Natural capital markets: Putting a price on nature
Carbon markets are just the start of a revolution putting a price on nature.
Whether its the deforestation of our rainforests, the leakage of waste plastics into the ocean, or the destruction of the coral reefs by pollution, the damage being done to our natural ecosystem is becoming clearer by the day.
The main pressures on terrestrial, marine and other aquatic biodiversity include habitat loss and fragmentation, over-exploitation of natural resources, pollution, invasive alien species and climate change. The root cause of this loss of biodiversity is our growing demand for food, fuel, water and land, combined with inefficient resource misallocation in global production and consumption systems.
In the same way that markets are providing a way to price the externalities related to carbon emissions and incentivise behaviour change, governments are also looking to markets to help put a value on our natural capital. Natural capital is defined as, “The stock of renewable and non-renewable natural resources (e.g. plants, animals, air, water, soils, minerals) that combine to yield a flow of benefits to people” according to the Natural Capital Coalition.
Biodiversity provides annual benefits worth $125-140 trillion according to the Organisation of Economic Cooperation & Development (OECD). This is equivalent to more than one and a half times the size of global GDP, directly benefiting a host of resource-intensive industries like food, agriculture and logging. There are also financial risks associated with destroying nature.
Biodiversity loss has been found to be directly related to an increased risk of zoonotic diseases in close to 3 out of every 10 case. Intensive farming increases the risk of disease developing in livestock or poultry, and then spreading to humans.
These and a number of other publications appears to have galvanised action by financial institutions, much like the 2006 Stern report led to action on carbon and the growth of markets designed to further those aims.
But how do you put a price on the diversity present in a particular ecosystem? Perhaps an even more basic question: how do you value a tree, or the soil or the stock of wildlife in a particular area? Is it based on aspects that contribute to the wider economy such as flood mitigation, crop pollination or something else entirely?
Here’s just one example. According to an analysis by the insurance firm Swiss Re, over half of global GDP relies on high-functioning biodiversity (for example, pollinators such as bees are thought to be responsible for between 5-8% of global food production), but about a fifth of countries are at risk of their ecosystems collapsing due to the destruction of the natural world.
In the markets the price is based on the scarcity of an asset and the value that it brings. Nevertheless, the value of natural capital is likely to change over time as we discover ways in which biodiversity protects or enhances our lives and our economies. How do you discount the value of those future natural capital benefits when the impacts (either positive or negative) could be years or decades into the future?
Some voluntary biodiversity offset schemes link the value of tree loss to a carbon credit. For example, companies would pay countries blighted by deforestation for carbon credits linked to the avoidance of deforestation or the reforestation of land previously cleared or otherwise unproductive. Indeed, research commissioned by energy company Shell estimated that “an area the size of Brazil being reforested offers the possibility of limiting warming to 1.5C”.
However, that misses the broader diversity benefits that natural capital brings. The price of nature should also include the opportunity cost as a result of not bringing that resource into productive use. For example, forests in Brazil could be cleared to plant soybeans or for logging. Not being able to do that has a cost. It means a loss of income to the Brazilian economy. It means there is less land available to plant, or what land is available might be lower quality, resulting in lower yields. Everything has a cost.
In 2019 the Brazilian government suggested that they could implement measures to “maintain the forest”, but called on those with the means to pay for it to help Brazil out. The country’s environment minister, Ricardo Salles called for more investment and development in the rainforest area, estimating that $120 per hectare per year would be sufficient to pay farmers and other locals NOT to develop their land. Enabling individual countries to trade the right to exploit their natural capital is likely to be one of the most cost effective ways of tackling both biodiversity loss and climate change.
Nevertheless, simply saying that your country’s natural capital is worth this much may not be enough to preserve it. For example, channelling vast shipments of cash to remote parts of Brazil by itself will only succeed if it is adequately enforced by the government. Directing payments to the legal economy present in vulnerable ecosystems may not be enough if the bulk of the damage is being meted out by illegal operators. Meanwhile, protecting one area might just shift the problem to other lands, which could have even worse environmental outcomes.
Brazil was not the first country to toy with the idea of being paid to protect their natural capital. The tiny nation of Ecuador is covered under a large, biodiverse rainforest. It also sits atop a lucrative oil reserve estimated to hold over 800 million barrels of heavy crude. In 2013 Ecuadorean President Rafael Correa proposed leaving the oil in the ground, but only if wealthy donors coughed up $3.6 billion. For that, Ecuador would leave the oil untouched and the natural capital of the rainforest would be protected.
Unfortunately for Ecuador and its rainforest, the cash was not forthcoming. All told Ecuador managed to receive pledges totalling $13 million, 0.36% of the sum Correa had suggested. In a televised speech announcing that he was abandoning the proposal, Correa lamented, “The world has failed us.”
Lack of clarity over how the plan would work in practice, and the absence of credible assurances that the oil would be left in the ground proved insurmountable. A US State Department cable uncovered by Wikileaks, noted that U.S. officials were dubious about the "lack of clarity on the guarantees that the [Ecuadorian government] will provide; continued pressure to develop the petroleum reserves; and likely Ecuadorian resistance to an internationally managed fund because of sovereignty concerns."
It’s not surprising that very little money was forthcoming. A web of tangled threads need to be unwound before donor countries would have the confidence to pledge large amounts of capital. As ever there are trade-offs, in some instances the trade-offs might not be clear, or they may even conflict. For example, how should the value placed on natural capital be weighed up against the value of carbon emission abatement?
In addition, while carbon savings in one part of the world should be broadly equivalent to savings made elsewhere in the world, no such equivalence currently exists when it comes to natural capital. The opportunity cost of not cutting down forests varies across the globe as well. Deforestation in countries such as Brazil, Malaysia and Ecuador is typically related to commercial interests (linked to the production of soy, palm oil, crude, timber and beef), while in other less developed countries, such as the Democratic Republic of Congo it is linked to the agricultural demands of a growing population as smallholders clear land to grow cassava and maize.
Other countries perhaps offer a better example of the way forward - rewarding good behaviour, rather than disincentivising bad behaviour. The central African country of Gabon is one of only a few countries that are net sequesters of carbon (other examples include Guyana and Bhutan). Successive Gabonese governments have sought to protect the country’s rainforest, and so the “green superpower” is in the unique position of being a net sequester of some 100 million tonnes of carbon per annum. In 2021, Gabon received the first emission reductions payment, part of a $150 million pledge from Norway.
How much could this cost the global economy? According to a UN report published in 2021, investing 0.1% of global GDP every year in restorative agriculture, forests, pollution management and protected areas by 2050 could avoid the breakdown of natural ecosystem “services” such as clean water, food and flood protection.
There are other potential costs as well - less agricultural land means less space to grow crops and that could be particularly damaging for low income countries. Analysis by charity Oxfam found that if developed countries became over-reliant on tree-planting in less developed countries to offset their carbon emissions then this could push food prices up 80% by 2050.
It seems unlikely that we will see a natural capital market in which the price of biodiversity and the risk of ecosystem loss is updated in real-time. However, that doesn’t mean that individual companies will not want to factor natural capital into their business planning. For example, the failure of management to adequately respond to biodiversity related risks will increasingly be considered a red flag for investors in resource industries.
According to the OECD, businesses face 6 main risks in not adequately managing natural capital: ecological, liability, regulatory, reputational, market and financial.
- Ecological risks: Such risks are mainly operational risks associated with resource dependency, scarcity and quality, for example linked to: increased raw material or resource costs (e.g. limited natural resources like timber or fresh water); deteriorated supply chains (e.g. due to resource scarcity or more variable production of natural inputs); or disrupted business operations.
- Liability risks: parties who have suffered biodiversity-related loss or damage seek compensation from those they hold responsible. In January 2019 the Brumadinho dam in south eastern Brazil gave way. It unleashed a torrent of mud into the surrounding areas, leaving 270 people dead in its wake while also contaminating both land and the Paraopeba river with toxic waste. Brazil’s worst industrial accident cost Vale, the Brazilian mining giant a $7bn compensation pay-out.
-Regulatory risks: these include restrictions on land and resources access, clean-up and compensation costs, procurement standards, and licensing and permitting procedures or moratoriums on new permits.
- Reputational risks: businesses face reputational risk linked to growing pressure by investors, consumers, shareholders, policy makers and civil society to assess, report and manage risks to society and the environment, including biodiversity risks. Oil majors typically charter out 99%+ of their oil tanker demand to independent shipping companies. That didn’t use to be the case. Although independent shipping companies have gradually taken an increased share of the oil tanker fleet, that trend accelerated in the in the aftermath of the Exxon Valdez disaster in 1989 when oil majors including US oil company Exxon divested from the oil tanker business given the negative reputational damage they incurred or others potentially risked facing in the future should a similar disaster befall them.
- Market risks: changes in consumer preferences (e.g. towards products with reduced biodiversity impacts) or purchaser requirements (e.g. biodiversity safeguards in supply-chain requirements) can create market risk for companies.
- Financial risks: businesses, banks and investors may also face financial risk, including insurance risks (e.g. linked to higher insurance premiums stemming from biodiversity loss); access to capital (owing to higher cost of capital, or more stringent lending requirements based on negative impacts or dependencies on biodiversity); and loss of investment opportunities as investors increasingly integrate biodiversity in their investment strategies. As ecological risks to businesses increase, business and financial organisations may face depreciation of assets.
As businesses wake up to their natural capital risks there will be increased demand for market based solutions that they can use to manage their risks. In the same way that carbon pricing provides an incentive for carbon abatement and mitigation investment, being able to put a value on natural capital will help businesses make smarter decisions.
Although natural capital markets are only at a nascent stage, I expect governments and the private sector to increasingly rely on them in the future as the success of carbon markets becomes clear. Experience in how carbon markets have evolved over time will become ever more valuable for investors seeking out opportunities as these markets evolve.