6 March 2025
Introduction
The governments of the UK and its constituent nations have ambitious plans for the development of our natural capital. Forestry is a key priority, with targets and programmes for planting 30,000 hectares of woodland each year, roughly double the rate of the last decade.
This is partly to meet UK Net Zero objectives (forests remove carbon from the atmosphere), partly to increase supply of timber (a low carbon building material), and partly to achieve biodiversity objectives.
The majority of timber forest planting in the last decade has been funded by private landowners and investors, but with substantial public support in the form of grants and tax reliefs.
The combination of substantially increased planting targets and tighter constraints on government spending means that the government is looking for other ways to increase private sector involvement.
The prime candidate is the use of carbon credits. The UK government established the Woodland Carbon Code (WCC) over 10 years ago as body to regulate the issuance of carbon credits for UK forest projects.
In a previous article, I argued that pension funds may be willing to invest in forest planting, part financed by selling carbon credits, but only if they could expect to achieve a competitive rate of return - perhaps somewhere near 10-12% per annum.
UK natural capital investing: sources of investment capital
In this piece I explore whether forestry projects backed by the sale of WCC credits can achieve this level of return. I begin with a simple indicative project and then consider three variants.
1. Returns for a simple forest carbon project
The steps involved in planting a WCC-certified project are as follows, with indicative information about woodland size and the financial costs involved. This is based on a 500ha project in the Cairngorms, predominantly planted with native species (Scots pine and birch) with revenues solely from grants and the sale of carbon credits.
Y1-3 Planting phase
- Buy land - a 500ha former grouse moor - cost £2.5m.
- Apply for grants from Scottish Forestry
- Plant trees (i.e. scots pine, birch, alder etc.) - cost £2.1m
- Receive grant of £1.5m about 70% of costs
- WCC validation
Y 3-10 Establishment
Establish and maintain forest, pay for insurance - modest annual costs
Y15 Verify carbon sequestration
Sell first WCC verified units. Revenue depends on carbon price
Y20 Second verification
Sell more units
Y25-Y100 Subsequent verifications
Repeat
Does this project generate the 10-12% return pension funds need?
To answer this question, I built a DCF model to calculate internal rates of return (IRR) for the project, estimating costs and revenues for each year. Costs are fairly easy to estimate; there's good data from actual projects.
Revenues are another matter. There is data for planting grants, though public spending cuts mean availability is in question. But the sale of carbon credits is the largest source of revenues for this project and these are highly uncertain. The WCC provides a calculator which facilitates estimate of the number of credits likely to be generated by the project, but revenues are the product of the number of credits and the carbon price.
There is a very high degree of uncertainty about the future price of WCC carbon units. The market currently depends entirely on voluntary purchases by corporate buyers who wish to use the credits to offset their own emissions. In theory, companies with Net Zero commitments will eventually need offsets, but concerns about greenwashing, controversies in the voluntary carbon markets and anti-ESG sentiment means there is little clarity about future demand.
Scenarios help deal with uncertainty. So, here are IRRs calculated using my DCF model, with 3 carbon price curves.
- High carbon price: £200 in 2030, £600 in 2050: IRR = 11%
- Mid carbon price: £100 in 2030, £300 in 2050: IRR = 8%
- Low carbon price: £50 in 2030, £150 in 2050: IRR = 5%
The conclusion from this modelling is that to get a pension fund return of 11%, you need very punchy carbon price assumptions. Today, prices for WCC units are around £25-30 or so. I doubt pension funds will accept return forecasts based on Mid or High carbon price forecasts. They'll want a conservative base case, which means IRRs are too low.
The fundamental problem here is the 20 year wait for the forest to grow enough to generate WCC units. There are two aspects to this:
- Distant revenues hurt IRRs. High discount rates erode present value of distant revenues. £100 in 2050 is worth just £6 today if you discount at 11%.
- J-curve problem. Pension funds accept negative cash flow 'J curves' lasting 3-6 years, but here you have to wait 20 years for positive cumulative cash flows! I suspect this is a bridge too far.
The initial conclusion is that this model is simple 'plant-and-wait' model probably won't work for pension funds. Are there ways to improve the return outcome?
2. A model that generates higher returns by selling 'PIUs'
When you set up a WCC project, Pending Issuance Units (PIUs) are issued matching the total number of verified carbon units (VCUs) expected for the whole life of the project. Each PIU is a promise to deliver a specific VCU at a fixed time-period in the future. PIUs can be sold immediately.
Why might someone buy PIUs? Imagine a company with a Net Zero target plans to offset its residual emissions in 2045 using verified carbon units. One option is to wait till 2045 and buy the VCUs it needs on the open market, perhaps for a very high price. Another is to buy PIUs today, locking in lower prices, and take delivery of the corresponding VCUs when they are due.
From the perspective of a forest project, the ability to sell PIUs eliminates the punishing 20 year wait for revenues described above, boosting IRRs and removing the J-curve.
Using the same forest model as the last post, if 50% of project PIUs are sold in year at the start, the project would hit a pension fund 11% target return even with the lower carbon price scenario (i.e. £150 in 2050).
PIUs have two problems though.
- It can be hard to find buyers for PIUs with due dates after 2050. Companies often have offset plans up to 2050 but not beyond that date. They will need them eventually, but given only around 10% of UK companies survive 20 years, 'wait and see' makes sense. This means projects can only bank on selling the PIUs with dates before 2050 - only about 15-20% of the total for a typical 100-year project.
- Selling PIUs creates uncertain liabilities for projects. Corporate PIU offtake contracts often insist that sellers make good any VCUs that aren't delivered, because, say, some of the trees died or grew more slowly than expected. Making good shortfalls at 2050 carbon prices could be very costly.
You can hedge this risk by only selling some of your PIUs (say, up to 50%), leaving you a reserve to use if needed. Insurance may also be possible.
Together these problems mean that you might only be able to sell just 10% of your total PIUs (50% x 20% of PIUs available up to 2050). This helps returns a bit, but not enough to satisfy pension funds.
There are a few corporates who will buy across PIU 'vintages' and will accept non-delivery risk. Forest projects lucky enough to find them can make this model work. There has been some discussion of a government backed PIU purchase facility of some kind. This might resolve this problem and make this model work more widely.
3. A 'portfolio' approach to make forest carbon projects investable
I'm arguing that waiting 20 years for revenues from carbon credits is the fundamental problem that undermines the investability of UK forest carbon projects. But that raises a puzzle: timber forests take even longer than 20 years to generate revenues from the sale of timber - typically 25 or 30 years - and yet timber funds seem to have no problem attracting capital. How is that possible?
The answer is multi-age forest portfolios. Timber funds don't just buy bare land and plant trees, they also buy stocked plantations, building a mix of mature harvestable trees, younger plantations, and bare land. This means there is little wait for revenues and no big 'J-curve'. Pension funds have invested at scale.
Could the portfolio approach work for forest carbon?
It works for timber because the UK has thousands of established sitka spruce plantations of varying ages, so buying mature trees is fairly easy. This simply doesn't apply to carbon forestry.
The first WCC forests were only planted around 15 years ago and there were few of them. So, if you raise £100m fund, you can't expect to be able to create a multi-aged WCC portfolio in the same way forestry funds do.
In 10-20 years time, this should change as more WCC forests reach maturity. What are the options in the meantime?
Buy some existing WCC forest or their Pending Issuance Units. Carbon revenues will still be a few years off, but in 5-10 years' time you will have VCUs for sale. A 10 year wait is better than 20, and you might improve IRRs if the purchase price is right.
Build a mixed portfolio of timber and carbon forests. This will get you revenue sooner and diversify risk. The Foresight Sustainable Forestry Company uses this model. Often nature funds don't like commercial forestry on biodiversity and aesthetic grounds. But timber is needed for sustainable construction, and we don't grow enough of it. There are ways to enhance its biodiversity.
Build a mixed forest/non-forest portfolio - adding peat restoration, farming, BNG, wind, eco-tourism etc. This is something like the Oxygen Conservation model. This brings earlier revenues and diversifies risk.
Strategies 2 and 3 don't just create earlier revenue, they also diversify into tried and tested business models. Diversification and familiarity drive required returns down a bit. 8-10% rather than 11% perhaps? But, they do add complexity which many pension funds don't like.
Conclusion: these strategies can make forest carbon investable for pension funds, but they do have trade offs!
4. 'Partnership' models can make UK forest carbon investable
The initial model above doesn't deliver competitive returns in part because it is based on purchasing land which is expensive, even in the Highlands of Scotland.
But what if you don't buy the land? Could you find another way to gain access to land for the project? A few big investors are trying to make landowner 'partnership' models work. The idea is something like this:
- Landowner and investor sign a joint-venture agreement for 20 years
- Landowner provides land
- Investor:
- pays for and manages tree planting
- pays to establish and maintain the woodland
- receives planting grants
- makes annual payments to landowner for life of the JV
- receives Woodland Code Pending Issuance Units (PIUs) covering first 30 years or so
Investor sells verified carbon units as they are created and any residual PIUs.
After 20 years, investor exits the project; JV reverts to landowner, along with remaining PIUs and ongoing responsibility for forest.
For investors, this model swaps a big initial capital cost for deferred payments over the long-term (reducing their present value). This boosts IRRs a bit, though I suspect not enough to get near to 10%.
For landowners, you get to keep your land; you get a forest planted and established at someone else's expense; and you get revenue to replace the e.g. sheep subsidy payments you have foregone. You also avoid exposure to carbon price risk (initially at least).
For land reformers you avoid a new wave of absentee landlords buying up large swathes of land - a particular concern in Scotland.
But partnership models are tricky.
Tax issues - partnership models may reduce the tax reliefs landowners can get for forestry. (Though the Budget's new £1m cap on BPR has reduced their value for large estates).
Inflexibility - nature projects last decades and may need to change over time, for example, with changes to regulations, tax, the WCC, or if new (e.g. biodiversity) credits become available. Renegotiating contracts can be difficult, particularly if trust breaks down.
Post-exit arrangements - many nature funds plan to exit after 15-25 years. Landowners worry about their liability for delivering VCUs. If they get to keep a large share remaining PIUs, this helps, but it reduces investor returns.
It's too early to tell whether the idea will work.
Investors are split on this concept. Some refuse to do projects if they don't own the land, others are willing to give it a try.
Conclusions
The analysis in this paper suggests that it is not straightforward for forest carbon projects to achieve the high levels of returns required by pension funds.
Selling a significant proportion of PIUs would make projects more competitive, but currently there are few buyers. A government supported PIU purchase facility may provide a solution.
Developing forest portfolios that mix traditional timber forestry with carbon forestry can help achieve return targets, but given they depend heavily on existing mature forests will deliver less carbon removal per pound invested.
Partnership models can reduce project costs and offer another route to higher returns, though at the cost of significant additional complexity. It is not clear how many landowners and investors will have the stomach for this route.
Finally, it is worth noting that the UK government recently proposed including WCC credits in the UK Emissions Trading Scheme. If this were to happen it would substantially reduce demand uncertainty and WCC prices would likely converge with UK ETS prices.
This would reduce the risk premium and required rate of return for WCC projects, perhaps by 1-2% bring them to the 8-10% range. It may also make pension funds more willing to consider a Mid-carbon price curve. These two changes would bring the required and projected returns in the simple model identified at the start closer to alignment.
This change would not, however, address the J-curve issue. I doubt investors would be willing to wait 20 years for revenues. But would be an important step to achieving investability for WCC projects and would mean that the other options described above would be more likely to deliver competitive returns.
Please note that this paper is written by the author in his personal capacity and does not reflect the views of the organisations he works for.
Read the other articles in Craig's thought leadership series on UK natural capital investing
UK natural capital investing: sources of investment capital
Author
Dr Craig Mackenzie is a Senior Lecturer in Sustainable Enterprise at the Business School.