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July 25, 2022updated 03 Aug 2022 4:17am

Are sustainability-linked bonds suitable for nature finance?

As Uruguay plans a sustainability-linked bond with nature-based targets and the International Capital Market Association launches key performance indicators for biodiversity, some bankers question whether such instruments make sense for financing nature conservation or restoration.

By Virginia Furness

natrue finance, sustainability-linked bonds
Oliver Withers of Credit Suisse says sustainability-linked bonds may not be the most effective vehicle for conservation finance. (Photo courtesy of Credit Suisse)
  • Uruguay readies its first sustainability-linked bond with a forest-linked key performance indicator (KPI), while perpetual bonds are also being mooted as possible vehicles for nature finance.
  • The International Capital Market Association has updated its registry of KPIs to include a biodiversity focus for certain sectors.
  • Despite such developments, bankers are raising questions over whether sustainability-linked debt is suitable for nature finance.

Dedicated nature finance makes up a tiny fraction of the huge volume of capital allocated to green and sustainable projects. Aside from a handful of dedicated biodiversity equity and impact funds and a small amount of biodiversity-focused debt, nature finance remains the domain of grants, philanthropy and a few particularly engaged corporates.

Capital Monitor has identified 28 bonds worth $14.5bn with proceeds dedicated to biodiversity, deforestation, reforestation and nature, based on data supplied by sister company Global Data (see chart below). But sustainability-linked debt is being mooted as a possible vehicle for nature finance amid scepticism from some bankers.

For instance, there are hopes that a new sovereign deal that embeds nature targets and new industry guidance on biodiversity key performance indicators (KPIs) may pave the way for future issuance.

Uruguay's plan for a nature-focused bond

Uruguay has been sounding out investors for a new sovereign sustainability-linked bond, according to a presentation from its debt management unit (DMU). The only other government sustainability-linked bond so far was sold by Chile in March.

The structure of the Uruguayan deal is yet to be finalised, but it is expected to contain an innovation in the form of a two-way coupon ratchet: a step-up if the issuer misses its target and a step-down if it meets them. It is also expected to embed a forest preservation KPI that will trigger a coupon step-up if the government fails to enforce legislation to avoid deforestation.

"We would prefer not to share any additional information (other than what is publicly available) until we have completed the whole framework underpinning the transaction," Herman Kamil, head of the sovereign debt management office for the Uruguayan government, told Capital Monitor by email.

Uruguay made a zero-deforestation commitment at Cop26 after in 2016 introducing a policy to reduce carbon emissions caused by deforestation and forest degradation. The country lost some 23% of its tree cover between 2001 and 2021, according to non-government organisation Global Forest Watch.

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As Uruguay derives a large amount of national income from beef exports – around 20% of total exports in 2019 – there is a lot of pressure to clear trees for grazing land.

“As many countries have experienced, if you don’t have a robust policy framework or robust enforcement, it’s very hard to avoid people clearing land to make way for agriculture and animal husbandry,” says a banker with knowledge of the deal. “They want to show they can expand forest cover to permanently store carbon and act as a source of carbon sequestration.”

The deal faces challenges. Investors must accept a possible coupon step-down, and there are issues with defining what constitutes ‘native forest’. Uruguayan legislation does not align with international definitions of high conservation-value forest, the banker says.

However, a successful deal would pave the way for “every sovereign on the planet” to use sustainability-linked debt to deliver public policy objectives, he adds.

It may take time for such instruments to scale up. Blue bonds – which finance ocean-related conservation projects – have been around for some years now but remain a niche concept.

Still, the International Capital Market Association (Icma) is working to support such developments. The non-profit group, seen as the industry standard-setter for market developments, updated its guidance on the sustainability-linked debt in June amid greenwashing concerns stemming from inconsistencies and a lack of ambition in such transactions.

This saw it include biodiversity targets in its registry of KPIs for sustainability-linked debt, which provides guidance to help investors and issuers navigate the growing focus on this area.  

Questions over sustainability-linked bonds and loans

Oliver Withers, biodiversity lead at Credit Suisse, says sustainability-linked bonds are important for financing sustainable production and consumption – which are critical to stemming biodiversity loss – but he also flags issues with them.

Such instruments may not be the most effective vehicle for conservation finance for two reasons, he suggests.

Firstly, their tenor is too short, so they are set up to finance outputs rather than outcomes. Sustainability-linked loans and bonds tend to have maturities of five years, so it is very hard to tie true biodiversity outcomes to them, as it generally takes at least ten years to see biodiversity improvements.

Secondly, the metrics of sustainability-linked bonds, and guidance from Icma on KPIs, tend to be focused on reducing biodiversity loss (rather than making biodiversity improvements), as businesses have more direct control over this and it is easier to measure, adds London-based Withers.

This means KPIs are focused on improving production and consumption practices rather than actively conserving biodiversity. Placing more land under conservation is a positive move, for instance, but it does not necessarily lead to a better biodiversity outcome.

But that was by design, as corporates are still mostly focused on risk management of factors material to their business rather than biodiversity impact as a whole, says Arthur Krebbers, head of climate and ESG capital markets at British bank NatWest, who helped devise the KPIs.

The ability to tailor KPIs to a company’s specific business and location is part of their appeal, says Judson Berkey, group head of engagement in the chief sustainability office at Swiss bank UBS. “The financing rate for a food and agriculture company could be dependent on the level of sourcing of certified commodities from a particular region.”

That makes sense, Withers says, as most companies are not in the business of conserving biodiversity. In addition, instruments that tie capital to improved biodiversity outcomes are extremely rare, in part because it is so difficult to measure such outcomes because there is no industry standard.

Withers cites as an example the rhino bond he worked on for Credit Suisse as one such example; it ties the interest rate paid to the rhino population in two South African conservation areas.

For his part, Krebbers says sustainability-linked loans or biodiversity-focused private placements may be more appropriate instruments for nature finance than sustainability-linked bonds. The latter tend to focus on one material KPI, such as greenhouse gas emissions, whereas sustainability-linked loans have scope for a broader number of targets, he says.

Perpetual bonds touted as a nature finance solution

Innovation in sustainable capital is not just coming from the finance industry. Indy Johar, executive director at Dark Matter Labs, a Dutch company that applies complex science to solving problems like climate change, says perpetual bonds are an effective mechanism for driving non-equity investment in nature finance.

Such debt has no maturity date, allowing it to be treated as equity. Issuers pay coupons on perpetual bonds forever and do not have to redeem the principal.

Commonland, a Dutch company that develops long-term landscape restoration projects, has since 2013 been working to engage the pensions industry in direct investment in landscape restoration. It has developed a science-based approach to identify natural and social returns as well as financial ones.

“From a traditional investor’s point of view, thinking about biodiversity landscapes is in the embryonic stage, so we wanted to build a framework to make it [more accessible to investors],” Commonland CEO Willem Ferwerda tells Capital Monitor.  

Most nature finance is for isolated projects rather than addressing broader ecosystem challenges, he adds. Commonland’s approach is to identify landscapes of 100,000 hectares or more and to bring in blended investment to help restore and protect ecosystems.

Such transactions will provide patient capital with returns of 2-3% up to a maximum of 5%, Ferwerda says, declining to say how much money Commonland has raised thus far.

It seems likely to be some time before investors alight on a popular, scalable approach to nature finance.

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