Reducing Bankability Challenges for Nature-Based Solutions
Understanding the financing challenges for nature-based solutions points to solvable problems to improve the quality and integrity of these carbon credits.
The potential for nature-based solutions to deliver meaningful climate change mitigation impact is clear. The terrestrial carbon sink sequesters 3.61 petagrams of carbon annually and is responsible for removing over 33% of total anthropogenic emissions from industry and land use change over the past ten years. Recently, nature-based solutions, particularly REDD+ (reduced emissions through deforestation and degradation), have been under intense scrutiny. A Guardian article last month highlighted several studies that found more than 90% of rainforest offset credits issued through Verra were essentially junk.
Criticism has poured in from all sides. MRV systems need to improve and incorporate better technology use. Alternative financing mechanisms need to be deployed. Better carbon accounting must take place. Incumbent registries need to be replaced. The market needs to fix its issues with perverse incentives in carbon credit issuance. Some argue that we shouldn’t use nature-based solutions at all for climate change mitigation. Criticism is a necessary feedback loop for progress; the carbon markets are new and will continue to face challenges.
There has been an air of villainization of those working on nature-based solutions, often by people who have never once set foot on a nature-based solution project in the Global South. While there may be cases of intentional fraudulent claims and scamming the market, I’d argue that most of these project failures are not intentional. Nature-based solution projects are wildly complex, and many of the project teams on the ground are doing their best to deliver quality projects. Unfortunately, this can sometimes seem like a sysiphean task, and the global climate community needs to seriously increase access to the resources and skills development needed to meet these demands. After all, it is the West that is the main contributor of emissions; if we expect the Global South to clean up our mess, we better be providing as much support and resources as we can to do this properly and respectfully.
To better understand where support is needed, it is helpful to see where capital is flowing for nature-based solutions.
Follow the money and see where it goes
Nature-based solutions are notoriously underinvested in. For example, while climate finance doubled in the last decade, nature has only attracted 2% of climate finance per annum.
Landscape of Climate Finance, Climate Policy Initiative
In a CrossBoundary report on financing for nature-based solutions, the CrossBoundary team also highlights the $700B+ annual funding gap for nature. Financing nature is notoriously challenging and very risky, so it is unsurprising that this is the case. Diving a bit deeper into these challenges and risks can help identify opportunities for better support and solutions. We can look at these risks in the following way, as with any sort of investment:
Investment risk = project bankability risks + systematic market risks
Project Bankability Risks. NbS projects are risky to finance just by the nature (pun intended) of the projects themselves. As NbS projects seek to preserve and restore natural carbon sinks, it’s important to realize how nascent the science behind these efforts really is. It wasn’t until the 1990s that the scientific community discovered that the Earth’s terrestrial ecosystems were a significant carbon sink. More recently, scientists discovered that biodiversity and even fungi also play vital roles in the quality of and potential for carbon storage in terrestrial ecosystems in a way that had never been recognized before.
When you add project design and implementation risks, complex stakeholder management risks, financing risks, and a volatile carbon market with an uncertain price per ton of CO2e on top of newly emerging scientific discoveries, it is humbling to consider just how challenging NbS project implementation can be. As a result, NbS projects face major project bankability challenges, given these uncertainties and risks.
Systematic Market Risks. With over two-thirds of terrestrial carbon sequestration potential in the Global South, traditional financing challenges of investing in frontier markets add another layer of risk and complexity to NbS projects. Brazil, China, Colombia, Indonesia, and India account for over 50 percent of the world’s ecosystem restoration potential alone. In addition, political and policy risks, limited transparency, market volatility, information asymmetries, liquidity risks, and property rights risks exist. The cost of capital in many of these markets with high carbon storage potential for nature-based solutions can be extremely high because of the many risks involved.
Managing systematic market risks is exceptionally challenging because of the many factors that are simply out of the control of funders and project owners. While organizations can do their best to manage and incorporate systematic risks into their decisions, there are clear opportunities to improve the bankability of nature-based solutions projects.
If the climate community wants to increase the quality of nature-based solutions and reduce the risks of investing in these projects, more support and capacity-building are needed to improve the bankability of NbS projects.
Key factors of bankability for NbS projects
Bankability refers to the financial attractiveness of a project. For nature-based solutions, a bankable project can attract commercial investments and demonstrate commercially acceptable returns. Just as in the business world, there are certain elements that investors look for to determine whether a venture is attractive or not, such as having a differentiated product with a significant market opportunity and a high-quality team with execution capability. While investability is not one-size-fits-all, it is often helpful for those founding businesses to understand what investors look for to inform which sources of capital are appropriate and what they will need to hit as milestones to raise the money needed to scale.
The same can be said for NbS projects: while more private capital is needed to support nature, NbS projects must meet private investors' needs and investment criteria (some may argue that strict adherence to delivering market-rate returns also needs to change for NbS). The qualities of bankable NbS projects point to opportunities to build capacity for NbS projects and help to mitigate some addressable financing risks to open up greater access to capital.
A study from South Pole and WWF sought to identify some of the most critical success factors of NbS projects. They grouped these success factors into four overarching groups: 1) technical set-up and design, 2) feasibility and piloting, 3) investment structuring, and 4) revenues and impacts. Each success factor contributed to mitigating the risks associated with the project or the risks of slow or unsteady long-term revenues.
Common Success Factors of Bankable NbS Projects, WWF and South Pole
Technical Set-up and Design. Under technical set-up and design, the most important factor that the research team found to secure investment was the project owner’s expertise in developing and executing NbS projects. Funders place an extremely high priority on project owners' track record and capability because of how vital their experience is in reducing implementation risks and delivering a high-quality project. A track record demonstrates the project owner has the technical know-how across the spectrum of ecological expertise, stakeholder management, and project execution capability to see this project through to the end and realize the financial returns expected.
An NbS project must also be developed in accordance with existing legislation that enables productive engagement in the carbon markets.The authors also noted that the ability to influence existing legislation and collaborate with the public sector was another necessary criterion for a high-quality project. Consider an example from Kenya where the national government had proposed declaring carbon a natural resource, which would bring carbon credits under their natural resource laws that required a 60% cut to go to the government. This sort of policy would cause most, if not all, carbon projects to be unbankable because the economics just wouldn’t work out. Fortunately, after lobbying the government, policymakers reached out to these project owners for feedback and input. The ability to engage with policymakers and help develop and influence enabling policy can dramatically shift outcomes for an NbS project.
Feasibility and Piloting. The demonstration of the project’s business case and an economic analysis of the intervention are essential factors in the bankability of a project. If an NbS project is expected to attract investment, there must be a realistic path to generate revenue through the valuation of ecosystem services. Project proof of concept or demonstration, capacity-building support, and procuring a project anchor funder are other essential components of feasibility demonstration and piloting. These factors are relatively self-explanatory.
Investment Structuring. Securing the right type of capital that is attractive to private investors is another significant challenge. Because of the riskiness of the investing environment, these projects often have to bring in a combination of capital sources. These financing options range from concessional loans and credit guarantees to blended financing options. Blended finance is a particularly interesting opportunity for nature-based solutions because of its ability to use public capital to reduce investment risk and attract greater private capital in return.
Another important consideration for investment structuring is the size of the NbS project and the ability to aggregate smaller projects into larger deals. As one project owner stated, “it’s easier to raise USD 400 million than USD 4 million”. Given the high transaction costs, these projects have to hit a minimum threshold of ticket size to be financially attractive. By aggregating projects into larger offerings, these projects can hit greater scale to make the economics of a financing deal make more sense. The challenge comes in the actual operations and complexity of managing a project that can increase the execution risk.
Revenues and Impact. One of the first questions on the mind of an investor is, is there a there there? –– meaning is there a market opportunity that’s big enough and that you can realisitically capture? The same goes for NbS projects. Two of the most essential factors in determining the bankability of an NbS project are the ability to secure a market and to secure offtake agreements. Naturally, this makes sense: a funder will have far more confidence in the return of a project if buyers are already confirmed and are willing to pay for the credits generated.
Another critical factor in the bankability of NbS projects that can become quite complex is the diversification of revenue streams. Because of the volatility of carbon markets and carbon credit prices, generating revenue from a single source (e.g., carbon credit sales) is quite risky. By diversifying revenue streams, projects can open up the opportunity to develop stable sources of revenue outside of carbon credits alone. This could be in the form of ecotourism or sustainable businesses. Additional revenue streams add additional complexity and could become even riskier to an investor if deemed an execution risk. Again, the execution capability of the project team is essential.
A model to explain the bankability of a nature-based solutions project might look something like this:
Throughout all of these debates and criticism of the quality of nature-based solutions, what has been abundantly clear is that the global community is simply not providing enough support to those on the ground doing the work.
While access to capital is a clear challenge for scaling nature-based solutions, so is access to the proper training, skills development, and support.
Improving the bankability of NbS projects
Perhaps the most critical factor that the WWF and South Pole’s publication highlighted in the bankability of NbS projects was the execution capability of the project owner’s team. The complexity of an NbS project is high. The skillsets required range from ecology and conservation management, project management, financing, business development, sales and marketing, and a lot of stakeholder management, particularly when engaging responsibly with indigenous communities.
How can we develop better training and support for project teams to build these critical skillsets needed to deliver high-quality projects? To solve this, it would do the carbon markets a whole lot of good to invest in training and skills development to address the factors that I’ve highlighted in the graphic above. I think we need to be building training programs and certification programs to disseminate these skillsets to develop more bankable NbS projects at scale. Currently, it is very hard to find a complete set of these skillsets in every NbS project team, and developing these skills often requires time and plenty of trial and error.
Unfortunately, we don’t have time for trial and error. If we want to see investments in nature-based solutions scale, we need to get these projects designed and implemented correctly from the start.