How investible is natural capital?
Five key things I took away from a recent discussion on the increasingly important investment theme of natural capital.
One of the most fascinating books I recently read is Andrea Wulf’s ‘The invention of nature’. It is a lively account of the life of the explorer, naturalist and geographer Alexander von Humboldt. On his many travels, Von Humboldt was always looking for patterns and connections between all kinds of life – reflective of a holistic worldview that recognises that systems do not function in isolation, but within bigger systems.
Of course, most people know that nature is crucial to human life. Or, as the economist Herman Daly put it: “The economy is a wholly owned subsidiary of the environment, not the reverse.” Yet, our economy continues to function in a way that exploits and exhausts nature to such a degree that we risk destroying the basis.
The cartoonist Graeme Mackay visualised this quite vividly below.
The conclusion is clear: restorative action is badly needed. As Schroders CEO Peter Harrison argues in his blog ‘why we must make nature investible’, we need to rethink our relationship with nature, and the financial sector must play its part.
But how? In his blog, Peter explains Schroders’ approach: “We have pledged to change the behaviour toward nature of every company we invest in; we will create new nature-based investment products, and use our solutions business to channel capital into new and existing funds. By doing so, we help our clients make a positive impact while also diversifying the sources of their returns.”
Clearly, this is not straightforward and won’t happen overnight. We are well into the realm of new investment models and analysis that remains challenging with current data sets, but tackling that challenge is urgent and cannot wait for perfect answers.
But what does it mean for clients? How investible is natural capital? Are clients thinking about this at all? We explored these questions in a panel that I moderated at a client conference in March.
There were five key takeaways. First, natural capital is much bigger than people think. In the first paragraph I mentioned biodiversity breakdown as a bigger problem than climate change, but let’s put it into numbers as well: the annual value of ecosystem services is estimated at over $120 trillion, about 50% higher than global GDP. However, as Schroders’ Global Head of Sustainable Investment Andy Howard pointed out, payments for ecosystem services are 40x smaller. So, there is a huge gap between value and financial value, which can be closed by monetising a larger proportion of ecosystem services.
This is happening, driven by regulation and, as a result, corporates trying to offset their negative externalities, for example by investing in reforestation. In fact, corporates are moving faster than the supply of new projects, as Schroders’ Head of Alternatives Andrew Dreaneen argued on the panel. There is a massive need to develop new projects.
Second, the social dimension is extremely important. Deputy CEO at BlueOrchard and Head of Sustainability and Impact at Schroders Capital, Maria Teresa Zappia, explained that no less than 1.2 billion people are highly nature dependent, relying on nature for three quarters of their basic needs.
Moreover, Maria Teresa pointed out, the social dimension is also crucial in successfully developing natural capital projects. Defining the rights to land of local communities is typically a critical component. Often, especially in emerging markets, these are not formalised and may require active involvement of NGOs to ensure land tenure is formalised prior to any conservation projects take place. And when the projects take place, local communities tend to know much better than outsiders how to protect local natural capital.
Third, natural capital is indeed on many clients’ minds. We started our panel by asking the audience if they currently allocate/advise to nature-based solutions. To my surprise, 54% of the audience indicated they did, where I was expecting a single digit percentage. Of course anecdotally I knew that clients were asking for it – especially with institutional clients setting targets, wealth managers looking for biodiversity products, and family offices taking it into account in their long-term investments for next generations. But this was much more widespread than expected.
Fourth, products are coming. In private assets, there are products on sustainable forestry; regenerative agriculture; and increasingly conservation (protect and restore), which used to be venture philanthropy, but now also comes in return-seeking forms. On the listed side, biodiversity engagement funds offer potential, with clients asking for leaders in industries with high exposures, and intense engagement to improve biodiversity performance and reporting. And these products tend to come with a good portfolio fit, as they tend to have low correlations; and a biodiversity engagement fund tends to have very different holdings than the typical sustainable equity product. Moreover, biodiversity offers an interesting holistic lens to a portfolio, which allows one to better identify and manage risks otherwise not seen. However, in some natural capital products it does involve giving up expected returns, which is acceptable only to a small subset of clients.
Fifth, there are still large bottlenecks. Getting a decent risk-return can be challenging in natural capital solutions. Public-private partnerships are often needed to make it work and reduce risk. Many standards still need to be set, and monetisation is far from straightforward.
Some people have more fundamental concerns: by treating nature as an asset class, we again get the typical reductionist and short-term behaviour that got us here in the first place. There is merit in that warning, and when mobilising capital we should put sufficient safeguards in place to ensure that nature really benefits. At the same time, a lot of experimentation is needed to develop a wide diversity of mechanisms to mobilise capital for nature. It is a massive challenge, but it’s worth it and I’m sure that Alexander von Humboldt would have taken it up as well.
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