, in the last decade, spending on infrastructure globally exceeded $2.5 trillion per year spanning various sectors as transportation, energy, water, and telecommunications. With the significant investments, built infrastructure has proliferated in scale and complexity to include railways, expressways, tunnels, bridges, seaports, airports, telecommunications towers, power plants, data centres, commercial/ industrial real estate and so on.
Pricing in the Negative externalities of Built Infrastructure investments - Evolution of Natural Capital Funds (NCFs)
This was however achieved at the cost of the Natural infrastructure, whose ecosystem services, by the way, were never "priced in" by the markets - public or private. This was famously and somberly articulated by Nicholas Stern, the chair of the Grantham Research Institute at the LSE in 2006 in his report to the Govt. of UK:
Climate Change is the greatest and widest-ranging market failure the world has ever seen
Fast forward to 2024, the same can now be extended to nature at large. In their widely cited paper in Science last year, Katherine Richardson et al. for the first time documented the scope of this failure-
6 out of 9 "planetary boundaries" have now been transgressed, suggesting that Earth is now well outside of the safe operating space for humanity
The root cause enabling these appalling transgressions is ignoring the true cost of negative externalities associated with the investments into built infrastructure. The ecosystem services provided by nature are priced in highly selectively to include just the procurement of direct resources (timber/bamboo etc). This however tends to drastically underestimate the true cost, by discounting the financial value derived from other important ecosystem services provided by an existing functional forest/ agro-forest/ grassland (including carbon sequestration, regulation of ground water, local atmosphere among others).
Accounting for the multitude of ecosystem services provided by a natural infrastructure such as a sustainably managed forest by ascribing them each a true market value, tends to highlight the significant underlying revenue streams and its role as an economic asset to the financial markets. Over the past decade, this in particular has brought about the evolution of so called Natural Capital funds (NCFs).
Channeling Institutional Capital into Natural Infrastructure or Nature-based Solutions (NbS)
As these ecosystem services started to be priced in within the economy driven either by regulations (EU ETS, UK's Biodiversity Net Gain) and/or market forces (Voluntary Carbon Markets), investment capital started to be increasingly channeled towards natural infrastructure to tap the high potential upside, as the regulations and market forces drive the prices of these ecosystem services closer to their full and fair value.
Earlier this year, the Sustainable Markets Initiative’s Natural Capital Investment Alliance (NCIA), put in place by Charles III, came up with an investor guide- Investing in Nature. The compendium lays out two broad ways today, for institutional capital to find its way to natural infrastructure-
1. Direct Institutional Investments into Natural Capital
Investors can invest directly in natural capital through NbS and real assets.
1. a. Investing in NbS
NbS or Nature-based Solutions is the colloquially used industry wide term to refer to Natural Infrastructure. As defined by the International Union for Conservation of Nature (IUCN), NbS is a broad term, but generally, it refers to projects that seek to protect, manage and/or restore critical ecosystems, while addressing societal challenges and providing holistic benefits for both people and Nature. This is often done with the intention of both preserving or improving the environmental integrity of the ecosystem itself and of the services and well-being that humans derive from it.These strategies aim to make a positive impact on land, freshwater, oceans and air through changes in land use and/or management practices.
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One important feature of NbS projects is that their financial sustainability typically depends on payments for ecosystem services (PES). PES are policy or market instruments that allow for financial compensation in an ecosystem service such as carbon sequestration, water flow, climate regulation, storm damage prevention or pollination. The most widely known market instruments today are carbon credits.
Although the carbon credit market is still very much developing, PES markets have historically been successfully deployed for many years. This includes in the United States where, through various regulatory frameworks such as the Clean Water Act (1972), the loss of certain ecosystems such as wetlands, streams and habitats through development are by law required to be compensated through the preservation and restoration of an ecosystem elsewhere so that there is no net loss to the environment. This system known as mitigation banking, is one form of many PES markets globally.
In 2023, BloombergNEF estimated that the global annual flows into these markets were approximately $9.8 billion. There are in fact over 550 active PES programmes around the world today and increasing, as per another study in Nature by Salzman, J., Bennett, G., Carroll, N. et al (2018)., with recent high profile developments such as Biodiversity Net Gain (BNG) in the UK.
1. b. Investing in Real Assets: Agriculture and Forestry
Agriculture and forestry assets rely on natural capital, namely soils, water and microorganisms to derive economic value. Investors in these assets can contribute to safeguarding and enhancing positive environmental and social impacts while mitigating the often substantial damage associated with land usage. To achieve such impacts, investors must ensure they are facilitating the transition towards more sustainable land management practices. As per the SBTN Interim Targets laid out by Science Based Targets Initiative to guide a corporate net zero plan, strategies such as regenerative agriculture or improved forest management, can target direct outcomes across biodiversity, soils, water and carbon. A 2022 study from McKinsey found that agriculture is responsible for 85% of all biodiversity loss but changes to agriculture could deliver 72% of the total potential improvement in biodiversity loss identified.
Agricultural and forestry assets can generate income through leases, which present lower risk, or through the production and sale of commodities, which entail higher risk. However, the specific risks associated with agriculture and forestry investments – including geopolitical, policy, market, climate change, and water security risks – vary across different locations and commodities.
expected total returns, net of fees, range from 7-8% for agriculture and 6-7% for forestry, with yields of 3-4% and 2-3%, respectively.
2. Investments into Equity
Here, investors can target corporates which are developing and scaling solutions to key Nature-related risks or taking advantage of Nature-related opportunities.
2. a. Investments in Private Markets (VC/PE)
Entrepreneurs and private equity firms are increasingly focusing on developing products and services to support the growth of climate and Nature markets. These include a wide range of tools and infrastructure mechanisms that are required to channel meaningful amounts of capital into Nature.
Thematic private equity investment in Nature represents only a fraction of the broader investment landscape, but it is gaining traction. Similar to the established patterns in climate and energy transition investments, there is a rising trend in activity, including start-ups and early-stage businesses focusing on Nature-related ventures. A notable example is Nature technology (Nature tech) which applies technological and scientific advancements to preserve the environment, monitor ecological changes and promote sustainable natural resource management.
2. b. Thematic Equities (Public Markets)
In line with the initial thesis on the market failure in accounting for values provided by different ecosystem services, an institutional play is targeting long-term, structural trends by identifying mispriced opportunities that arise due to the broader market’s struggle (and potential failure) to effectively account for the long-term value generated by these themes that may take years (or even decades) to be realised. The increasing popularity of thematic funds has been partly driven by growing investor demand for sustainable or impact-specific strategies. Consequently, many of these funds and the themes they target relate specifically to one or more of the 17 UN Sustainable Development Goals (SDGs).
Nature-related thematic investing involves targeting entities that are at the forefront of addressing the drivers of Nature and biodiversity loss. Examples of these drivers, include: land-use change, climate change, pollution, natural resource use and exploitation, and invasive species. Although investing to manage Nature-related risk is a new theme within equity investing, the growth of the broader thematic universe over the past decade, now accounting for 2.9% of global equity fund assets, suggests that the opportunity is growing. Developments such as the TNFD are expected to facilitate standardisation in reporting on Nature and biodiversity-related risks.
Conclusion
As more institutional capital finds its way to fund Nature and its underlying ecosystem services, we see increasingly trends of more than one strategies being housed under the same asset manager. This in my opinion, is increasingly prudent from an investor's point of view, as more often than not a forest or an agro-forestry project developer would seek and in fact prefer fungible capital to fund multiple aspects of the project internally at any point.
A multi-strategy fund helps capture different points in the risk-return curve of the upcoming asset class, and opportunities to structure and re-structure exposure as a project evolves.
To close, borrowing from a fantastic recent working paper by Terrasos, in architecture, form follows function; likewise infrastructure financing is designed to deliver funding at the same pace as the development, maintenance and reconstruction of the facilities requires. It thus follows that the institutional capital increasingly eyeing this upcoming asset class is flexible to be able to adapt as the underlying mechanics evolve, but also deep to be able to follow through, and scale it through its long term economic life.