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ESG Focus: Biodiversity Ready To Roll

ESG Focus | Sep 30 2022

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ESG Focus: Biodiversity Ready To Roll

Biodiversity has been the long-mooted laggard on the ESG front, but the new ESG investment category has come of age.

-Welcome to the era of natural capital
-A cause matched to an opportunity
-Deforestation (carbon), oceans, water, and so much more
-Bankable Biodiversity and Certification
-Carbon insets are the new kid on the block
-Biodiversity is mainly a Scope-3 play
-Biodiversity risk – there will be losers

By Sarah Mills

Biodiversity has been something of a laggard on the ESG front, in part because of a lack of bankable options.

But the think tanks have been knocking heads and the number of bankable biodiversity options are rising and being wheeled out onto the investment stage.

The main kick-off is scheduled for late 2023 following the final iteration of the Task Force for Nature Related Financial Disclosures report, and many companies are preparing ahead of time.

Biodiversity is being positioned as an overarching class of “natural capital” with strong overlaps with emissions and circularity.

It has a broad remit, which encompasses emissions projects, water resources, oceans, forests, development, agriculture, recycling and so much more.

The financial opportunities posed by the biodiversity thematic are enormous: it covers climate change; deforestation; habitat loss and nature degradation; over-exploitation; air pollution; water pollution; invasive species; illegal trafficking and hunting; urbanisation; and encroachment. 

Combined, these issues affect every sector and asset class. 

The six sectors with strong dependence on, or that have strong impacts on biodiversity include: Real Estate; Mining and Markets; Chemicals and Materials; Supply Chain and Transport; Retail; Consumer Goods and Lifestyle; and Aviation, Travel and Tourism.

The Financials sector also has an indirect impact, in a similar manner to financed emissions; and the Agricultural sector (steward to large tracts of land) will also be affected.

Biodiversity now has its own climate-change-equivalent task forces, institutes and standard setters, which means its rollout is imminent.

Governments globally are also regulating and legislating on biodiversity issues, as witnessed recently in Australia with the launch of a biodiversity certificate scheme.

The Climate Connection

Biodiversity and climate change are considered to be “deeply connected”, a phrase used to signal the large and relatively poorly defined overlap between the two.

While emissions have largely been split out from the biodiversity category, certain emissions categories such as carbon sequestration in soil and carbon insetting fit more seamlessly into biodiversity investment structures.

Deforestation is also both a carbon and biodiversity play.

These areas are materially relevant to Scope 3 emissions, which we discuss below.

Similarly, recycling, water management and forestry tend to operate independently but there is considerable overlap and some projects in these areas will be able to attract biodiversity capital, particularly in the areas of ocean plastic, water usage and agriculture.

This article provides an introduction to the biodiversity investment market, examines existing investment options and recognises that more bankable options are being sought and added to the growing compendium.

Biodiversity – A Problem Meets A Solution

Cynics may question the science of climate change, but few would question the self-evident and devastating impact of human actions on biodiversity over the past 70 years.

As Citi says in a research paper on the subject: “Putting biodiversity on a path to recovery is the defining challenges of our time.” 

One only has to look around to see the accelerating rate of deforestation, unbridled development, the devastating effect of plastic in oceans, overfishing and the collapse of pollinator populations such as bees.

An average decline in animal populations of -68% has been recorded since 1970 and it is estimated one million animals and plant species are threatened with extinction, which if actualised, is being referred to as the sixth mass extinction.

Diversity is critical to the planetary systems that underpin life on earth, including human life. 

Capitalism relies entirely on these systems and has no long-term future without biodiversity – hence the push by big capital to protect the asset base.

After 30 years of the unbridled rape of the environment, the agenda is shifting.

According to the World Economic Forum, roughly US$44trn of economic value generation moderately or highly depends on nature.

Industries highly dependent on nature account for US$13trn or 15% of global GDP while moderately dependent industries constitute US$31trn or 37%.

Pollinators alone account for about US$217bn of annual agricultural output.

The Biodiversity Market

The “natural capital” market, or some might call it the sustainability market, is huge.

The Global Sustainable Investment Alliance estimates the sustainable investing market was US$35trn in 2020, and this is set to increase sharply over the next two decades.

The Global Biodiversity Forum has identified a minimum annual funding gap of US$700bn going forward, and both public and private sectors are being called upon to plug the gap.

Biodiversity is a carbon play, a water play, a biotech and technology play, a food play, a development play, an equity play, a property play, a fixed-income play and a commodities play, among others.

For example, food producers in particular will be seeking farm-wide accreditation on a range of metrics, such as water and carbon to sell their products to large downstream distributors such as supermarkets, or on to commodities markets.

Commodities and use-of-proceeds bond contracts are likely to have built-in accreditation certificates, creating biodiversity-graded markets. 

For example, use-of-proceeds bonds linked to “land use” totaled US$414.4bn in 2020, according to Citi.

On the carbon front, biodiversity will play to two markets: the carbon offset market and the carbon inset market (more on that below); and will be a particular focus for Scope 3 emissions reporting.

Natural Asset Companies (NACs) have been established as a new class of publicly traded assets by the New York Stock Exchange: “sustainable enterprises that hold the rights to ecosystem services produced by land, such as carbon sequestration, biodiversity and clear water”.

The NYSE reports natural assets produce an estimated US$125trn annually in global ecosystem services, such as carbon sequestration, biodiversity and clean water.

The World Economic Forum estimates nature-positive solutions represent a US$10.1trn business opportunity and can create 395m new jobs by 2030.

Investment Opportunities Galore

Just a few years ago, Credit Suisse’s report titled Unearthing Investor Action on Biodiversity noted the category's major constraint was a lack of bankable options.

This is no longer the case. 

The inclusion of water usage under the biodiversity banner provides a very bankable anchor.

Water usage is simple to measure and compare, and water already carries a price.

Similarly, opportunities that once might have been labeled “impact” investment (and still are) have been drawn under the biodiversity banner.

For example, in the smart agriculture sector alone, biodiversity initiatives encompass geospatial analysis, optimisation software and hardware, digital carbon platforms and alternative proteins.

But wait, there’s more. Producers can feed electricity into the grid, tinker with irrigation pumps, install desalination plants, sequester carbon in the soil (the clean energy regulator expects carbon to be stored in the soil for 25-100 years), and use slow-release fertilisers – and then there’s forestation and habitat-generating opportunities.

That’s just agriculture.

Vertical prawn farms are already in play, then there's the prospect of a decades-long transition to vertical grain farms, digital management of reefs, transportation challenges, fashion, and cultivated meat just to name a few.

All of this will be funded through an elaborate carrot and stick methodology underpinned by biodiversity certificates, carbon insets, government subsidies, private investment and regulatory legislation.

Movement At The Station

Morgan Stanley expects biodiversity challenges will be addressed at a faster pace than climate initiatives have in the past, given biodiversity will be able to capitalise on climate momentum and the standards and reporting structures that are already in place.

The analysts adds that these challenges are considered more pressing than climate because rebuilding ecosystems is far harder than capturing incremental carbon emissions.

Already, most of the world’s major companies are prepared for the entrance of biodiversity. 

Half of Europe’s major listed companies now report on biodiversity metrics.

In Australia’s August reporting season, 25% of ASX100 companies referred to biodiversity nature impacts, up from 14% in 2020, notes Macquarie.

These included The a2 Milk Company ((A2M)), GPT Group ((GPT)), Aurizon Holdings ((AZJ)), and a slew of resources companies.

Macquarie expects Australia’s major corporations will start announcing targets in 2023 after the Task Force on Nature-Related Financial Disclosure’s final biodiversity report is published.  (TNFD is biodiversity’s equivalent of the Task Foce on Climate-Related Financial Disclosures (TCFD)

Bankable Biodiversity Certification

Biodiversity lags emissions on the measurement front, which makes it difficult to develop bankable projects, but all that is expected to change with the publication of the TNFD report next year.

There is also a push to develop a standardised global biodiversity certification scheme.

At the moment, the certification market is something of a dogs breakfast. 

Biodiversity benchmarks are in the process of being established but differ between industries and countries, and lack simple, accurate, comparable, universal accounting metrics.

At the moment, certification tends to operate in a similar manner to organic certification, with certification obtained by an industry body or independent certifier according to a set standard.

Countries and industry bodies have developed a dazzling array of certificates, many of which bear little in common with each other, so they aren’t fungible or necessarily bankable – at least not yet.

Although, when it comes to attracting capital and customers, the more highly accredited certificates do count, particularly within the inset market, which we discuss below.

In Australia, the Federal Government has announced a biodiversity certificate scheme, and major State Governments are also implementing biodiversity initiatives.

Certification And Biodiversity Insets And Offsets

Certification underpins the development of biodiversity inset and offset markets.

Biodiversity offsets are the equivalent of carbon offsets/carbon credits. 

Most major biodiversity carbon plays are likely to separate out into the carbon credit market – such as deforestation – with other offset markets to be developed (Australia just recently launched a biodiversity scheme for agriculture).

But insets are where biodiversity certificates come into their own. 

We outline the concept of insets in the carbon insets discussion below, but basically offsets refer to credits purchased on an externally traded market, and insets refer to credits built into a company’s asset base. 

For example, a mining company might rehabilitate ecosystems on its land, or reduce water demands on the external environment.

Downstream markets to producers will be seeking verification for biodiversity, if they wish to attract big capital, in the same way as they are expected to reduce their carbon footprint. 

For example, big supermarkets will seek biodiversity certified products (Woolworths ((WOW)) is already establishing relationships in this respect)

Insets are expected to have more cache than offsets (although the proof will be in the pudding) given the validity of offsets can be difficult to ascertain, and critics say offsets allow companies with deep pockets to buy their way out of environmental responsibility.

Insets are more easily verifiable (although still not perfect), and are not a licence to pollute or destroy.

Insets ensure a company is taking direct responsibility for the carbon emissions and biodiversity in their own supply chain and are improving sustainable management at the source. 

For example, companies with large holdings in rural areas are calculating native vegetation to count towards certification.

Existing biodiversity systems (such as an existing forest stand) have less value than projects that enhance biodiversity on the land or that enhance biodiversity within those existing forests. The latter are most likely to be recognized and attract a higher reward.

Carbon Insets The New Kid On The Block

Carbon insets are already being used for biodiversity certification.

Everyone has heard of carbon offsets, which relate primarily to emissions reductions, but few have heard of carbon insets.

Carbon insetting allows companies to track and measure their carbon balance within their businesses.

In the biodiversity setting, carbon insets refer primarily to deforestation (as in each tree on a property can be counted towards a company’s carbon profile and therefore has a dollar value) and carbon sequestration in the soil.

Carbon insets support the implementation of practices such as tree planting and soil management, and projects that promote climate resilience, protect biodiversity and restore ecosystems.

In the more general setting, it is a typical emissions play primarily encompassing renewable energy systems such as solar or wind.

At this stage, the main adopters of carbon insets are most likely to be the agricultural and mining industries, but over time, this is likely to extend to the property and development market, or companies with large property or office assets that wish to reduce their carbon profile.

Carbon insets are a less efficient way of measuring carbon, but for some businesses, synergies provided can prove a tipping point, and they allow a producer greater control over the business’s carbon profile.

For example, in the cotton market, it is estimated that accredited products can attract a small premium, not enough to cover costs, but which can then be added to tax breaks and incentives.

Scope 3 Emissions Is The Main Game 

But really, biodiversity certification is more a game of competition and brand recognition in the Scope 3 emissions space than a revenue stream (and one assumes equivalent broader biodiversity scope 3s will also be introduced in the not too-distant future).

Over the past two years, companies have been focused nearly exclusively on Scope 1 and Scope 2 emissions but they are now shifting their focus to supply-chain emissions.

During the August reporting season, for the first time Australia’s major companies started reporting on biodiversity and Scope 3 emissions.

Jarden reports these included Suncorp ((SUN)), QBE Insurance ((QBE)), Mirvac Group ((MGR)), Charter Hall Group ((CHC)), Woolworths, Auckland International Airport ((AIA)) and Spark New Zealand ((SPK)), and the broker expects this to accelerate in 2023.

Producers that promote diversity will find favour will major suppliers.

Australian developments

There has been a flurry of activity on the certification front this year.

On August 26, the Labor Government announced its intention to create a national voluntary biodiversity certificates scheme.

The scheme operates in a similar manner to the carbon offset market.

It recognises landholders who restore or manage local habitat and grants them biodiversity certificates, which can be sold to other parties.

It aims to protect waterways, provide habitat for native species, reduce erosion, protect topsoil, improve drought resilience and create shelter for livestock.

It will be open to all land managers, whether they’re farmers, people interested in conservation or indigenous managers.

The government says the nation’s biodiversity and carbon credits schemes will operate in parallel and both will be regulated by the Clean Energy Regulator.

Taxes and subsidies

Which takes us to the question of taxes, grants and subsidies.

Globally, governments are expected to support biodiversity through a range of taxes and subsidies.

These are expected to be substantial.

Already in Australia alone, the Clean Energy Finance Corporation recently gave $75m to Paraway Pastoral Company.

Big capital is also likely to favour large corporations with insets, providing an extra incentive.

Critics Have Their Say

Critics say there are more straightforward solution to the biodiversity problem such as ending native forest logging, regulating land clearing and paying landholder and communities directly to improve habitats.

“What is not at all clear, is why anyone would think that creating a so-called 'biodiversity offset scheme', where some people can destroy habitat as long as someone else promises to improve habitat, is the cheapest or best solution. And suggest redirecting billions in subsidies to biodiversity criminals to government protection,” says Polly Hemming, senior researcher at the Australia Institute.

Correct or not, such critics appear to be fighting the tide of capital, and while their alternative suggestions may be included as one part of the biodiversity toolkit, biodiversity certification is likely to be a growing trend.

Losers And Risks

Just like carbon, the introduction of biodiversity will deliver its share of risks and losers (fossil fuels being an obvious long-term loser on the carbon front).

Part 2 of this series outlines biodiversity risk, growing disclosure and regulatory nets, and the sectors and companies most at risk.

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