Natural Capital Pitfalls and Opportunities

Natural capital is the world’s stock of renewable and non-renewable natural resources, such as soils, air, water and living organisms. The opportunity to achieve whole of portfolio positive natural capital impact, while improving risk adjusted returns, is emerging as the most important investor opportunity since we turned our attention to net zero. Investors are currently impacting natural capital in their portfolios – mostly the impact is negative and unknown. Our view is that there is financial upside to evolving to deliberate mitigation of negative impacts (such as land degradation leading to habitat displacement) and cultivation of positive impacts (such as carbon sequestration)

The opportunity

Opportunities associated with natural capital investing are emerging at a prolific rate. There exists genuine opportunity to both invest in natural capital aligned projects, as well as to improve the natural capital performance of a portfolio across all asset classes. However, let’s also call out an elephant in the room – we hear a lot of talk about natural capital investing but how much of this talk translates into genuine action on the portfolio? This is in many cases due to the genuine challenges that an investment team faces when they seek to understand how to apply portfolio-wide principles to a subject that is notoriously complicated and regionally nuanced.
Our view is that with risk comes opportunity. Each of the natural capital risks or impacts described below are relevant to investors wishing to avoid financing the degradation of natural capital and resultant economic and reputational damage. Equally, each of the risks described below brings opportunity, to improve the performance of existing investments by ameliorating natural capital elements.

Financed deforestation, or proactive afforestation?

Financed deforestation is occurring at an alarming rate in Australia. The Nature Conservancy found in its recent report, Banking on Nature Destruction, that in Queensland alone between 2018-2020, over 364,000 hectares of conservation significant habitat was cleared, and over 143,000 hectares of that clearing was financed by Australian banks (Figure 1 below).

Figure 1: Areas of conservation significant deforestation in Queensland by Funder 2018-2020 (Source: The Nature Conservancy).

The potential for investments to unwittingly finance deforestation is immense. Only with careful diligence and stewardship, will investors avoid the risk of financing direct (and potentially unlawful) deforestation activities.

The opportunity for reforestation of degraded areas comes with the added benefit of potential carbon credit generation. Carefully planned projects that do not over-promise on habitat complexity or like-for-like status can contribute to the mitigation of the devastating impacts of deforestation in the long term.

Financed environmental water harvesting, or water preservation?

The acquisition of agricultural assets often involves the acquisition of water rights. These water rights usually make an agricultural project more economically viable, and provide certainty regarding returns for both cropping and grazing enterprises. However, the use of these rights, particularly in areas where environmental flows are not regulated, can cause significant impact to downstream ecosystem health.

Agriculture projects that implement environmental flow protection (that is, that reduce the volume of water drawn as water flows reduce, to ensure environmental flows remain), and can verify these practices, are less likely to be negatively impacting on natural capital resources, and may in fact be able to prove a measurable improvement in aquatic ecosystem health against an acquisition baseline. Projects that include the acquisition of water rights and return that water to the environment entirely, could improve natural capital values.

Financed species loss, or biodiversity preservation?

Any industry that involves land clearing can impact on biodiversity values, unless careful controls are implemented. It is almost impossible to mitigate the impacts to biodiversity from land clearing with new plantings. According to the Department of Environment and Heritage, it takes over 100 years to establish mature habitat trees with standing hollows, and as such, the habitat loss associated with land clearing cannot be mitigated within multiple generations.

Consideration of biodiversity requires attention to the quality and quantity of habitat preserved (as offsets or otherwise), the connectivity of that habitat, the like-for-like nature of any offsets, whether those offset areas would have been protected anyway, (conversely, whether the protection of those offset areas can be guaranteed in the long term), and whether offsets are being proposed that involve prohibitive lag times for biodiversity values (such as tree plantings to offset the loss of mature tree habitats).

Financed soil degradation, or enhanced soil quality?

The amelioration of carbon content in soil, while challenged by methodological complexities, has a positive impact on natural capital values in many ways, including increased water storage in soil, reduced runoff to aquatic ecosystems, improved microbial soil activity, and increase in pasture biodiversity. Carbon capture via tree plantings in areas of agricultural land that are not viable for either cropping or grazing can positively contribute to soil structure, decreased runoff, increased biodiversity, and ecosystem function. Carbon capture and storage in the agricultural sense is almost always a positive – however, care must be taken when considering whether this carbon is contributing positively to the land, biodiversity or water, or whether it is simply contributing positively to the bottom line (such as improved carbon content in a monoculture cropping project). Both are valid investment opportunities, but arguably only the former can be considered positively impacting on natural capital values holistically.

A practical application to a portfolio

While a portfolio-wide materiality assessment is recommended to identify natural capital opportunities and risks, the two industries most often touted as natural capital aligned investments are agriculture and forestry.

Forestry projects that incorporate a carbon credit as part of the underlying business case can produce positive additionality in relation to economic returns; however, care must be taken when considering forestry as a natural capital opportunity.
For a forestry project to be contributing positively to natural capital, the project would need to be demonstrating measured improvement (from a baseline) to natural capital elements within its footprint. This may include increasing soil carbon, improving water quality and flow, and preserving biodiversity and habitat. Projects that incorporate active ecosystem function, through biodiverse plantings, habitat corridors, selective harvesting, and watercourse protection, are likely to be positively impacting on natural capital values. However, adding these elements to a traditional forestry project adds significant cost and complexity, and these elements are difficult to implement effectively. As such, there are currently very few forestry products in the market that can show measurable outcomes against these metrics.

Agriculture presents numerous risks to, and opportunities for improvement of, natural capital. Deforestation, soil degradation and environmental water harvesting are all hallmarks of traditional or conservative agricultural activities. However, the gaining momentum of sustainable or regenerative agriculture practices brings significant natural capital opportunities. Increasing soil carbon, increasing biodiversity, increasing environmental water flows, improving water quality, and capturing carbon in environmental plantings are all opportunities to both ameliorate the performance of the underlying asset, and to provide positive natural capital outcomes.

Conclusion

The opportunities and risks associated with natural capital investments are both significant. Sifting through the genuine opportunities to improve financial performance and natural capital outcomes is a specialist skill that the finance industry should be investing in.