Chris Howells and Andrew Dreaneen discuss how today’s investments in natural capital can profit portfolios as well as the planet and humanity
Sustainable investments in the form of impact strategies and renewable energy sources will play a key part in insurers’ journeys to net zero.
But the role of natural capital is less frequently discussed. ‘Natural capital’ refers to the world’s stock of natural assets and ecosystem services that, when combined, yield economic, environmental and social benefits. ‘Natural assets’ comprise forests, soil, air, living organisms, geological features and water.
With the recent climate change COP26 and biodiversity COP15 still fresh in the minds of investors, the potential for natural capital investments to contribute towards the ambitious objectives set has increased in relevance.
All things nature
Investing in natural assets for financial return is not a new idea. Traditionally, it has taken the form of farming, timber, mining, energy, and ocean and marine-based activities. The return was generated from the associated income and capital appreciation derived from natural resource management and/or extraction.
Natural capital investing adds a sustainability dimension, aiming to leave positive externalities while achieving financial return. The investment is in not just the resources but also the associated ecosystem services – the benefits that natural assets provide to humans. These include carbon sequestration (the capturing, removal and storage of carbon dioxide from the atmosphere), biodiversity (an enabler for healthy environments), pollination (essential for crop growth), water and air purification, and soil protection.
Natural capital investments explicitly balance the trade-off between financial return and the sustainable management – and ideally enhancement – of natural goods and services. Sustainable forestry, for example, seeks to mimic the natural cycle of degeneration and regeneration, balancing the harvesting of forestry assets for commercial use with the preservation and improvement of regional biodiversity and ecosystem services.
Sustainable natural resource management is not the only means by which investors can tap into natural capital. The ‘next level’ is to invest in projects whose primary objective is conservation. While these projects frequently overlap with forestry and agriculture, which can act as sources of return, their primary goals are to protect, manage and restore critical ecosystems and stores of irrecoverable carbon. Examples include forest and wetland restoration projects, which can help to boost biodiversity and cool the planet through increased carbon storage.
Regulation
Investors are increasingly looking to maximise impact while also pursuing financial returns. In places where insurers are subject to a prudent person principle, firms are required to take account of their investment strategy’s potential impact on sustainability factors, although they are not compelled to invest in sustainable or impact strategies.
In addition, regulators are producing increasingly detailed climate risk stress scenarios, such as the Bank of England’s Climate Biennial Exploratory Scenario 2021 and the European Insurance and Occupational Pensions Authority’s study on sensitivity analysis of climate change related transition risks. Insurers will need to explore ways of mitigating the impacts revealed in their asset and liability portfolios, whether they are borne on the balance sheet or, in the case of unit-linked business, by policyholders.
Where applicable, regulatory capital charges will typically depend on the form of the investment, with different requirements for private equity and debt, and qualifying infrastructure investments (if defined in the regime). Interestingly, under Solvency II, agricultural land and forests would be treated as property, attracting a flat 25% capital charge and boosting the asset class’s capital efficiency.
Carbon credits
This is all very well for positive externalities, you might be thinking, but what about financial return? The monetisation of ecosystem services and their integration into financial markets is an area of ongoing exploration, with the voluntary carbon market being one well-known example. For investors in conservation projects, while some traditional income streams may come through the sale of sustainably harvested timber and crops, the potential to enable carbon sequestration provides another possible revenue stream: carbon credits.
Carbon credits are not exclusive to conservation. In our earlier examples of regenerative agriculture and sustainable forestry, the primary objectives may be traditional financial return, but sustainable management practices can also result in soil and forest carbon sequestration, generating carbon credits.
Each credit represents one tonne of emissions of carbon (or another greenhouse gas equivalent) avoided or removed because of the project. To show that avoidance or removal has occurred, project developers must implement stringent methodologies, which are verified, validated and audited by independent third parties.
When the credit is issued, the project developer can sell it on the voluntary carbon market. The price is set based on the project’s perceived quality, and the purchaser can do what they want with the credit. In general, they will either take the credit out of circulation to offset against their own emissions, or sell it for profit on the secondary market. (Figure 1 shows how the voluntary market has grown in recent years.) An investor can therefore build a conservation portfolio to offset their carbon footprint on an ongoing basis, or use it to boost yield – or both.
In many cases, conservation projects can enhance ecosystem services in ways that go beyond carbon sequestration. Analogous markets for other ecosystem services – such as the nascent voluntary biodiversity credit market – are emerging, and can represent future additional sources of income for conservation projects.
Relevance for insurers
Insurers’ investment strategies have a variety of financial, environmental and social objectives, and natural capital solutions can play a part in achieving them:
- Long-term cashflows: projects have a long lifetime, from design and development through to the productive lifetime of the resources or technology. This makes them suitable for matching long-term liabilities
- Inflation protection: projects with forestry or agriculture exposure have established markets and revenue streams that positively correlate with inflation.This is valuable for meeting inflation-linked claims liabilities and expenses, and preserving cashflow value in real terms
- Diversification: timberland, for example, is negatively correlated with fixed income, and has low correlation with global equity markets – trees will grow regardless of economic cycles and market conditions!
- Societal impact: there are philanthropic and societal benefits in contributing to climate, biodiversity and communities’ living environments. In the longer term, the positive impact on factors affecting health will play out in life and health claims
- Environmental impact: natural capital investments can contribute to net zero targets. In the long term, these would also materialise as reductions in property and casualty claims – for example, afforestation can improve natural flood defences Illiquidity and complexity premia: the investments are private market transactions structured as debt and/or equity project finance, requiring expertise to source, develop and manage.
Expected risks and returns
With project lifetimes extending to 15–20 years and above, we estimate projects’ achievable internal rate of return to range from 6%–10%, depending on type and scope.
Using publicly available indices as proxies, we compared risk (as measured by volatility) and return for natural capital investments with traditional asset classes, using farmland and timberland as examples (Figure 2).
Other than the volatility of, for example, carbon prices, investment risks manifest in the form of unexpected impacts from environmental policy and adverse macroeconomic circumstances. These can be mitigated by investing in projects that are diverse in type, objective and geography.
Make your mark
Through the protection of our ecosystems, through land management, and the restoration of forests and wetlands, we could reduce net carbon emissions by a quarter by the end of the decade. And investors can make their mark on the future of our planet by supporting such solutions.
Chris Howells is head of global insurance clients at Schroders
Andrew Dreaneen is head of alternatives and natural capital at Schroders
