Andrew Dreaneen considers whether natural capital is the most exciting investment innovation of our time and how we can break down barriers to make it more investable.
Flood risk protection, wildlife habitats, and spaces for recreation and wellbeing are not traditional topics for asset managers. Yet these, and other nature-related themes, are creating a huge buzz amongst our industry and our clients.
Investing in natural capital represents one of the most exciting innovations in private assets in years. Potential benefits range from yield enhancement and portfolio diversification to positive biodiversity and climate impacts. However, despite these benefits, natural capital only accounts for 0.2% of total assets managed globally1. Yet asset managers could play a key role in designing the innovative investment solutions that enable the potential of this asset class to be truly unlocked and brought to scale – both in terms of sums invested and impact made.
A number of barriers currently stand in our way, with fiduciary risk and return, illiquidity, deal flow, and scale representing the most frequently encountered. But the best views come after the hardest climbs, and to paraphrase George Bernard Shaw2, if we are to scale natural capital to the extent needed to meet both global biodiversity objectives and increasing demand, we need to create, rather than wait for, the right opportunities.
Scaling institutional finance by enhancing returns, reducing risk and tackling scalability
The significance of these hurdles varies between different investors. For institutional investors, allocations to emerging asset classes must complement the overall organisational objective to preserve capital and maximise risk adjusted returns. This means the risk-return profile must be comparable to traditional vehicles – something that doesn't always appear obvious with natural capital.
When it comes to investing in assets such as forestry, for example, investment terms are long, yet returns tend to be bond-like. When you compare this to other private asset classes with similar lock-up periods but markedly higher returns, it can be far more difficult for fund trustees to get comfortable, despite the potential for a stable long-term income and capital appreciation.
"When it comes to investing in nature-based solutions, there are degraded ecosystems everywhere in dire need of conservation finance, but very few bankable projects"
Often, it's a bit like not seeing the wood for the trees. However, natural capital could offer additional avenues to enhance rates of return through alternative revenue streams. With forestry, for example, this might mean leasing land to renewable energy developers, mitigation banking, ecotourism and access to emerging nature-based credit markets (e.g. carbon credits).
Risks can be moderated through geographic diversification or participating in blended finance vehicles with development banks. Here 'first loss provisions' can be used, so any early losses of defaults are absorbed by the grant funding from the bank, insulating private investor capital.
Scalability is also a significant barrier for institutional investors who are accustomed to deploying hundreds of millions into investments at any one time. When it comes to investing in nature-based solutions (NbS), there are degraded ecosystems everywhere in dire need of conservation finance, but very few bankable projects – most of which are only around $5 million to $20 million in size. An even smaller subset of these projects meet the quality thresholds investors have set when considering NbS.
Institutions can rise to this challenge by aggregating NbS to enable larger pools of capital to participate. Akaria Natural Capital, one of the first dedicated natural capital asset companies in Singapore, set up by Schroders and Conservation International, for example, has a dedicated team focused on originating and developing high integrity natural capital solutions in South East Asia, with ambitions to help scale private sector finance into conservation and launch a series of nature impact strategies.
Improving liquidity for intermediaries, and deal flow for private equity
When it comes to intermediaries, illiquidity is perhaps the biggest barrier to investing in nature, with long investment terms a challenge for many in private wealth. Emerging listed vehicles, such as thematic public equity funds that focus on active ownership and engagement around nature and biodiversity-related risk, help fill some of the demand from this cohort. Other innovations look to grant access to real assets (such as forestry) or the voluntary carbon market through listed vehicles.
"This space is on the cusp of a booming innovation cycle"
There is an emerging thematic opportunity in private equity and venture capital investing, but the lack of mature, late stage and growth investment opportunities is a challenge. However, this space is on the cusp of a booming innovation cycle that looks to change this. Most of the opportunities today are either start-ups or early-stage, but they will be crucial for scaling the infrastructure and ecosystem to support the growth of the natural capital market.
Can we realise the full opportunity to invest in nature?
With demand so strong and the need so great, asset managers have an opportunity to explore ways to develop innovative investment vehicles that connect the growing pools of capital seeking nature investments with that clear funding need. We see real assets such as forestry and farmland, NbS, and private equity investments in supply chains, technology and innovation, as representing key routes for deploying capital into nature today.
Whilst many of the barriers to at-scale investing can be tackled with alternative revenue streams and de-risking, listed vehicles, and diversification, these alone will not be enough to scale nature finance to the extent needed. At the same time, we need to see a whole ecosystem of service providers, such as investment platforms, carbon developers, agri- and nature-tech to support investors to finance nature. Only when this market infrastructure begins to fall into place, can we truly work towards the scale and efficiency needed to build a highly competitive asset class.
We believe there is currently a strong first mover advantage and the opportunity is for the asset management community to create the vehicles that can provide comfort to clients and deliver on fiduciary objectives.
Andrew Dreaneen is Head of Natural Capital at Schroders.
Note to Editors
Important Information: The views and opinions contained herein are those of Andrew Dreaneen, Head of Natural Capital, Schroders and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.
1 Source: JP Morgan and Schroders. Natural capital assets under management assumed to be $350bn based on Schroders Capital research and estimates. Global assets under management $175tn, taken from JP Morgan Alternative Investments Outlook and Strategy, February 2023.
2 Don't wait for the right opportunity: create it."—George Bernard Shaw