6 April 2017

The growing case for conservation finance

Conservation finance may appear to be one of the most esoteric investment niches, but experimentation and innovation is giving way to proof of concept – attracting a growing number of institutional investors along the way. Mark Nicholls reports

Conservation finance: helping to protect Kenya's Tsavo Conservation Area. The Chyulus Hills project is using revenues from sustainable cattle management, carbon finance, and water tariffs to finance the conservation of a critically important area that provides a third of Mombasa's fresh-water supply.

It's widely understood that a large gulf exists between the need for funding to protect the world's vulnerable ecosystems, and the volume of funding that is changing hands. It is also understood that most of this money, to date, has come from public or philanthropic sources, often in the form of grants. What is less well understood is that environmental NGOs, entrepreneurs and financiers are constructing business models, projects and investment vehicles that are combining conservation outcomes with competitive commercial returns, and which are beginning to attract mainstream investors.

"There is a paradigm shift underway in the market," says Gautier Queru, Paris-based investment director at Mirova, a subsidiary of Natixis Global Asset Management, which is raising a fund aimed at addressing land degradation. "Financial institutions are starting to seize the opportunity that exists in investing in conservation and natural capital."

According to a recent report from Credit Suisse and McKinsey, some $300 billion-400 billion is needed annually to preserve healthy terrestrial and marine ecosystems, and the clean air, fresh water and biodiversity on which we all depend.1 Currently, just $52 billion/year is flowing towards conservation projects.

The sector's genesis was in 'debt-for-nature' swaps in the 1980s and 1990s, where developing countries agreed to protect vulnerable ecosystems using revenues freed up by sovereign debt relief, in deals brokered by international environmental groups. These were followed by conservation finance transactions structured by donor governments and development finance institutions.

Defining conservation finance

A broad definition of conservation finance is the raising of capital to support land, water and resource conservation. However, in recent years, practitioners have tended to more narrowly define the area to investments that generate cash flows, thus excluding some grant-based and/or philanthropic activities, while intent is also considered important.

For example, in two landmark reports on conservation finance (in 2014 and 2016) Credit Suisse and McKinsey focus on "investment mechanisms that activate one or more cash flows generated by the sustainable management of an ecosystem, which in part remain with the ecosystem to enable its conservation, and which in part are returned to investors."

In the latest assessment of the size of the conservation finance market, carried out by information provider Ecosystem Marketplace, its authors add the following caveat to their definition of conservation investment: "Conservation impacts must be the intended motivation for making the investment; they cannot be simply a by-product of an investment made solely for financial return."

More recently, they have been joined by so-called impact investors – often high-net worth individuals, family offices or foundations – who seek positive environmental and/or social impacts in addition to a financial return. Many of these investors are prepared to take more risk, or accept lower returns, in pursuit of these positive impacts.

"Now, a new source of capital is emerging," says Agustin Silvani, the Washington, DC-based vice president of conservation finance at environmental NGO Conservation International (CI). "We're seeing clients of banks and asset management firms, and even the beneficiaries of public pension funds, requesting investment products in this space. It's moving from philanthropy to the private sector."

"People want to see their money being put to uses that are socially and environmentally beneficial," agrees Ricardo Bayon, a San Francisco-based partner at Encourage Capital, an investment management firm that offers conservation finance funds. "This new generation doesn't buy into the myth that when you're doing an impact investment, you're necessarily giving up returns. You can do both – you can at times have your cake and eat it."

What has changed in terms of attracting investors towards conservation finance is the ability of asset managers to structure investments that can tap into project cash flows to generate attractive risk-adjusted returns – whether from environmental commodities, such as carbon credits, ecosystem services such as wetland restoration credits, or more conventional food and fibre commodities, albeit produced sustainably.

"We're now in the position of being able to point to specific examples of how investments can be structured and can show performance, as opposed to relying exclusively on a conceptual model," says Christian del Valle, managing partner at Althelia Ecosphere, a Luxembourg-based specialist asset manager which, among other vehicles, is investing a 105 million conservation-focused climate fund, developed in partnership with CI.

"Althelia targets returns that can be derived from real assets [namely sustainably produced commodities] paired with new markets, such as carbon. And investors can now visit the projects in question rather than simply reading about what they might look like in a Powerpoint presentation. That makes a big difference."

Among environmental markets, those for carbon credits offer the largest potential – although developers concede that it has not thus far realised its potential. Most demand for carbon credits from forestry or other land-use projects is from the voluntary market, which is relatively small, and where prices are low and have been volatile.

Prices tend to be higher in compliance markets, such as that established in California under its AB-32 climate change legislation. Here, emitters are permitted to use carbon offsets, including those from forests in the US, for up to 8% of their emissions cap.

"Carbon has had lots of problems as an environmental commodity," says Bayon at Encourage Capital. "But as things were imploding in Europe's carbon market, California was quietly building a robust market, and we saw that and made investments in it." Encourage's EKO Green Carbon Fund has successfully invested in forest management projects in the US that generate carbon offsets, and is in the process of returning capital to investors.

Meanwhile, other regulatory frameworks exist that provide payments for ecosystem services (PES). A whole range of such markets exist in the US, most at the state level, offering tradable credits, tax benefits or direct payments for developers offering a number of environmental benefits, such as habitat restoration, carbon sequestration and nutrient management.

Chandler Van Voorhis is co-founder and managing partner at C2I, whose investment advisory firm, ACRE Investment Management, has created a number of conservation finance businesses that invest in the US, including in reforestation projects and real estate investments designed to monetise ecological credits. "Carbon is not always the most valuable asset," he says. "If you can tap into wetlands credits, or those for reducing nutrient loads, the blended return can be astronomical."

But perhaps the most valuable revenue streams available to conservation financiers are those generated by food and fibre commodities that are demonstrably produced to high social and environmental standards. These markets are seeing much faster growth than their conventional equivalents, driven not only by ethical consumers but, crucially, by multinational food processers and retailers who see a number of advantages in the production techniques employed.

"We've been making the argument that production techniques that emphasise environmental and social sustainability and provide security of supply and [protect a buyer's] licence to operate are becoming more entrenched," says del Valle. "Corporate buyers understand that … this is about risk management, fiduciary responsibility and their obligations to their shareholders and employees."

The approach taken by conservation-orientated investors helps to make projects less risky, argues Clément Chenost, an investment director at Moringa Partnership, a Paris-based sustainable agroforestry fund manager. "We're investing in Latin America and sub-Saharan Africa. Investors perceive these regions as risky, and ask for higher returns to compensate for the country risk."

Conservation International and conservation finance

As a major international NGO, CI's mission is to protect nature for the benefit of all. As is usual for NGOs, that normally means doing more and more with limited budgets. Agustin Silvani from CI explains: "One of our roles is to find innovative ways of financing conservation – whether in leveraging donor funds, government money or, in this case, private capital. What we've found over the years is that working to crowd-in private capital to conservation not only broadens our impact, but also makes us more efficient and effective as an organisation. If private capital can finance some of the sustainability focused interventions – for example on global commodities such as coffee or tuna – that helps us strategically deploy our limited philanthropic dollars for maximum impact." 

For more than a decade, CI has been at the forefront in innovation in financing conservation, having raised and deployed with partners over $500 million through mechanisms including trust funds, debt swaps, loans, carbon finance, conservation agreements and payment for ecosystem services. Among other private sector ventures, they have supported the eco.business fund, the Althelia Climate Fund and the IFC Forests Bond. So what's the next big thing for CI? "We're taking these investments mainstream. Together with forward-thinking investors and partner organisations, we're hoping to make nature-based investments a new asset class. It may take five or more years, but one day investing in conservation will be as routine as investing in renewables is now. When we look at the problems we're all facing, from climate change to feeding a growing population, we really have no other choice than to rely on the solutions nature provides." 

"When you're making investments in agriculture and land, these are very sensitive issues," he explains. "While the conventional approach is to buy large, monocultural estates, we limit land purchases, but instead work in partnership with farmers … and make sure we deliver strong social and environmental impacts." Such investments, developed in close cooperation with local landowners, and with positive social and environmental outcomes, are likely to be less vulnerable to expropriation or conflicts over land-use, he says.

The appeal of conservation finance investments is three-fold, says Queru at Mirova: they offer tangibility, yield and impact. "Since the financial crisis, the demand from institutional investors is for real assets: investors want to understand what they are investing in. Investors are looking for yield, and projects that are involved in the long-term production of sustainably produced soft commodities can generate those yields. And investors want to be able to demonstrate impact."

On this last point, the agreement at the UN in 2015 on the 2030 Sustainable Development Goals (SDGs) has provided a framework for investors to assess the environmental and social impacts of their investments. A number of the 17 SDGs – and the 169 targets that underpin them – relate to issues of conservation and associated social benefits.

"We are seeing a willingness from investors to finance the SDGs," adds Queru, citing the SDG investment initiative launched by 18 Dutch financial institutions, managing almost 3 trillion in assets, last December.

Specifically, Mirova is currently market-testing its LDN Fund project, which will blend public and private finance to address land degradation by investing in agriculture, forestry, and other projects which promote sustainable land management, as well as conservation and land restoration projects. The European Investment Bank is undergoing due diligence for a potential 60 million commitment towards the planned 300 million target, and other public institutions are also considering investments, which will help to partially derisk the fund for private sector investors.

This fund is just one of a growing suite of investment vehicles offering investors a range of conservation finance opportunities. CI, alongside Frankfurt-based advisory firm Finance in Motion and German state development bank KfW, launched in 2014 the eco.business Fund, which works with financial institutions in Latin America and the Caribbean to provide debt financing to sustainable agriculture, aquaculture, forestry and tourism enterprises.

The fund helps local banks to understand the opportunity that exists in helping their clients implement more sustainable practices, says Sylvia Wisniwski, a managing director at Finance in Motion.

"We think we can create an interesting sweet spot," she says. "We contribute by [encouraging banks to] move their portfolios into sustainable agricultural practices. On the one side, this fuels those businesses and, on the other side, we help banks recognise that this can be an interesting differentiator in terms of improved credit risk," given that sustainable agri-businesses tend to be better run and more resilient to the effects of climate change, for example.

The fund targets market returns for private investors, with governments and development banks taking on more risk, allowing private investors – in this case family offices, high-net-worth individuals and foundations – to come in behind, Wisniwski says. Finance in Motion is raising an additional 125 million into the fund, of which Wisniwski expects private investors to contribute 25-30%.

The green bond market is also being brought to bear on conservation finance. Last year, the International Finance Corporation (IFC), a member of the World Bank Group, issued its first-of-its-kind Forests Bond. Investors in the $152 million bond – which included major US institutional investors such as CalSTRS and TIAA-CREF, and Australian insurer QBE – can choose to be paid coupons in cash or in carbon credits generated by the Kasigau Corridor avoided deforestation project in Kenya. The carbon credit element was underwritten by mining giant BHP Billiton.

Vikram Widge, IFC"From a financial perspective, they are essentially buying an IFC triple-A bond with an embedded carbon option," says Vikram Widge, IFC's head of climate finance and policy. "But they are – by design – associated with the whole [conservation finance] construct … They had to understand the process, the impact and the reputation impacts to them, if any, because they are publicly associated with the Kasigau project."

"It's about educating the investor about a new asset class. The fact that [institutional investors] are engaging and educating themselves is a huge leap forward," he adds. "If someone comes in with a similar structure, they won't have to jump the same hoops."

Conservation finance specialists are also broadening the market out in new directions. No fewer than four investment vehicles intended to promote sustainable fishing and marine conservation practices are currently being marketed to investors.

Althelia is raising funds for its Sustainable Ocean Fund, backed by the European Investment Bank and AXA Investment Management. Encourage Capital has teamed up with Zoma Capital, a family office, to launch a sustainable seafood investment company, called Pescador Holdings. Rare is expecting to launch it's $20 million Meloy Fund focused on coastal fisheries, and the government of the Seychelles plans to issue a $15 million 'blue bond', guaranteed by the World Bank and the Global Environment Facility, the proceeds of which will be used to support the island nation's transition to sustainable fisheries.

There is no lack of investor interest in conservation finance as an investment opportunity, say market participants. Evidence of this excess capital was demonstrated by a recent report from Ecosystem Marketplace seeking to size the conservation finance market.2 At the end of 2015, investors who participated in the survey reported $3.1 billion in unallocated capital – compared with the $2 billion deployed in 2015, and three times the $1.1 billion committed in 2014. All but three respondents said they planned to raise or allocate more capital to conservation investments in the next three years (2016-18) than they had in the prior three-year period.

"This is one of the report's more interesting data points," says Bayon at Encourage Capital. "It belies the belief that the problem is money: investors have money they want to invest that is burning a hole in their pockets."

The issues are more on the supply side. "The biggest challenge is the pipeline of projects in which institutional investors would be interested," says Fabian Huwyler, director of sustainability affairs at Credit Suisse in Zurich. To date, outside some of the large conservation forestry funds in developed markets, most conservation finance deals and funds have been small. "We're trying to look at structures that can be scaled," he adds, noting that, given the ticket sizes in which large investors typically invest, bonds need to be at least $100 million in size and funds greater than $500 million.

Part of the answer lies in developing incubators and accelerators that can channel early-stage funding and technical support, says Huwyler. Such incubators "can provide conservation start-ups with the infrastructure, knowledge and access to financing necessary to develop their ideas to a proven concept stage." Crucially, such incubators can bring together the environmental and social expertise with the project development and finance skills needed to structure transactions that are attractive to investors.

A number of such initiatives are underway. For example, CI is working with the World Resources Institute to develop a pre-investment facility that will bring together technical assistance, business development services and knowledge sharing. "The amazing thing is that, as investor interest has picked up in the last few years, we've moved from being capital-constrained to pipeline-constrained in conservation finance. With this facility, we aim to remove those bottlenecks by helping projects clear the final hurdles to becoming 'investment-ready'," says Silvani at CI. "It is intended to help support a transition from one-off investments to a healthy pipeline of landscape restoration opportunities."

In addition, last September saw the launch of the Coalition for Private Investment in Conservation, which counts Credit Suisse, The Nature Conservancy, International Union for Conservation of Nature, and Cornell University as founders. Focusing on priority sectors including forest landscape restoration, sustainable agriculture intensification, sustainable coastal fisheries and resilience, and watershed management, the coalition aims to develop new investment models and funding pipelines.

For many conventional investors, there are prosaic reasons for remaining reluctant to invest. Many of the opportunities are relatively long-term – of eight to 10 years – and offer little in the way of secondary market liquidity. On the other hand, some of the environmental markets that provide conservation revenue streams are uncertain. "Many of these markets are not sufficiently long term," argues Van Voorhis at ACRE Investment Management. "California only extends out to 2020, for example. Timber investments are typically 12-15 years in duration. To bring in new investments, markets need to offer longer-term policy frameworks that sync better with biological timeframes."

And, in any youthful sector, many investors want to see evidence of successful investment before they commit, notes Chenost at Moringa. "We're seeing a lot of interest, and an understanding of the theme, which is good," he says. "But what investors want to see is a track record. It will be important to have successful exits – and we are building that track record."

Wisniwski at Finance in Motion would also like to see more mainstream asset managers join the boutiques that currently dominate conservation finance. "It would help a lot if the traditional, more conventional asset managers would pick up this topic and bring larger solutions and products to the market.

"And it needs more asset generators and asset managers like us who can find and structure these assets … who have the level of specialisation needed," she adds.

These challenges notwithstanding, market participants are confident that conservation finance is set to accelerate. "The level of sophistication of this industry and the people within it has grown tremendously in the last five to 10 years," says Bayon at Encourage Capital.

"We now have this crop of people in the space who understand what a deal looks like, who understand finance and business, and that deals need to have revenues and returns to pay investors, and who understand that investments need to have conservation benefits … We're getting the capacity in this space that will drive the deal flow that, in turn, will drive the investment."

  1. Conservation Finance – From Niche to Mainstream: The Building of an Institutional Asset Class, Credit Suisse and McKinsey, 2016
  2. State of Private Investment in Conservation 2016, Ecosystem Marketplace, 2016
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