26 July 2018

Channelling capital into forest conservation

A significant increase in the level of private finance being channelled into forest conservation is required in order to meet the aims of the Paris Agreement, a roundtable organised by Environmental Finance and Finance for Forests heard. Michael Hurley reports

Image: Wildlife Works/Lisa Kristine

As investor expectations grow on disclosure and management of climate-related risks, now is the time to scale up the level of private finance allocated to the conservation of forests, according to US-based NGO Conservation International (CI).

The current levels of public funding are inadequate to protect the world's forests and their assets, and achieve the targets set out by the Paris Agreement. Greater private finance is required, the organisation said.

Along with multinational law firm Baker McKenzie and mining giant BHP, CI manages the Finance for Forests initiative, which co-hosted the roundtable.

The Finance for Forests initiative works to advance private sector support for conservation.

"One of the really important things about REDD+ is that it offers an immediate solution to reducing emissions" – Fiona Wild, BHP

A significant investment opportunity in the area already exists, in the form of initiatives such as the UN Programme on Reducing Emissions from Deforestation and forest Degradation and the role of conservation, sustainable management of forests and enhancement of forest carbon stocks in developing countries (REDD+), the roundtable heard.

REDD+ was established under the UN Framework Convention on Climate Change to provide economic, social and environmental incentives for developing countries to reduce emissions from deforestation and related activities through the creation of carbon credits.

An example of the kind of innovation required to scale up conservation finance came in the form of IFC's Forests Bond, issued in October 2016.

The $152 million deal, which is one of the largest REDD+ transactions to date, allowed investors to choose to have the coupon paid in cash, or in carbon credits, or a combination of the two.

Investors who opt to receive REDD+ credits can either retire them to offset their carbon footprint or sell them in the voluntary offset market.

The bond originated from a June 2014 request for proposals from BHP for projects to support its REDD+ strategy.

The IFC – the private sector arm of the World Bank Group – contacted the company to discuss the possibility of a carbon-linked bond, and the idea was then developed over several months, with the support of CI and Baker McKenzie (see box: Agustin Silvani).

BHP provided a $12 million 'price support mechanism' to ensure that the project can sell a minimum quantity of carbon credits every year until the bond matures.

"If investors choose cash, then BHP takes the credits", explained Vikram Widge, head of IFC climate finance and policy, at the time.

BHP also contributed to CI's Alto Mayo Protected Forest REDD+ project in Peru, which aimed to improve forest governance.

"Taking action on REDD+ now may avoid the need for more disruptive or more costly action in the future for a company like BHP," Fiona Wild, vice president of sustainability and climate change at BHP told the roundtable (see box: Fiona Wild).

"A number of really significant policy changes suggest that investing in REDD+ is becoming more of a requirement than a choice for a corporate" – Martijn Wilder, Baker McKenzie

Meanwhile, Martijn Wilder, a partner at Baker McKenzie, said that, since the bond was issued, there has been a number of "really significant" policy changes that suggest investing in REDD+ is becoming more of a requirement than a choice for a corporate (see box).

However, there remain hurdles that need to be cleared in order to make REDD+ a viable business case for large corporates, according to a representative from a large oil and gas company, who asked to remain anonymous.

"REDD+ has such huge potential in terms of the scale of the tonnes of emission reductions that can be generated, relatively quickly at relatively low cost," the participant said, "but we feel the scale element is going to be achieved more through compliance, which we think is coming for all the reasons Martijn highlighted, but we're just not seeing the pace of development at the moment."

"It's easier for us when we're involved on the trading side, to deploy hundreds of millions of dollars, and it requires much less work internally than, for example, investing in a forestry project for $10 million," said another professional working at another oil and gas company.

"We really want these markets to become a commodity," he added. "But we've made a long journey without many results. Concerns on the supply side keep coming all the time.

"And within conservation organisations there are different views on the value of carbon, so it's not helpful if regulators are thinking of pushing forward with carbon markets in a given jurisdiction and a conservation organisation says 'I don't want forestry to be part of those markets' – this is happening now, and it disincentivises demand."

Phil Vernon, an independent international development expertHowever, Phil Vernon, an independent international development expert, warned that if carbon emissions reduction products such as REDD+ become commoditised, project developers and investors risk losing sight of the social factors.

"How can you be sure the human element isn't going to become invisible, and that the disbenefits – which inevitably are going to occur – will be mitigated by the people that incur them? Once it gets into the finance department [of a large organisation], they can't possibly be thinking about these kinds of things," Vernon said.

But Agustin Silvani, vice president of conservation finance at CI, said the social and environmental standards that support REDD+ are strong enough to dispel fears of some local communities that they will be displaced.

"The projects that we work on [are] the community's idea. That's not to say that every REDD+ project is amazing; there are gradients in quality, but they should all demonstrate strong climate, community and biodiversity benefits.

"People [need to be able] to trust that REDD+ works. Nobody has much negative to say about solar panels – how do we get REDD+ to that point?" Silvani asked. However, he added that while companies the size of BHP are able to "do a tonne of due diligence" to ensure the quality of projects, "those are high transaction costs... so if you want to get to a market that is transacting freely, those costs have to be reduced quite a bit".

Silvani suggested BHP's bond should be used as a case study for potential future issues that incorporate REDD+, in order to attract more capital into forest conservation. An attendee from a climate advisory firm suggested the scale of opportunity for investment in REDD+ could be huge, because of the need for countries to meet their Nationally Determined Contributions (NDCs) pledged as part of the Paris Agreement.

"Everybody who analyses the NDCs knows they're a long way from getting anywhere near the reduction we need [to limit climate change to] 2°C. If you calculate the shortage of emissions reductions across all the NDCs, 30 billion tonnes is the effort required just to meet the NDCs between 2021 and 2030."

However, this opportunity could be missed unless lawmakers clarify which kind of credits will be eligible under the Paris Agreement as methods to reduce countries' carbon emissions.

"If we knew certain credits were eligible, we've potentially got a 30 billion tonne [carbon] sink there," the advisor said. "Each developing country has got unconditional commitments as part of their NDCs, and if you look at the way Article 6 [of the Paris Agreement] is drafted, these countries need to make a decision as to whether they will allow the international transfer of those credits, or keep them for their unconditional commitment.

"The demand is not that far away, what we don't have are those two very important regulatory decisions," he added.

Baker McKenzie's Wilder agreed, and said: "Out of all the potential mitigation activities under the Paris Agreement and country NDCs, addressing climate change through REDD+ and forests remains a significant opportunity.

"Many NDCs still do not include [or] adequately deal with REDD+ as part of their mitigation efforts... The extent to which it will be possible to transfer large mitigation outcomes from forests under Article 6 remains unclear," Wilder said.

"In addition, how forest-based carbon is treated and the flexibility to trade it is also dependent, to some extent, on whether a country has included forests in its NDC or already transacted it under a mechanism such as the World Bank's Forest Carbon Partnership Facility (FCPF)."

The FCPF is made up of two funds that support countries in their REDD+ preparations. It was launched by the World Bank, environmental non-profit The Nature Conservancy and nine donor governments, at COP13 in Bali in 2007.

"For those countries that have not incorporated REDD+ mitigation in their NDC – or pre-committed to do so – there would seem to be far more opportunity to enter into transfer arrangements in return for payments for that mitigation effort, or for results [of mitigation]," Wilder added.

"In fact, transacting mitigation outcomes not included in an NDC arguably do not need to be accounted for as debits against NDC commitments and therefore make the economics all the more attractive, [with] payments being used to achieve other mitigation and adaptation outcomes," he explained.

Analysts have previously suggested that because a number of countries, when they devised their NDCs, did not clearly state that REDD+ credits would be included in their accounting this meant the sellers of credits could trade more freely and potentially benefit from an advantageous price in other markets.

In the US, efforts at the state level will help America meet its Paris Agreement commitment in spite of the federal government's withdrawal from the Agreement, Wilder added.

"We see [some] US states with carbon trading programmes, particularly California, which incorporates [parts of] Canada," he said. "And the fact that California will host its large climate summit in September this year with UN support is of itself a significant indication of US engagement at the state level."

Abyd Karmali, Managing director of climate finance, Bank of America Merrill Lynch

Abyd Karmali, managing director of climate finance at Bank of America Merrill Lynch (BAML), said he is surprised that none of the 56 corporate signatories to the 2014 New York Declaration on Forests – a pledge to end the loss of natural forests by 2030 – has so far invested in REDD+.

It was signed by 188 public and private bodies, including national and regional governments, NGOs and indigenous peoples.

He said the issuance of another forestry bond in the mould of the IFC's 2016 deal would benefit the overall success of the scheme.

However, it still appears that investors require a triple-'A' rated issuer to feel confident about committing capital, which "significantly narrows the crowd" of potential issuers.

BAML was one of three banks – along with BNP Paribas and JP Morgan – to help fine-tune the bond structure by roadtesting the design with potential investors.

"Feedback [from investors] suggested no willingness to take any innovation [and] no premium for the fact that this was an environmental, social and governance product, which was disappointing" – Abyd Karmali, BAML

"Feedback [from investors] suggested no willingness to take any innovation [and] no premium for the fact that this was an environmental, social and governance (ESG) product, which was disappointing.

"Similarly, none of the corporates we spoke to were willing to be investors in the bond – it was a subset of investors from the ESG investor community," said Karmali.

However, the Green Climate Fund (GCF)'s commitment to provide $500 million to a pilot programme that will finance REDD+ emissions reductions projects, and $392 million to fund another 11 climate finance projects in developing countries, announced in October, "is promising and we should see some innovation come out from that," Karmali said.

The GCF is a South Korea-based international fund set up by the 194 countries who are parties to the UNFCCC to assist developing countries in adaptation and mitigation practices to counter climate change. It has a $2.59 billion portfolio of 54 projects and programmes.

Aviation is also an area of potential demand for REDD+ credits.

"We spoke to airlines to see if they would be buyers in the [IFC Forests] bond, thinking that they would be early movers in wanting to have REDD+ as a hedge, but none of them took this up," he said.

The International Civil Aviation Organisation (ICAO)'s Carbon Offsetting and Reduction Scheme for International Aviation, which will allow airlines to offset any growth in their emissions beyond 2020 levels with reductions in other sectors, "is still a 'wait and see' moment," Karmali added.

The scheme's rules are currently being reviewed by the 192 countries that are ICAO members ahead of its introduction in 2021.

A portfolio manager at an investment management firm said the example of Colombia, which introduced a commercial carbon tax in June 2017 that allows companies to meet their carbon tax obligation by purchasing domestic REDD+ credits, could be a model to follow.

"It immediately drove a huge amount of investment into REDD+, because the market was massively undersupplied. People are biting your arm off for Colombian REDD+ credits. "That sort of model works very well," he said. "Countries are looking to replicate that across the Americas, in Chile, Mexico, and Peru."

Agustin Silvani, Conservation International – Scaling up conservation finance with the Forests Bond

Agustin Silvani, Vice president of conservation finance, Conservation InternationalHow do we finance more forest conservation? That is something with which we have struggled, all of us in this space for a while.

How do you get more capital moving in? One way is by channelling capital markets and just being a bit more innovative in how we move money into REDD+.

That is where the IFC Forests Bond comes in.

For the proof of concept we were saying, 'If we build it, will they come?' The message we kept getting over and over from pension funds, from insurers, from the big pools of capital was, 'We get it – we want to participate but we cannot, either for fiduciary reasons or for other sorts of risk reasons.

So give us an instrument that we know.

Give us vanilla and we will eat it.' That sort of thing.

That is why it is innovative in one way and very purposely noninnovative in another way.

We wanted to make it look and feel as much like a plain vanilla bond as it could.

Basically, IFC issues one of their usual AAA-rated bonds.

The coupon, as it would usually, is paid out in cash.

However, it has this embedded option in it where investors can receive credits instead of cash.

That is really the innovation in the bond.

In exchange for verified emissions reductions, those [investments] are then forwarded, or paid, to the Kasigau project, which is a REDD+ project in Kenya, where there is unsustainable cattle grazing and poaching of elephants.

That was the structure, with BHP acting as the guarantor, essentially, for the carbon credits.

It is a way of monetising the carbon and including a cash coupon to the investors. That is what we floated two or three months [before the deal].

We were expecting for it to be a $75 million issuance, which is obviously small for IFC standards. It was oversubscribed, so it ended up being a $152 million bond.

For us that meant if we built it, yes, people did come and then the types of folks that we wanted to come did show up.

The investors in the bond are big pension funds in the US, insurance companies and a whole bunch of companies from other industries.

However, they are basically non-traditional REDD+ investors.

The point now is that we have a structure.

It is not perfect at all; it could be tweaked. However, now it is a case study. Now there is a track record to build on.

We can take this to funding agencies like the Green Climate Fund and say: 'Instead of or in addition to running your own REDD+ programmes, why don't you put in place a price floor? How would that stimulate the market? If you are a company, instead of going in yourself, what if you and Macquarie, say, came together in a coalition and established a price floor for REDD+? For the investors in the bond themselves; what would motivate them to take that credit option, take that embedded option and actually take the credit instead of the cash coupon? It was a lot of work but we need there to be many other bonds, or similar instruments.

Fiona Wild, BHP – Why invest in REDD+?

Forests are really significant carbon sinks.

Fiona Wild, Vice president of sustainability and climate change, BHPTherefore, addressing deforestation and forest degradation can significantly reduce global emissions.

When you look at BHP's business, greenhouse gas emissions are an inevitable part of what we do, whether it is from the power that we use, from the diesel that we burn or the fugitive methane emissions from our coal and petroleum operations.

Therefore, we absolutely have to prioritise emission reductions in our operations.

However, what REDD+ offers is a really cost-effective way for us to offset the emissions which are really hard for us to reduce directly.

This was particularly important when we started to set longer-term goals: the net-zero operational emissions goal, for example.

Increasingly, we are seeing that investors and other stakeholders are taking the view that it is not enough for companies to plan for a range of plausible climate outcomes in the future.

Taking action on REDD+ now may avoid the need for more disruptive or more costly action in the future for a company like BHP.

One of the other things which is really important about REDD+ is it offers an immediate solution to reducing emissions.

While it is really important that we focus on things like carbon capture and storage in the industrial sector, it is not enough.

What REDD+ can give us is a low-cost, readily-available technology, which gives us that sort of biological bridge to some of those other technology solutions which may be available in decades to come.

The final area around REDD+ which makes it really interesting for us is the co-benefits that it can deliver.

We have investments in a number of REDD+ projects that can really demonstrate that community development outcome, biodiversity benefits, watershed protection.

In terms of our integrated REDD+ strategy, there are really three component parts to it.

In a nutshell, we look at the governance, we look at project support and we look at market stimulation.

In terms of governance, with Baker McKenzie, we developed a consolidated guide to REDD+ rules.

I like to think of this as a kind of dummy's guide to REDD+.

REDD+ is complicated, trying to explain it to people is hard.

Therefore what we wanted to be able to do is develop a guide which could help policymakers and project developers navigate their way through the REDD+ rules and get a feel for whether this could be something that they could get their heads around.

The second area is around project support.

We directly invest in two REDD+ projects.

We work with the Alto Mayo project in Brazil.

We also work with the Valdivia project in Chile.

The final area is market stimulation.

This is working with the IFC, Conservation International and Baker McKenzie to develop the world's first forest bond, which really aims to improve demand for REDD+ by allowing investors to take their interest as either cash or credits.

Martijn Wilder, Baker McKenzie – Why companies need to invest in REDD+

The IFC Forests bond was launched almost a year and a half ago.

Martijn Wilder, Partner, Baker McKenzieI think what has happened in the last 18 months is there have been some really significant changes to do with policy and investor engagement that make investing in REDD+ and also the need to take action on climate, from a corporate point of view, companies must act on rather than something that is optional.

The first change is the implementation of the Paris Agreement.

It sets out a clear trajectory we need to hit in terms of emission reductions.

This is resulting in more and more countries introducing emissions trading schemes, or carbon taxes, or some sort of policy mechanism to put an obligation on industry to reduce emissions.

As we move forward, we will see more countries develop their domestic programmes to cap emissions or endorse mitigation measures which for many countries include REDD+.

The second change, which is very important, is while we see growing legislation placing obligations on companies to address climate, in many jurisdictions what we have also seen is a legal obligation on directors to actually take into account climate change.

This is resulting in an increased willingness from many companies to think about the impacts of climate change on their business and what they can do to manage climate change and regulation.

They will also start hedging their position because they know that carbon pricing is coming.

How can they position themselves now to reduce their future exposure, for example by taking an option over REDD+ offsets? Thirdly, this obligation is further reinforced by the owners of those companies, the shareholders, who are demanding that companies take action on climate change or to consider climate change, and to disclose their actions, and the large financial houses that invest in those companies also taking action.

This rapid increase in shareholder engagement has also driven the divestment campaign away from fossil fuels, and a lot of that capital has been going into renewables and measures that reduce greenhouse gas emissions – again making REDD+ a focus.

This has all been further reinforced by the FSB's Task Force on Climate-related Financial Disclosures placing an obligation on financiers to disclose, in effect, what their climate exposure is.

They can only do that by getting information from companies they own, therefore putting more pressure on those companies.

Finally, we are also seeing a significant rise in public litigation, particularly in the US, relating to two issues.

One is the failure to disclose.

Where you have a company that failed to disclose that led to a financial loss, there are a number of [live] US actions to sue company directors for loss caused to shareholders.

The second is simply holding companies to account for their actual contribution to climate change.

The City of New York is suing five of the major oil and gas companies.

What the strategy seems to be is similar to that used for tobacco legislation.

The endgame may be to set up a very large fund that will actually finance climate mitigation and adaptation measures using repatriation of money from the major corporates.

The challenge will be if other governments then start doing similar litigation in other countries how do you, if you have contributed to one fund, manage contributions to others? In conclusion, these trends all ultimately go to a company's social licence to operate.

I think there is increasingly an expectation that companies will operate in a good manner.

There is no doubt that, in the last twelve months we have seen a significant shift in the level of engagement of corporates, which were previously not interested in climate change.

All of a sudden they are trying to understand their exposure, what can be done, and the role the land use sector and REDD+ can play.

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