UK natural capital investing: sources of investment capital

Introduction

The governments of the UK and its constituent nations have ambitious plans for the development of our natural capital, with targets and programmes for planting woodland, restoring peatland and halting depletion of biodiversity. These objectives have been adopted partly to meet UK Net Zero objectives – damaged peatland is a big source of emissions and new woodland is a significant carbon removal opportunity. There are also benefits in the from of ecosystem services like flood prevention.

Achieving these goals will be costly, estimates are in the billions or even tens of billions¹. Nature restoration is largely a public good and will need to be funded partly via public finance. Unfortunately, public finances are under heavy pressure, following high expenditures during the Covid pandemic and in the face of ageing populations. So rather than placing the whole burden on taxpayers, governments are looking to recruit private finance to support development of natural capital.

The basic proposition is that private investors may be willing to deploy their capital to co-finance woodland planting or peatland restoration and then generate returns from the sale of carbon or biodiversity credits to voluntary or mandatory credit markets.

I am currently researching various aspects of this proposition; the current article focuses on potential sources of supply of capital.

UK pension funds

With over £2tn of assets², UK pension funds are the biggest pool of UK private capital. Are they likely to invest in UK natural capital projects?

Forest and peat restoration projects have three key investment characteristics, they are:

• Long-term. Minimum investment period is 10 years, and projects can last for decades
• Illiquid. Money is locked up for five or ten years
• Risky. Carbon credit price trends are very uncertain, there is a chance the project will offer low or negative returns.

This is a tricky combination for today's pension funds.

Defined Contribution (DC) £600bn

These days, most people save into DC funds which are managed in personal pension pots where investment decisions are controlled by the customer. This means that DC schemes invest in funds that can be sold on a few days' notice. DC funds typically cannot invest in illiquid forest and peat projects that lock up your money for years. There are some ‘default’ DC funds that may be able to make small illiquid allocations. The largest of these are managed by insurance companies, so I’ll discuss them in the next section.

Defined Benefit (DB) £1500bn

Before DC took over, people saved in DB schemes with a collective pot and centralised decision-making. DB schemes could make long-term, illiquid investments like forestry. However, long-ago, these funds were mostly closed to new members and are now in their mature, de-risking stage, investing in bonds and bond-like Liability Driven Investment strategies, and not making new investments in risky, illiquid assets.

Local Government Pension Schemes (LGPS) £350bn are the exception.

These DB schemes are still open to new members and can invest in risky, long-term assets. A few LGPS pools do invest in natural capital, though this seems to be mostly on global basis and biased to commercial forestry, rather than in UK nature-carbon projects. Though this may change in the future. There are a few other public sector pension schemes (e.g. USS, Pension Protection Fund) which have appetite for illiquid private markets investments.

UK insurance investors

With £1.8tn of invested capital, it is the next biggest pool of assets in the UK. Many of the largest DC pension schemes are managed by big insurers like L&G, Phoenix, Aviva and Scottish Widows, so there's a fair bit of overlap with pensions.

Insurance assets fall into two main categories:

With Profits

Like DB pensions, With Profits funds are a legacy model and funds are shrinking fast as they mature. While they still have some appetite for risk, these funds have little or no capacity to make the new long-term, illiquid allocations required for natural capital.

Unit-linked Funds

These include DC funds. They have, until recently, been invested exclusively in public market equity, bond and real estate funds. These funds require liquidity because customers can change their investment allocation at short-notice. This would have been a barrier to their funding natural capital, but change is afoot.

While it is true that customers in DC funds need to be able to move their money between funds, in practice, most keep it in the 'default' funds which have a stable centrally-controlled asset allocation policy. This stability means that, in theory, these default funds can make a small illiquid allocation. In 2021, the FCA approved a new fund structure called a Long Term Asset Fund (LTAF) to enable default funds (aka Master Trusts) to do this in practice.

The UK government wants insurance firms to use LTAFs in earnest, partly to get the higher returns for savers that private markets can deliver, and partly because this could provide a large pool of patient long-term capital to fund early-stage UK businesses. Under the government's 'Mansion House Compact' many DC schemes are committing to 5%+ allocation to LTAFs, so this segment is growing fast.

It is possible some LTAFs will make allocations to nature. I have found one or two that mention this theme, though I haven't yet found any with UK nature allocations (tell me if you've found one). It is early days, but these DC schemes are growing quickly, so in the longer-term LTAFs could be a significant source of finance for UK nature.

Wealth investors

The wealth sector is fragmented, with tens of thousands of rich individuals and families, each with assets in the millions or tens of millions, rather than the billions often managed by pension and insurance funds.

However, this sector has a more natural fit with natural capital than these large pools do. Wealthy-family money tends to be managed for the long-term, often with intergenerational objectives, so there is appetite for long-term risk and willingness to tolerate illiquidity, making it well suited to natural capital investing.

Reducing tax liabilities is a focus of wealth investors - particularly inheritance tax. Forestry offers striking advantages on this front, with no income tax payable on timber sales, no capital gains tax on growth in value of trees, and business relief for inheritance tax.

These generous tax benefits deliver a substantial boost to net-of-tax returns from forestry, and it is likely that carbon forest and peatland projects will also benefit from some of these reliefs.

Many wealthy investors currently invest via private equity forestry funds. Gresham House is the largest UK fund provider with £3.5bn of forestry assets (and is now Scotland's third largest landowner). Hight Net Worth investors can become limited partners in Gresham's funds with a relatively small minimum investment (£100k).

Gresham claims returns of 17% per annum for the sector over the last 20 years³. It's hard to find an asset class that's done better (though whether it is repeatable is another matter). The main downside is very limited liquidity, making it hard to exit at short-notice.

Gresham House offers timber-focused funds rather those focused on carbon credits. Timber plantations do sequester carbon but are not (normally) eligible for Woodland Carbon Code credits due to the Code's 'additionality' rules - timber projects are economically viable without credits and so 'would have happened anyway.'⁴

The other route for wealthy investors to invest in nature projects is direct land ownership. Many of the biggest rural estates in the UK are owned by wealthy individuals or family trusts, who deploy their own capital to invest in forestry and nature projects. Today, wealthy landowners are probably the most significant category of nature investors in the UK. This is a topic I will cover in a future article.

Conclusions

A substantial majority of pension and insurance assets are likely to be unavailable for investment in long-term nature projects. The pension and insurance funds that can tolerate illiquid investments are by-and-large very mature schemes and so have little appetite for taking long-term risk. Conversely, the less mature schemes that do have appetite for long-term risk tend to use investment models that require liquidity.

There are two important exceptions. Local Government Pension Schemes and a few other public-sector defined benefit schemes (e.g. USS, Pension Protection Fund) may want to invest in nature projects, if expected returns are satisfactory. New Long Term Asset Funds may also allow the larger DC funds to invest in these projects too. As yet there are few examples of these funds investing in UK nature projects, though this might change.

The Wealth sector is different. Here investors do have appetite for long-term illiquid investments and so are interested in natural capital. There are also considerable tax benefits from forestry which they are well positioned to capture. This sector – and particular the subset that is interested in direct land ownership – is particularly important as an immediate source of finance for nature projects.

¹GFI (2021) The Finance Gap for Nature
²PLSA (2023) Pensions and Growth
³Gresham House (2024)
⁴WCC (2024)

Craig Mackenzie is a Senior Lecturer in Sustainable Enterprise.

Further updates on Craig Mackenzie's research