Katrina King, Australian Financial Review, 10 October 2021
COP26 – the United Nation’s Climate Change Conference – will take over Glaswegian conference halls in just over three weeks.
While politicians, scientists and environmentalists will be clambering to attend, it’s also a date firmly marked in corporate, institutional investors’ and fund managers’ calendars, signifying the growing momentum in global boardrooms committing to net zero targets by 2050.
From just 30 last December, to 128 signatories today, the growing popularity of the international asset managers’ movement Net Zero Asset Management Initiative is further proof investors are clambering towards net zero solutions. These 128 signatories represent almost $60 trillion in funds under management – about half of all global funds under management.
This momentum and its implicit demand for carbon offsets, is propelling the growth of global carbon markets which have witnessed more than a five-fold increase in value to €229 billion; all between 2017 and 2020.
Harnessing investment returns alongside net zero targets is a key goal of institutional investors and the natural capital sector offers exciting opportunities in this space.
Natural capital represents those nature-based assets which deliver economic returns through commercial, environmental and social measures and are based in land, soil, water, ocean or even plant and animal species.
The capital generates market value by producing both goods and services, including traditional commercial farm returns, while also generating unique and additional value through other environmental market initiatives such as Australian Carbon Credit Units (ACCUs), Reef Credits and Bio-Diversity payments.
The appeal of the natural capital sector lies in this ability to generate two income streams. While the growth of the ACCU market is exceptionally strong, I appreciate it is nascent and investors can often baulk at innovation uncertainty. The benefit of this two-tiered income stream is that natural capital projects will still be able to achieve positive returns from the agricultural component of the project.
While Australian agriculture has historically been of interest to many offshore investors, we have yet to see it solidify as a mainstay in asset allocation for domestic institutional investors. However, I believe the focus on the twin income streams present in natural capital is driving a change in this behaviour.
For institutional investors, natural capital projects offer a range of positive portfolio attributes including a compelling risk-return profile. The trend of a burgeoning global population and associated economic growth, driving demand for food and fibre, is coupled with a reduction in arable land and clean water. This means today’s farmland investment opportunity has strong supply and demand dynamics.
According to the Australian Bureau of Agricultural and Resource Economics and Sciences, large-scale farmland in Australia has delivered a solid 9.7 per cent total return over the 30-year period between 1980 – 2017. More recently, the ANREV Australia Farmland Index returned 8.46 per cent on a 12-month rolling basis in the first quarter of 2021, and Total IRR returns have ranged between 8 – 18 per cent since 2021.
There are also benefits from a portfolio diversification perspective: farmland has demonstrated historically low performance correlation to traditional assets, both in Australia and globally.
Farmland as a ‘real asset’ investment is a long-term inflationary hedge with strong commodity representation in CPI benchmarks for raw materials/food, a strong historical correlation with inflation and outpaced inflation rates over the long-term in a variety of global market environments.
The added benefit of natural capital is the “E” Elephant in the ESG Room and the access to carbon offsets that natural capital provides.
But where do natural capital projects sit as part of a broader investment portfolio? As with agriculture which acts as its closest commercial proxy, natural capital is often considered an ‘alternative’ investment class within the Strategic Asset Allocation (SAA) structure.
While alternatives were originally sought for excess return, the 2008 Global Financial Crisis saw an increasingly risk-averse investor base seek greater ‘shock- absorption’ in real assets which could deliver competitive returns over traditional assets, but with lower overall portfolio risk through greater diversification, lower correlation, lower volatility and inflationary protection.
The unique real asset attributes of agriculture, and by extension, natural capital, are well-suited to this ‘portfolio view,’ where reduced volatility and increased efficiency is increasingly preferred over the expected portfolio return in investor strategies.
With alternative asset strategies set to grow significantly over the next few years – particularly in the natural resource space – we will see a growing SAA ‘bucket’ for natural capital investments.
So as the world’s political, scientific and investment leaders converge on Glasgow, we look for articulation of global goals and targets and know that it will accelerate interest in the economic, financial and environmental benefits that can be cultivated by integrating natural capital into not only a net zero emission strategy, but also a robust SAA framework.
Katrina King is General Manager for research and product innovation at QIC