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January 24, 2023

Can biodiversity markets deliver for both nature and investors?

By Katie Kedward

While conservation urgently needs investment, creating nature-related financial markets holds its own challenges and cannot be seen as a panacea.

Investment in nature conservation is currently around five to seven times lower than required to reverse the precipitous decline of the world’s ecosystems and species. Over recent years, a veritable smorgasbord of financial instruments have emerged aiming to fill this global biodiversity ‘finance gap’, from sustainability-linked loans to carbon offset credits to green bonds. 

Sustainable finance and policy circles now prioritise ‘mainstreaming’ these instruments to fund biodiversity goals, such as those outlined at the recent COP15 meeting in Montreal last December. Scaling up and ensuring the investible appeal of nature-related asset classes is seen as integral to mobilising the untapped large-scale financial flows of institutional investors. 

Well-designed market mechanisms can play an important and targeted role in addressing biodiversity loss. However, in a recent academic paper, we argue that an over-reliance on private institutional investors to fund conservation outcomes should be treated with caution. 

Institutional investors have specific requirements that are rarely met by nature-related assets. These include competitive returns, standardised and transparent investment terms, liquid secondary markets, and – most importantly – large transaction sizes.  

Competing objectives

Various evaluations have documented the disappointing results of previous attempts to scale up nature-related financial instruments. Many of these schemes were found to have achieved little or no ‘additional’ biodiversity outcomes and to have systematically underinvested in effective governance. A recent Bloomberg analysis of over 100 sustainability-linked bonds sold to European investors and worth a combined €70bn found that most were linked to climate targets that were weak or irrelevant or that, in some cases, had already been achieved. 

Such weak environmental performance occurs when investors get lost in chasing multiple – and potentially competing – objectives. Effective conservation delivery has notoriously high transaction costs, related to on-the-ground monitoring, due diligence and enforcement. Aggregating small localised conservation projects to meet the minimum ticket sizes of large-scale investors has the added expense of standardisation and reporting against robust counterfactual baselines. 

Not only will such transaction costs conflict with institutional investors’ need for broadly competitive returns, but the inherent complexity of nature also means ecological outcomes are subject to unusually large uncertainties, and may take decades to materialise. Assuming such benefits can be monetised, these still may not fit the requirements of large-scale investors who conventionally discount long-term returns. 

In other words, we cannot underplay the potential trade-off between achieving robust biodiversity outcomes and meeting the needs of large-scale institutional investors. Market-led environmental governance approaches are attempting to mitigate this trade-off, but themselves have been plagued by fundamental conflicts of interest.

Moreover, strategies to catalyse investor involvement by using blended finance mechanisms may not be as promising as assumed, given the complex and costly exercise required to render nature markets conventionally ‘investible’. 

For example, Belize’s $364mn pioneering debt-for-nature swap, which made use of US and Belizean public funds to ‘derisk’ a conservation-linked debt restructuring deal for private investors, is now regarded as an inefficient and expensive use of public budgets. The Belizean government will have to pay $84mn in transaction costs to various financial intermediaries over the lifetime of the deal, as reported by Bloomberg, amounting to 23 per cent of the deal size. 

Institutional mismatch

The use of public funds to make the risk-return characteristics of nature-related investments appealing to institutional investors is likely to become even more expensive in the current climate of global uncertainty and rising interest rates. 

Taken together, these challenges indicate that positioning emerging nature markets and large-scale investors together as a panacea to funding the biodiversity gap is misguided. 

Public investment into conservation also needs to increase and should not be deprioritised. Conservation is ultimately a complex public good and is difficult to monetise. In some instances, it may be simpler to make the case for direct public good provision, rather than rely on the disaggregation of ‘bundled’ ecosystem services into various markets for soils, water, carbon, species, and so on. As a first point of call, public funds should be urgently redirected from environmentally harmful subsidies.

Nature-related financial instruments must be well targeted and accompanied by robust mechanisms for monitoring and compliance, with additional governance by public bodies and civil society where necessary. Framing nature conservation as a private investment opportunity should also not distract from the simultaneous need to rapidly reorient portfolios away from harmful economic activities that are driving biodiversity loss. Both of these aims may require the increased involvement of financial regulators.

At this critical stage in the future of our biosphere, we cannot create biodiversity markets simply for their own sake. We must ensure that the push to attract large-scale financial flows does not undermine the environmental integrity of nature-related financial instruments. 

Katie Kedward is policy fellow in sustainable finance at University College London.

A service from the Financial Times