'CEOs will be shocked how close they are to tipping points' – Can nature-based solutions win market favour?

What have been the key developments in nature-based solutions (NbS) from an investor perspective in recent years?

Many investors still struggle to understand what NbS are and how they make money. Basically, any activity that protects, restores or manages ecosystems in a sustainable way while benefitting society or the economy is an NbS. This ranges from restoring mangroves to protecting coastlines to peatland restoration to capture carbon. Agriculture and forestry can be an NbS if managed sustainably.

With the market still not mature, a few landmark initiatives stood out. Mangroves were fashionable a few years ago. The idea of planting a Great Green Wall to protect against the growing Sahara received a lot of attention. The World Bank issued a 'rhino bond' to finance wildlife conservation in Africa. The ocean has become fashionable, seen in the context of 'blue bonds'.

The main question will always be where the money comes from to pay back private investors. Often it came from governments. Private investors are pre-financing conservation projects run by governments. But that is a fairly limited way of making money. Sustainable agriculture and forestry are not tied to government money. They can rely on selling their products and profit from some kind of credits.

The primary challenge is that using nature and destroying biodiversity is mainly free. The key to unlock money for NbS will be to make corporates participate in biodiversity restoration and conservation. The only people currently spending on it are construction firms, as they're required to by law, and governments.

Are there any pioneering projects that highlight how NbS can mature?

Some newer investment ideas involve agri-tech and solutions that support sustainable agriculture. The increasing focus on nature-related risks driven by the Taskforce on Nature-related Financial Disclosures (TNFD) and regulators could also create opportunities to invest in data, analysis and consulting.

Another interesting angle is where the money isn't made by what your company or land produces but by selling credits for sequestering carbon or restoring biodiversity. There is a strong link to voluntary carbon credits but biodiversity credits also are on the rise. Corporates are increasingly interested in making 'nature positive' claims. They will need biodiversity credits to compensate their negative impacts. In some countries, such credits have even become law. In France and the UK, construction projects can compensate for biodiversity impacts either on-site or by buying certain approved credits. These are generated by natural parks or other habitats in the same country. In the UK, the first fund has been set up, a private equity fund investing in a company aiming to manage and distribute these biodiversity credits.

How important will blended finance be to NbS?

It depends as biodiversity is so broad. Typically, the further you are from home and traditional investments like agriculture or forestry, the more you are out of the comfort zone of investors like insurers and pension funds. They want guaranteed returns, stable environments and a long track record. There, blended finance can be beneficial as it has a risk-bearing capacity and can unlock private money. But it doesn't solve the issue of generating meaningful returns to pay back investors. That's a more difficult question.

NbS projects are often overlooked by mainstream investors because of small ticket sizes – how can this be tackled?

Whatever NbS you invest in, the secret will be to find a structure big enough to attract investors. You can see a similar development in the climate space. At first climate-related renewable projects were fairly small and now they've grown significantly.

It all depends on having enough projects to make money but then also finding a structure where you can pool smaller investments. That may be a fund or securitisation structure or setting up lending arrangements which recycle capital, ie, providing loans and receiving paybacks continuously. We've looked at a few structures, for example, bringing in investors to finance the transition to sustainable agriculture in Brazil. Loans to individual farmers were small but if pooled in a lending facility were big enough to attract institutional investors. Also important is creating standardised structures where you don't need costly bespoke arrangements for every transaction.

The sector is usually seen as closely linked to the fortunes of carbon markets – will that be a help or hinderance in the years ahead?

Voluntary carbon or biodiversity credits can be a key to unlocking private capital. Many of the bigger projects currently rely on voluntary carbon credits to generate returns. The current discussion on the credibility of such credits also impacts NbS. I don't know how many stories I have heard of deforestation projects around the globe selling carbon credits where there was no forest at all. This undermines the willingness of corporates to spend on voluntary credits, including biodiversity credits.

Also, regulation is taking a closer look at the various nature-positive or neutral claims made by corporates. The EU is about to pass regulation forcing corporates to prove such claims – the so-called Green Claims Directive. At the same time, regulators start looking at nature-related risks in the portfolios of banks, insurers and asset managers. The first TNFD reporting of corporates will probably show extreme dependencies on failing ecosystems.

There is a lot in the air currently and biodiversity credits will probably share the fate of voluntary carbon credits. If the market finds a solution for voluntary carbon credits, it's good news for wider credit-based schemes.

What are the key developments looming over the next 12-18 months?

I expect TNFD and regulatory focus on managing nature-related risks will change the way corporates and institutions look at biodiversity. We already see this in France where companies need to report their biodiversity strategy. Even with the very limited models and tools we have today, many CEOs will be shocked when they realise how much their businesses depend on nature – and how close we are to some ecosystem tipping points. Everyone has heard about the bees disappearing and what this means for agriculture and many other sectors.

Having to report on this will trigger public debate. CEOs will start thinking how to reduce dependencies and enhance ecosystems they depend on. This can be a huge push for investing in NbS to generate biodiversity credits but also to make sure relevant ecosystems remain functional. The asset management industry will be around to support these investments, both in NbS themselves but also in the ecosystem around them like data providers, analysis tools, consultants and distributors. I think that'll come in the next three or four years as the first TNFD disclosures will only come at the end of this year.

Herbert Smith Freehills will be attending and chairing a debate at the Impact Investor Global Summit at the Royal Lancaster Hotel, London on 14 and 15 May.

Click here for more analysis on the role of nature-based solutions in tackling climate change.