Sustainable risk-adjusted returns through natural capital

Written By: Gautier Quéru Investment Director and Land Degradation Neutrality Fund Project Manager Mirova

Gautier Quéru of Mirova outlines the land degradation issue and argues that investment in natural capital is poised to evolve from being a niche strategy to a mainstream asset class, with the potential for attractive risk-adjusted returns

It is estimated that 2 billion hectares of land is degraded worldwide, and an additional 12 million hectares of productive land is impacted every year. According to a 2016 study, land degradation has already negatively affected 29% of global land area. Land degradation is caused by activities such as overgrazing, unsustainable farming practices and deforestation, and it lowers the capacity of land to provide essential goods and ecosystem services. This affects the lives of millions of people in developing countries, with severe impacts on food security, livelihoods, climate change and biodiversity.

Large numbers of governments and non-government organisations worldwide believe so, and so do we. The concept of Land Degradation Neutrality (LDN) hit the news in 2015 when it was included in the United Nations Sustainable Development Goals. The UN has set a target of achieving LDN worldwide by 2030. LDN aims to maintain or increase the area of healthy and productive land over time. In other words, reaching the LDN objective requires economic growth and development without further land degradation. To date, more than 100 countries have signed up to one or more LDN-related initiatives.

Fighting land degradation also helps to reduce greenhouse gas emissions by preventing deforestation and over-farming. There is also potential for further reduction through low-emissions agriculture, agroforestry and ecosystem restoration.

Projects to prevent and reverse land degregation have been running for many years. Agroforestry and agroecology projects – combining sustainable production of raw materials (e.g. food and fibres) and nature conservation, as well as inclusion of local communities – have been developed in many regions across the world. They have demonstrated they can generate multiple benefits, including environmental, social and financial results.

This kind of productive financing is no wish list; it is taking place right now. Examples of existing initiatives include a combined sustainably-managed rubber plantation and conservation reforestation program in South-East Asia, which has led to increased productivity, new jobs and reduced deforestation. Another example is a climate-resilient coffee restoration and productivity enhancement program in South America. With co-operatives acting as key partners to channel capital to local farmers, this project has sustainably increased yields and raised incomes.

Hundreds of similar projects are underway across the globe. That being said, it still requires a great deal of time, effort and expertise for us to identify these triple bottom line ventures that can contribute to LDN.

We view the sustainable land use market as similar to renewable energy 10-15 years ago. Back then, renewable energy was a collection of new assets and technologies, with a limited track record and little access to bank finance. Projects were initially funded by public entities, and then scaled-up using blended finance schemes, just as sustainable land use is today. Now renewable energy is a mainstream investment category and there are hundreds of renewable energy funds managing billions of dollars. We believe that natural capital investments such as sustainable land use will turn into a popular asset class in the near future.

Many consumer and high street companies are starting to recognise the importance of sustainability for their brands, and are looking for certified commodities. They are prepared to pay a premium for sustainably-produced commodities, such as coffee, cocoa, tea and cotton, grown in accordance with specific environmental and social standards. Unilever, for example, has committed to achieving zero net deforestation by 2020 in its production of palm oil, soy, paper and board, and beef. Adidas is a pioneer member of the Better Cotton Initiative and has committed to using 100% sustainable cotton by 2018. Meanwhile, IKEA aims to source 100% of its wood from recycled and FSC-certified sources by 2020.

As demand for commodities sourced in this way grows, so this nascent market grows, providing new investment opportunities. It is not just a matter of reputation for corporations; they see it as an opportunity to rethink and secure their supply chains over the long term, in an environmentally and commercially sustainable way.

We focus on long-term profit-seeking investments in large-scale land restoration and land degradation avoidance projects, which aim to integrate smallholders and local communities. Although we operate worldwide, we have a targeted allocation of at least 80% in developing countries, mainly investing in sustainable agriculture and sustainable forestry, and to a lesser extent in green infrastructure and ecotourism.

Our approach seeks attractive financial returns using improved agronomic practices increases yields and product quality, while certifications such as Fairtrade, Rainforest Alliance and FSC attract premium pricing. It’s worth saying that the environmental and social (E&S) aspects of every investment opportunity we review are as important as any other financial considerations. As a critical component of our decision-making process, an E&S due diligence is systematically conducted before proceeding with any transaction, and we only consider projects that we believe can make a significant contribution to LDN.

We have seen many well-structured and operated projects in the market that can provide competitive financial returns. They typically use better varieties and techniques to raise yields and quality, which increases revenues. Combined with higher prices for sustainably certified products, projects can produce profits while still benefitting local communities and the environment.

One aspect is that due to the time taken for many crops to grow to maturity, there is often a sizeable upfront capex investment followed by a relatively long wait until positive cash flows. This means that long-term financing is required, often over 10 years. This constraint is one of the issues that limits current financing available for these projects, but it also represents an opportunity, as investors with long-term investment horizons (e.g. pension funds) are able to access the attractive returns available following the growth phase.

The sector is not yet mature, so investors do not always find it easy to find the right allocation bucket for it. Infrastructure and renewable energy encountered a similar challenge when they first took off. So far, many investors have included it in their responsible investment or impact finance allocations. However, a number of large Dutch and Nordic institutional investors have made sizeable allocations and view the asset class as a key component in their portfolios going forward. In addition, natural capital is a good portfolio diversifier. Not only is it decorrelated from financial markets, but it is genuinely geographically-diversified, with projects being launched in all emerging markets and in some developed markets too. The strategy can be implemented successfully in countries where capital markets are immature or inefficient, thus providing wider geographic diversification than traditional bond or equity funds.

Most people accept that humans are overexploiting nature while underinvesting in it. Investors have an opportunity to improve living conditions for millions of people, enhance the environment, and combat climate change. At the same time, by investing in sustainable land use projects, they can access good returns while seeking to mitigate the risk.