Palladium                            CAP0003

Written evidence submitted by Palladium International Ltd

Response to the Environmental Audit Committee’s Call for Evidence on the role of natural capital in the green economy

Please note that our response focusses specifically on woodland expansion and peatland restoration, funded via carbon finance.

What potential contribution can private capital investment make to measures to secure nature recovery?

• We must first define what we mean by ‘investment’ in this context. We define investment as: finance deployed to cover the up-front capital costs of new projects or business ventures, at risk to the funder, which is later repaid with a return if the project or business venture is successful.

• Currently, we see that the term ‘investment’ is frequently applied incorrectly by environmental NGOs in the sector. Often this term is used to describe projects that are mostly funded by government grants, which then receive additional funding later by selling carbon credits. In accounting terms, this is not an investment – it is additional revenue.

• In practice, we see four main models to unlock true investment into UK nature restoration:

1. Real estate investment: The acquisition of land in order to host a nature restoration project.

2. Private equity investment: Investment into a business that implements nature restoration projects.

3. Project Finance: Investment into the capital costs of a new nature restoration project – in a similar fashion to the way that investment works for the majority of infrastructure and energy projects in the UK.

• The first two investment models are becoming more common in the sector. The first model however comes with significant drawbacks - land acquisition is causing significant tensions within rural communities, especially in Scotland. The second relies on a portfolio of projects for businesses to deliver, which bring their own investment needs. The third: project finance – is the model we believe has the greatest potential to scale and replace government funding to start new projects. However, the project finance investment model is currently not working for nature projects.

• This blockage is due to one main obstacle: the way that public funding is currently deployed. In a nutshell – the government currently pays for nearly all up-front capital costs. Therefore, there is very little space for private investment into nature restoration projects. 

• We believe that the UK government needs change its funding policy in order to unlock private investment into woodland and peatland restoration projects.

What measures are necessary to (a) establish and (b) maintain the high-integrity markets in ecosystem services which are expected to attract private investment? What confidence do investors currently have in the UK’s arrangements for these markets?

There is significant investor interest in supporting new projects. For example, see the 15+ major investors that have joined the new Financial Institutions for Nature group established by the Green Finance Institute, and multiple new dedicated natural capital funds being launched.

The problem with the current approach to funding long-term carbon projects. The English and Scottish governments currently offer capital grants to cover from 75 to 100% of the up-front costs of peatland and woodland projects, via schemes such as Peatland Action and the English Woodland Creation Offer.

Private investment offers cannot compete with government grants to pay for capital costs. Landowners will always choose to take grant funding (which doesn’t not need to be repaid) over an equity or debt-based offer from an investor – as this funding will need to be repaid to the investor with a return. Public funding is crowding out the space for private investment. This is a significant barrier to scaling up woodland and peatland projects in the UK.

The current system is poor value for money secured for the taxpayer. Currently, up-front grants mean that the taxpayer takes on the majority of project capital costs. If carbon prices rise, then long term carbon revenues from these projects will generate windfall profits for landowners. There is no mechanism for a return or cost saving to be delivered to the public purse. Value for public money is therefore limited. 

The current funding model is not scalable. UK government targets for woodland creation and peatland restoration will require significantly more public spending than currently allocated, if all projects are to be funded by up-front capital grants. The Government’s Net Zero goal is to scale up woodland planting to 30,000 hectares planted every year by 2025. Last year we achieved less than 50% of this target (EAC Report 2023).

A better model for public funding to woodland and peatland restoration is needed - one that can unlock private investment and achieve better value for money.

We propose that government conduct a review of public subsidy models that can open up the space for private investment into woodland and peatland carbon projects. This would be similar to the consultation recently led by the Department for Energy Security and Net Zero into how best to unlock investment and growth of the UK’s engineered carbon removal projects (nature-based carbon removals remain a DEFRA responsibility, so was this not covered by the DESNZ review).

We agree with the conclusion of the DESNZ consultation that a ‘Contracts for Difference’ subsidy mechanism is the best model to unlock investment and growth into carbon removal projects – be they engineered, or nature based.

Proposal: The Government should explore using a Contract for Difference subsidy model to unlock investment into nature-based carbon projects

Brief summary of proposed Contract for Difference mechanism: Government would transfer the role of funding the upfront capital costs of new projects to private investors, rather than the taxpayer. Instead, the government support will focus on delivering results-based subsidies, once projects are already established. When carbon credits are sold by projects to private offtakers, the government issues a top-up subsidy payment to the project, as a second revenue stream. This top up subsidy mechanism is called a ‘Contract for Difference’. It ensures that, even if carbon market prices are too low at present or fluctuate significantly over time, landowners and project developers have confidence that they will receive the revenue they need to make a long-term project economically viable. 

The value of public top up payments is determined via a ‘strike price’: this is the total value of the revenues that the project needs to secure for the overall project to be economically viable. Strike prices are set competitively by government, to ensure best value for money. If market prices are below the strike price, the government issues a top up payment. If market prices exceed the agreed strike price, then the project returns the difference to the government. 

How value for money is secured for the taxpayer: If carbon market prices rise over time, then the value of public top up payments via the CFD mechanism decreases towards zero – delivering greater value for money.

Existing examples of successful use of Contracts for Difference: BEIS has used CFDs with significant success as the main subsidy mechanism for the UK’s renewable industry. They do this by topping up sales of kWh of electricity from renewable projects with public payments. This subsidy mechanism has unlocked billions of pounds of investment into offshore wind over the last decade.  More recently, DESNZ has adopted the Contracts for Difference model as the most suitable subsidy mechanism to support engineered greenhouse gas removal projects and unlock investment.

What role does the UK have in establishing international standards for natural capital investments, alongside other jurisdictions and financial centres?

We believe that we still need to prove that we can get this right in the UK. At the moment – despite much noise in the market and interest from investors - the government is still paying for nearly all of the capital costs of nature restoration projects. The public funding model for woodland and peatland restoration must be changed to unlock real investment.

September 2023