Mr James Heyburn (Imperial College London), Dr Pernille Holtedahl (Imperial College Business School), Dr Shefali Khanna, and Ivana Popovic (Imperial College Business School and Grantham Institute – Climate Change and Environment)                            CAP0018

Written evidence submitted by Mr James Heyburn (Imperial College London), Dr Pernille Holtedahl (Imperial College Business School), Dr Shefali Khanna, and Ivana Popovic (Imperial College Business School and Grantham Institute – Climate Change and Environment)

House of Commons Environmental Audit Select Committee: The Role of Natural Capital in the Green Economy Inquiry Submission

Explanatory note:

This response has been developed by Imperial colleagues from across the College’s expertise.

In this submission, the full names of contributing researchers will appear at the beginning of their first answer and any subsequent answers will begin with their initials. A full list of contributors is included at the foot of the document.

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

1.1

PH & IP: The public goods characteristics of many of nature’s services mean that the conditions for private provision often fail. For example, a forest produces biodiversity, increases rainfall, and prevents soil erosion in addition to timber—all of these are valuable outputs but only the latter is typically tied to a revenue stream. It follows that a private owner - who only gets compensated for the timber - will invest less in protecting the land and supporting the production of a range of nature services than the level which is optimal from a societal point of view[1]. Moreover, a fundamental requirement for private provision of any good is the adequate definition and enforcement of property rights, and these rights are absent for a large segment of the biosphere[2].

As a result of these characteristics, nature protection and restoration have traditionally been the purview of governments (indeed some 80-90% of nature investments globally have traditionally been made by governments)[3][4]. However, private capital investments can and must play a role in securing nature recovery both because the scale of the needs mean all avenues for financing should be explored but also because nature investments represent both a responsibility as well as an opportunity for the private sector. 

It is key to understand at this point that it is the government’s responsibility to create the conditions for this to happen. Creating and ensuring nature markets are fit for purpose is a crucial task for governments - to ensure impact and avoid distorted outcomes. 

Some of the ways in which private capital can secure nature recovery include:

(1)  Reduce private investments that are harmful to nature. Similar to public finance, private financial flows that harm the biosphere currently outweigh those enhancing natural assets, leading to a need to identify and reduce these harmful financial flows[5]. Reducing capital flow into activities harming biodiversity lessens the need for conservation or restoration funding[6]. Ensuring appropriate regulation and tax regimes (including distorting subsidies) are in place and enforced to direct this flow of private funds is the responsibility of the government. The UK’s Biodiversity Net Gain legislation is an example of this, but more could and should be done both nationally and internationally (e.g., to impact supply chains) to speed up this redirection. 

(2) Create business models where private capital can make a return from nature investments. This requires aligning incentives for private investors with those for nature restoration and will happen through compliance markets/regulation or voluntarily. An example of the first is the creation of a biodiversity credit market following the UK net biodiversity gain legislation. An example of the latter are investments made in ‘green infrastructure’ which protect an investors asset (risk reduction) and lowers maintenance costs. 

(3) Manage investment risks, provide disclosures, and engage with stakeholders.  Financial institutions can avoid harm and promote nature-positive investments by recognising, understanding, and managing the impacts their investments can create[7]. Examples include the establishment of screening tools and disclosure requirements - such as the Taskforce on Nature-related Financial Disclosures (TNFD). Making the TNFD mandatory would provide a strong signal and indeed is welcomed by many corporates and financial institutions[8]. Encouraging a culture of challenge and stakeholder dialogue, e.g., through companies’ annual meetings will put pressure on companies. The threat of divestment may be an effective ‘stick’ in this context (and possibly more powerful than the divestment itself). 

(1)-(3) are complementary measures and should be undertaken in parallel. (3) is where most focus has been so far among financial institutions but does not in itself create investments and so should be swiftly followed by attempts to actually redirect capital flows via (1) or (2).

There is - at least in the short term- more limited potential for the private sector to invest in “pure restoration and conservation activities” than in “real economic activities” that minimise damage to the biosphere[9]. As noted in the Dasgupta report, private investments currently mainly focus on the first category - enhancing natural assets through activities like sustainable agriculture and eco-tourism, rather than focusing on pure restoration and conservation initiatives, such as establishing protected areas and rewilding zones. This is because of a lack of revenues (or cost savings) associated with the latter: until nature markets are fully established, private investors will struggle to find a business case for nature restoration. 

It is also important to note that private capital investments may need support from governments or international mechanisms in the process of establishing a business case for nature. This is because nature markets are new; there is limited familiarity with the investment segment and risks are perceived as higher. De-risking mechanisms, e.g., through blended finance structures, are proving useful in launching nature investments globally.

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2. How can investment best be aligned with environmental benefits, so as to achieve or surpass the Government’s targets for nature recovery?

2.1

SK: As discussed in the Dasgupta Review, using measures of inclusive wealth that incorporate natural, human, and produced capital into national accounts will go a long way to align policy and investment decisions with the goal of achieving and possibly surpassing the Government’s targets for nature recovery. Albeit challenging, reaching an international agreement on a standardised approach for incorporating natural capital accounts into national accounts would create further opportunities for investment to be channelled into environmentally beneficial projects, both in the UK and overseas.

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3. 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?

3.1

SK: Establishing high-integrity markets for ecosystem services depends on having (a) a comprehensive and consistent accounting of natural capital, and (b) a scientific understanding of the benefits as well as the costs associated with the services that the ecosystem provides. As discussed in the Dasgupta Review, using measures of inclusive wealth that incorporate natural, human, and produced capital into the definition of economic growth will go a long way to align policy and investment decisions with the goal of preserving and protecting nature. 

With these two ingredients in place, the design of markets must then depend on the properties of the ecosystem under consideration. For incentive-based mechanisms such as payments for ecosystem services to be effective, marginal benefits must be constant across sources. However, non-constant marginal benefits are often found in the case of ecological systems, including oceans, forests, coral reefs, and lands, implying that markets that do not account for how the marginal benefits change across the ecosystems under consideration may not be as environmentally effective[10]. Often, more complex incentive-based systems such as permits, differential taxes or trading zones may be needed to differentiate between the type, location or other characteristics of ecosystems. Farley and Costanza (2010)[11] provide a set of recommendations on the design of payment for ecosystem services schemes (market services, open access regimes, congestible club or toll services, or public good services) depending on the physical and institutional characteristics (i.e., excludability and rivalrous nature) of the service along with examples of contexts where these approaches would be appropriate. 

Incentive-based mechanisms work by changing relative prices, usually of inputs and technologies, which may also affect the costs associated with achieving service provision. Therefore, offering greater flexibility in the methods used for complying with these schemes would help market participants withstand changes in relative prices, which would further contribute to the maintenance and longevity of the incentive scheme. Salzman et al (2018) analyse the trends and current status of three types of payments for ecosystem service schemes: (i) user-financed, where users of ecosystem services compensate landowners, (ii) government-financed, where governments acting on behalf of users compensate landowners (for example, government programmes in Costa Rica and China pay landowners for tree cover expansion activities that enhance flood protection and water quality among other ecosystem services), and (iii) compliance mechanisms, where regulated entities compensate other parties for maintaining or enhancing other ecosystem services in exchange for a standardised credit that satisfied their mitigation requirements (examples include water quality trading and the European Union’s Emission Trading Scheme). Across a range of domains, including water, biodiversity, and forest and land-use carbon, they identify four features as being key for scaling up payments for ecosystem service schemes: (i) given the public goods nature of most ecosystem services, demand must be created through subsidies or regulation, (ii) payments to landowners must be competitive with opportunity costs, (iii) using rigorous metrics that capture service values, and (iv) an efficient means of exchange that reduces transaction costs. As laid out in the Nature Markets Framework, ensuring that incentive-based schemes are inclusive, reward new environmental improvements, and do not permit double counting, where credits for the same ecosystem service can be sold more than once, would help to secure market integrity. All market data should be recorded for monitoring and oversight. Well-functioning markets would also provide the necessary incentives for innovation that could help to deliver ecosystem services more efficiently. 

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5. How can the proposed UK Green Taxonomy support high-quality investments which deliver genuine benefits to nature? What financial disclosures should the taxonomy require?

5.1

PH & IP: To promote high-quality investments with genuine benefits for nature, the proposed UK Green Taxonomy should equally prioritise both climate- and nature-related objectives. A significant gap in most sustainable finance taxonomies is their tendency to prioritise climate mitigation and adaptation over nature conservation and protection, as highlighted in a report by WWF in collaboration with Climate & Company[12]. The incorporation of do-no-significant-harm (DNSH) requirements in addition to technical screening criteria - in line with the EU Taxonomy- is a good principle to follow to mitigate such risks. In addition, the criteria for qualifying as a ‘nature investment’ (the technical screening criteria) should be robust as well as detailed enough to provide clear guidance - while also being flexible so that new technologies and approaches can be incorporated. The International Capital Market Associations’ (ICMA) Green Bond/Loan Principles can provide high-level guidance on what is generally thought of as ‘nature investments’ through the definitions applied to two of its project categories: Environmentally sustainable management of living natural resources and land use and Terrestrial and aquatic biodiversity conservation. 

Additionally, the green taxonomy should establish clear objectives that are aligned with high-level national policy goals, thus encouraging investors to actively contribute to these objectives[13]. Simultaneously, it should strive to harmonise with the taxonomies of other countries whenever possible, thereby minimising international market fragmentation (as recommended by the Green Technical Advisory Group (2022) and WWF[14]. Monitoring, coordinating with and learning from the EU Green Taxonomy - the most advanced and important taxonomy globally - will be particularly useful.

It is also critical to explicitly account for both primary and supply chain impacts on nature given that on average, supply chain operations contribute to 80% of the natural capital costs across various sectors[15]. A report by WWF[16] highlights that existing sustainable finance taxonomies often overlook supply chain impacts on nature. Notably, the European Union is the sole jurisdiction that partially includes supply chain impacts in its taxonomy's environmental performance criteria, although this coverage remains limited. Hence, embracing a comprehensive approach that includes direct and supply chain aspects can improve the accuracy of assessing the impacts of investments on nature, both domestically in the UK and abroad.

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6. How can the operation of natural capital markets ensure genuine net gains for nature? How do such markets address the risk of ‘greenwashing’ of investments and the offsetting of natural recovery in the UK against environmental degradation elsewhere?

6.1

SK: Natural capital markets that are limited in spatial or sectoral coverage run the risk of creating incentives for environmental degradation in unregulated areas or sectors just as the environmental benefits that pollution markets provide may be offset through leakage (Jack et al, 2008). Schemes that simply compensate landowners for the ecosystem services some part of their land provides may inadvertently give them the income stream they need to engage in environmentally harmful activities on another piece of their land or lead to more land clearing by new market participants. These secondary effects may be amplified to the extent that natural capital markets alter regional prices of inputs. Such problems can be mitigated by expanding the coverage of the nature market as widely as possible. There also exists a threat that landowners may engage in environmentally harmful practices unless they receive more compensation, which is a risk that could be mitigated by setting a clear historical baseline that cannot be manipulated.

6.2

PH & IP: Preventing greenwashing in nature-related investments necessitates a comprehensive approach. It includes establishing clear criteria for determining sustainable and nature-positive investments. The proposed UK Green Taxonomy, for instance, will provide a standardised framework for classifying such investments based on their environmental impacts and contributions to nature. Standardising definitions and metrics across the industry is also essential to ensure consistency and comparability and prevent misleading claims. An assessment by TNFD reveals that over 3,000 diverse nature-related metrics are used by standards bodies today, potentially hindering the measurement, management, and reporting of nature-related financial risks[17]. Improved transparency and mandatory disclosure requirements are also critical for preventing greenwashing. Companies and financial institutions should be obliged to report on the environmental effects of their investments, including both positive and negative impacts.

To ensure natural capital markets generate genuine net gains, the use of offsets should be closely monitored, and subject to clear rules that specify when offsets are permitted and when they are not. A mitigation hierarchy should be followed (avoid; minimise; restore; offset). The UK should learn from experiences elsewhere - predominantly the US where mitigation banking has been used in the context of wetlands for 30 years - to inform its framework, while bearing in mind that the geographical and time context differs (increasingly we have very little ‘nature budget’ left to play with (borrowing from the carbon budget vocabulary)) and so may require stricter criteria today than was the case in the US several decades ago. The UK net biodiversity gain legislation and accompanying credit market will provide an opportunity to experiment with different structures and may prove to be a positive and pioneering effort internationally, provided it is based on well-informed (state of the art) information and with enough flexibility to change course easily should that be necessary.

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7. What role can the UK’s financial markets play in developing the flow of international capital into the development of the UK’s natural capital?

7.1

PH & IP: The UK's financial actors can encourage the inflow of international capital into the development of the UK’s natural capital in various ways, including by: (1) establishing ambitious policies, targets, and strategies related to nature, signalling the UK’s commitment to sustainable natural capital development; (2) developing market instruments for investing in nature (for an overview and classification of those instruments and useful examples see, e.g., Holtedahl, 2023[18] and Holtedahl et al., 2022[19]); (3) developing expertise in nature-related finance, serving as a model for other investors seeking knowledge in this area; and (4) aligning the regulatory environment with other countries to facilitate the movement of international capital. As a result of these actions, the UK should become more attractive to foreign investors interested in investing in nature.

However, given the enormous needs for natural capital investments in developing countries, whereby far the richest as well as most threatened natural capital exists (e.g., in biodiversity hotspots; see e.g., WWF’s most recent Living Planet Report (2022b[20])), we believe the question should rather be how the UK financial sector can play a role in channelling the global flow of capital into underserved countries. To that end, the UK government should continue supporting international forest conservation and restoration initiatives and consider increasing contributions to these initiatives. Consideration should be given to scaling up contributions to risk mitigation facilities which enable blended finance structures and public-private financing solutions.

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

8.1

PH & IP: The UK should play an active supporting role in the development of international standards. Such standards include the EU’s Green Taxonomy (which is the leading taxonomy globally) but also nature-focused taxonomies such as the IFC’s Biodiversity Finance Reference Guide. 

Clear guidance is a prerequisite for increasing the volumes and liquidity of natural capital markets. Having one or a small number of standards on which the large financial centres agree is immeasurably better than each jurisdiction creating its own.

Contributors:

PH: Dr Pernile Holtedahl
Research Fellow, Centre for Climate Finance and Investment, Imperial College Business School.

IP: Ivana Popovic
Research Associate, Centre for Climate Finance and Investment, Imperial College Business School and the Grantham Institute – Climate Change and Environment.

SK: Dr Shefali Khanna
Research Associate in Energy and Environmental Economics, Imperial College Business School and Grantham Institute – Climate Change and Environment.

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Further information:

This submission was collated by the Imperial Policy Forum, working in partnership with Imperial College London’s Centre for Climate Finance and Investment, Business School and Grantham Institute for Climate Change and Environment. The IPF team supports the policy engagement work of Imperial College London researchers.

For follow-up correspondence with the submission contributors, or to discuss other ways in which the facilities and expertise of Imperial researchers can support the Committee’s work, please contact James Heyburn, Policy and Engagement Officer, Imperial Policy Forum.

September 2023