Mobilising private investment in natural capital: report

Executive summary

Finance Earth was commissioned by the Scottish Government, in partnership with NatureScot, to explore how voluntary carbon markets can be harnessed to accelerate the delivery of high-integrity peatland restoration across Scotland.

The project, "Mobilising Private Investment in Natural Capital" aims to understand both the financial and non-financial barriers to peatland restoration, the opportunities to scale-up restoration activities, and sets-out recommendations on how public capital can be used most effectively to crowd-in private investment into peatland restoration. The project was delivered through a process of action research, working iteratively with a large group of stakeholders including landowners, farmers, project developers, investors and carbon-buyers.

This project builds on NatureScot and Finance Earth's 2021 report, "Facilitating Local Natural Capital Investment" which evaluated a range of funding and financing mechanisms to unlock investment in Scotland's natural capital. It proposed two key mechanisms be developed, namely a Scotland Carbon Fund (SCF) and a Price Floor Guarantee (PFG). This report explores these two proposed mechanisms in more detail, and based on extensive stakeholder consultations, research and data analysis, provides recommendations regarding their design, particularly as it relates to the financing of peatland restoration.

The Challenge

The United Kingdom has one of the most depleted natural capital stocks on the planet. This extends to peatland, which cover approximately one third of Scotland's land area (when afforested peat is included). Peatlands are a key part of the Scottish landscape providing a range of ecosystem services spanning water filtration, carbon storage, flood management and biodiversity, yet about 2 million hectares are in a modified or degraded state. In their current condition, Scotland's peatlands are a net emitter of greenhouse gases (GHGs). In order to achieve its net zero target by 2045, Scotland will need to restore its peatlands.

Public investment in peatland restoration has been increased over recent years, but remains below what is needed to restore this natural asset at scale. The Scottish Government has a target to restore 250,000 hectares by 2030, and in 2020 committed an additional £250m in funds for this work. However, only around 6,000 hectares are currently being restored annually and beyond public funds, there has been minimal investment to-date from private sources, including through voluntary carbon markets.

The Opportunity: Voluntary carbon markets

Voluntary carbon markets are developing rapidly with an average 30% annual growth rate internationally over the last three years.^[2] Further growth is also expected over the next 20 years, as many businesses and organisations look to voluntary carbon markets as a key tool to deliver on their net zero commitments. While there are continued concerns around supply-side integrity in the market, multiple standards and codes have emerged over recent years which aim to provide market participants with confidence in project quality and their positive climate and environmental impacts. This includes the UK Peatland Code, a voluntary certification standard for UK-based peatland projects seeking to leverage carbon markets for income. As of 7^th September 2022, 92 projects have registered under the code, equivalent to c.15,000 hectares of degraded peatland. While this is growing quickly, it remains relatively small in the context of the total extent of Scottish peatland.

What we tested

1. Scotland Carbon Fund

The overall aim of a SCF would be to attract private investment in peatland restoration, with income from the sale of carbon credits providing positive financial returns for private investors. The fund would be open only to projects that met certain eligibility criteria, aiming to assure high-integrity and transparency in the projects being supported. Finance Earth analysed a series of fund design features and criteria, including fund type, investment mandate, capital structure, community benefit sharing mechanisms, and governance arrangements to identify how best to address key barriers in the market and unlock private finance at scale while ensuring that the Scottish Government's just transition principles and principles for responsible investment are respected.

2. Price Floor Guarantee mechanism

A PFG is a price control mechanism designed to transfer risk and provide confidence in early stage markets. Price floors are used to accelerate market development by removing the risk that prices fall below a pre-agreed threshold. Finance Earth analysed how such a mechanism might be designed to maximise the efficiency of public spending and support specific desirable outcomes like carbon storage, biodiversity or community benefit.

Stakeholder views and perspectives on voluntary carbon markets for peatland restoration

To inform our analysis, Finance Earth consulted with a wide variety of important stakeholders, including project developers, landowners, community organisations, investors and potential buyers of voluntary carbon credits. They identified both financial and non-financial barriers to the scaling of voluntary carbon markets to restore peatland in Scotland.

Despite these barriers, several stakeholders consulted had participated in voluntary carbon markets for peatland restoration albeit at a small-scale, and many displayed a keen interest to learn more about how it could work for them with a view to more active participation in the future. Of those that had engaged, many indicated a strong preference for holding onto a significant portion of their Pending Issuance Units (PIUs) until verification in order to retain as much value as possible. On the buyer side, several indicated an interest in purchasing carbon credits, potentially at a premium, if it could be shown that those credits also support other desirable outcomes, specifically community benefit and improvements in biodiversity.

Evaluation and recommended design features

Scotland Carbon Fund

The report finds a strong case can be made to develop a SCF as an effective tool to unlock finance for peatland restoration at-scale. Specifically, this should be structured as a project finance vehicle versus a liquidity vehicle. This structure would appear a better fit with the preferences of the market actors consulted and has a series of advantages, including:

• Better temporal alignment between revenues from the sale of verified carbon credits and project costs;
• Ability to capture any upside in carbon credit prices that would otherwise have been captured by intermediaries buying PIUs;
• Optionality to invest in capacity and supply chain building;
• A well-known institutional structure; and
• Ability to provide upfront project finance to cover restoration costs and project maintenance in the early years.

It was identified that a fund size of at least £50m would be required to allow for efficient management and a larger vehicle would be more impactful in restoring a larger area of degraded peatlands (although the availability of pipeline is a limiting factor).

The incomplete mapping data on the condition of Scottish peatlands and the limitations in terms of eligibility criteria set by the Peatland Code both create uncertainty over the size of the available pipeline of projects for restoration. As such, it was suggested that the SCF could pursue a wider investment mandate, spanning not only peatland and woodland carbon markets, but also providing finance to green companies operating in the peatland restoration sector to alleviate capacity constraints.

To avoid inadvertently contributing to land price inflation in Scotland, a leasehold investment strategy is also recommended. Under this strategy, land is leased from landowners and a portion of the carbon benefits is also shared with landowners, thereby limiting the transfer of land to large international investors. The leasehold investment strategy is also more in line with the objectives of the Scottish Land Reform bill and Scottish Land Fund in terms of addressing highly concentrated patterns of land ownership in Scotland.

A financial contribution to a SCF from the Scottish Government was viewed favourably by investors as an important display of commitment. A first loss position was seen as particularly impactful, providing further confidence in the market.

The fund could also be structured to share benefits with local communities, in line with Scottish Government's ambitions for a Just Transition and the Interim Principles for Responsible Investment in Natural Capital. A conservation dividend, payable above a pre-defined hurdle rate was found to be the most attractive approach, where a portion of profits are diverted from investors to communities as a donation.

The inclusion of governance tools to support investee projects was also considered. A central endowment fund was identified as a key means to support good financial governance, with funds structured to support long term maintenance costs. In a similar vein, a portfolio approach could allow for the sharing of risks, with projects pooling resources to insure against unforeseen delivery risks and cost overruns.

Finally, to overcome challenges faced by small projects, aggregation facilities could be structured under which a partner with a track record (e.g. an eNGO) could work with and aggregate a group of smaller projects and receive a pre-defined amount of investment capital from the fund.

Price Floor Guarantee mechanism

A PFG can operate alongside a SCF as an aligned mechanism, rather than an alternative to it as suggested in the NatureScot and Finance Earth 2021 report, "Facilitating Local Natural Capital Investment". The PFG provides project developers with confidence in project revenues over a fixed period, significantly reducing their downside risk (i.e. the risk of low carbon prices negatively impacting the financial viability of a project). This is valuable given the current volatility of carbon markets. It is particularly supportive of those projects where developers wish to hold some – or all – of their PIUs to verification. Retaining PIUs until they vest into verified carbon usually allows developers to achieve a higher selling price.

While many stakeholders expressed broad support for this approach, it was also noted that it would need to be carefully designed to avoid a "race to the bottom" in which low quality projects with a low cost base would manage to secure a guaranteed price for their carbon credits over high value ones (e.g. projects with multiple co-benefits such as biodiversity and community benefits).

Finance Earth assessed several existing PFG mechanisms and identified the reverse auction-based approach as the best fit with for the market for carbon credits from peatland restoration. Two potential auction structures, 'Uniform Price' and 'Pay As Bid' were identified as suitable models. While recent evidence indicates the former as the better option, further testing of both approaches is recommended and simplicity and accessibility should be prioritised.

The term of the guarantee was identified as a crucial feature of the PFG, with a longer guarantee offering significantly greater benefit to projects, but also a larger liability for Scottish Government. Another challenge is that it remains difficult to forecast demand for carbon credits over long time periods, particularly after 2050, with current demand being driven by institutions seeking to meet their near-term offsetting needs. As such, establishing a price floor that extends beyond 2050 could improve developer confidence in the long-term economic viability of projects, noting that the minimum project duration according to Peatland Code eligibility standards is 30 years.

To avoid a race to the bottom on project quality, eligibility criteria can be built in that limit access to only those projects that fulfil minimum requirements, aligned with public policy objectives, such as the Scottish Government Interim Principles for Responsible Investment in Natural Capital and the National Strategy for Economic Transformation (NSET). Eligibility criteria proposed by stakeholders included sites with specific physical characteristics (e.g., high altitude peatlands, forested bogs, etc.), community benefit, and biodiversity and water based co- benefits (e.g. flow attenuation and quality). It should be noted however that the eligibility criteria embedded within the Peatland Code already set a high bar for participating projects, and further criteria may well add limited value.

Other features including the indexation of the guarantee price, and the timing and frequency of auctions were also tested with stakeholders with some form of indexation likely to be attractive to potential investors.

Building coherence in the peatland financing ecosystem: operating payments

At current market carbon prices, peatland restoration projects are not viable without partial (and typically substantial) public funding or private forms of grant funding. However, full capital grants from public funding may serve to unnecessarily crowd-out private finance while not providing support for ongoing project maintenance costs. Restructuring Peatland ACTION grants to include an ongoing support or "Operating Payments" could provide multiple benefits, including confidence in cashflows over a fixed period. These payments could be provided alongside a lower capital grant that may be reduced over time as the market matures. In reorganising Peatland ACTION payments, it will also be important to consider the impact of agricultural land reform in potentially creating other income streams to support the management of peatlands post restoration. Operating payments may be provided for a fixed period of time or for the full operating life of the project A period of 5-20 years will allow projects to understand their costs prior to the sale of carbon credits, as well as provide confidence to potential investors in the market around the 'permanence' and integrity of projects.

Good financial governance

All three recommended financial mechanisms (SCF, PFG and operating payments) support good financial governance practices, i.e. sound planning for the long-term maintenance liabilities of restoration projects. Projects with poor financial governance are likely to struggle to cover ongoing costs, raising concerns for carbon buyers and prospective investors.

Conversely, projects with sound financial planning can expect to generate positive cashflows, even over an extended period (e.g. 50 years). In Section 9 we model a project scenario supported by the three mechanisms covered in this report.

There is a strong case to develop a SCF and aligned PFG as tools well suited to build market integrity and scale-up private investment in peatland restoration in Scotland. Delivering these mechanisms will resolve some of the key barriers identified by market participants. However, to maximise their effectiveness, these mechanisms should also be designed in tandem with changes to the public sector funding infrastructure to unlock investment and ultimately scale the market.