Natural capital: investing in our planet

In our recent briefing on Megatrends, we highlighted natural capital as one of four key megatrends. Now, Sarah Lochlund dives deeper into the trend, identifying what is driving it, and what returns it could hold for well-positioned investors.

Defining natural capital 

The Task Force on Nature-related Financial Disclosures (TNFD) define ‘natural capital’ as "the stock of renewable and non-renewable natural resources such as plants, animals, air, water, soils, and minerals that combine to yield a flow of benefits to people". As such, natural capital comprises assets ranging from biomes such as forests and wetlands, through to man-made areas such as farmlands.

To give scope to the size of the shadow that the natural world casts over the worldwide economy, it was estimated that 55% of global GDP is moderately or highly dependent on nature.

Tailwinds: the driving forces behind natural capital investment

Demographics | The global population is projected to exceed 9.7 billion by 2050. This population increase and aspirations for higher living standards will put pressure on the demand for food, crops, livestock, and timber for housing construction, driving the need for increased agricultural production and efficiency. 

Climate change | The disparity between nature’s significant contribution to meeting climate change challenges and the funding it receives, which needs to triple by 2030, means that there are opportunities for investors with long-term horizons to step in. Climate change also offers opportunities through another lens: an increased frequency of extreme weather events and temperature rises will impact on growing seasons and allow for commodities to be grown in different regions – perhaps some new grape varieties for English wine!

Regulation | Linked to the above, we expect changes in regulation (such as the TNFD) and accountancy practices (such as the UN’s System of Environmental-Economic Accounting) will elevate both prices and demand for natural capital. 

The reality is that businesses and governments are looking for investments that allow them to meet targets, and we believe that natural capital will be one of these. 

Potential Returns

For those providing funding to natural capital, the typical drivers of return include:

• Income yield - The income generated from the sale of the underlying commodities – such as timber or crops – or, for example, the coupons paid on bonds that fund the preservation of natural capital.     
• Capital appreciation - As the significance of natural capital for our development becomes increasingly evident, so does the demand and pressure to accurately value and account for it. We think this is likely to result in an increase in natural capital asset prices.
• Carbon Credits - Investors can use both voluntary carbon credits and carbon allowances to either offset portfolio emissions, speculate on carbon price movements, or hedge the impact of carbon price movements on other assets held.
• Future incentives - There may also be other emerging opportunities, such as those linked to Biodiversity Net Gain (BNG) requirements, which requires developers to provide a BNG of 10% for most new developments in England.

Investment Opportunities

Forestry 

Traditional investment in commercial timberland (as opposed to wild forests) has long been a staple in the United States, where lumber is a primary material for constructing homes. However, we’ve seen a rise in the number of UK forestry managers launching pooled funds. While returns primarily stem from harvesting trees, timberland investment also serves as a reliable store of value, offering diversification and steady income. 

Agriculture

Agriculture offers a diverse range of opportunities, spanning row crops (harvested on an annual basis), permanent crops (such as almonds, olives, and orchards) and livestock. As such, agricultural investments encompass a wide spectrum of commodities within funds.

When selecting a manager, crucial factors to consider include community impact and engagement, sustainable water management practices like trickle irrigation systems and shade cloth usage, initiatives to restore habitats and biodiversity, improving soil health to retain carbon and mitigate nutrient and sediment runoff, and reducing the use of harmful chemicals, including pesticides, herbicides, and veterinary medicines. 

Oceans

The largely untapped potential of our oceans presents another interesting avenue for investment. Seagrass, renowned for its ability to sequester CO2 and support commercial fisheries and biodiversity, holds promise. Blue bonds have been issued that look to support countries in their work to restore the value of their oceans. 

Risks 

The primary concern lies with climate-related risks (although there’s a common misconception regarding the risk of fire in forestry – generally, wildfires affect wild forestry rather than commercial forestry). Agriculture is vulnerable to flooding, disease, water scarcity and temperature changes, while other assets face challenges from hurricanes. 

Diversification across different geographical regions is crucial, accompanied by ensuring managers possess adequate insurance coverage. 

It is pivotal to avoid the pitfalls of poor management. Adhering to guidelines for planting native trees (“the right tree in the right place”), engaging in appropriate rewilding efforts, and avoiding monoculture are essential considerations in responsible agricultural land and forestry management.

It is important to flag that the solution to our climate goals and ‘Net Zero by the 2050’ target cannot be solely reliant on planting more trees. In the UK, there’s a delicate balance to strike between planting trees in places that does not destroy other valuable or protected habitats and ensuring an adequate food supply. While the benefits to nature are undeniable, we must also consider the potential social impact of higher costs associated with increased food imports and security of food supplies. 

Carbon credits

Carbon credits function by rewarding projects that refrain from tree felling, allowing participants to trade these credits. While the carbon credit market is in its infancy and trading can be complicated, it offers promising potential. However, discussions indicate that the financial incentives for preserving trees may not yet outweigh those of traditional timber harvesting, promoting ongoing monitoring of this evolving landscape and the valuation of carbon credits. 

Some countries (including the UK and US) operate a compliance carbon cap and trade system, where companies exceeding emission thresholds must report their emissions, with a collective cap that reduces over time. The goal is to force companies to decarbonise because the cost of reducing their emission becomes cheaper than the cost of permits. Conversely, businesses may engage in the voluntary carbon market to surpass regulatory requirements and invest in assets that remove greenhouse gas emissions from the atmosphere, subject to independent verification. 

Carbon credits offer promising potential for additional and diverse returns. However, the market is in its infancy, and is currently complicated and unproven.  Also, quality depends enormously on jurisdiction.  As such, we favour an approach where carbon credits are only a portion of overall returns, and not relied on to meet return objectives.

Accessing the Asset Class

Approaches to natural capital investment vary, each with its own risk-return profile. Some managers adopt a private equity-style approach, aiming to transform land usage with the goal of exiting within a 15-year timeframe. Others prefer a more conservative buy and hold strategy, implementing subtler changes over time. 

Additionally, the inclusion of carbon credit opportunities may vary among managers, contributing to differences in income and capital appreciation components within investment portfolios. For those investors without an appetite for illiquidity, listed options are available, where managers invest in natural capital stocks. 

Conclusion 

Investment into natural capital is critical to stay within our planetary boundaries. What’s more, this asset class provides diversification and we see strong demographic and regulatory factors that we expect to support valuations into the future. Conducting thorough due diligence is paramount to selecting managers who implement effective and regenerative land management practices. 

By making informed decisions and prioritising sustainability, investors can play a pivotal role in safeguarding our planet’s natural resources for future generations. 

This article is not intended to provide and must not be construed as regulated investment advice.