Forests take time to grow, and timberland managers take their time before changing strategies. But, with a new cohort of environmentally conscious investors being drawn towards the asset class, is it time for managers to re-think some of the fundamental principles behind timberland investing?
There is no doubt that timberland stands to benefit from powerful long-term tailwinds, although these introduce new dilemmas around the best ways to manage forestry assets. Demand for timber is rising at the same time as the need for forests to be left standing grows ever greater.
The UN’s Food and Agriculture Organization projects that global demand for primary processed wood products will expand by 37 percent between 2020 and 2050. This reflects, among other factors, the recognition that timber products are more sustainable than materials produced with fossil fuels.
And because trees remove carbon from the atmosphere, the forestry sector has a key role to play in enabling the world to meet its net-zero targets. The Intergovernmental Panel on Climate Change stated in its most recent report that carbon removals are an “unavoidable” part of reaching net zero, given the need to counterbalance emissions from hard-to-abate industrial sectors.
The growing market for carbon credits – in which companies pay for forests to be planted, as a way of ‘offsetting’ their emissions – opens possibilities for new ways to invest in forestry. An asset class that has largely been defined by its predictability could be set for a shake-up.
A pure play approach?
The concept that a forestry asset can generate revenues by absorbing carbon, as opposed to supplying timber, is gaining traction among at least some investors.
“We are interested in both the conservation pure plays, financed by carbon credits or other payments for ecosystem services that may emerge over time, and greenfield timber plantations that would have set-aside components as well, where you would restore natural ecosystems,” says Adam Gibbon, natural capital lead at alternative lender AXA IM Alts. He adds that his firm’s natural capital and impact investing strategy is seeking to deliver market rate returns, alongside carbon and biodiversity benefits. AXA IM Alts announced in July that it was taking a minority equity stake in Brazilian carbon removals investment manager Mombak Gestora de Recursos, while investing $49 million in Mombak’s reforestation projects.
Gibbon points out that the kinds of projects that Mombak is developing in Brazil would, until recently, have depended on small NGOs. Now, however, he believes demand for carbon credits means that reforestation efforts can be scaled up.
“We are only anticipating one revenue stream [from Mombak] and that is from the sale of voluntary carbon credits,” says Gibbon. “We are working with some of the most progressive buyers in the industry at the moment on long-term offtake contracts for those projects.”
Convincing corporates to invest in carbon credits is not straightforward, however. Carbon offsetting projects in the forestry sector have come under intense scrutiny in recent months. Many sceptics pore scorn on the very idea of carbon offsetting, suspecting that the purchase of ‘offsets’ merely provides an excuse for companies to continue belching out emissions.
Given these concerns, Gibbon sees a “race to quality” in the sector. Projects that can demonstrate robust carbon removal credentials are in high demand, he says, meaning large scale investment in such projects is required. “Buyers want to know that they are getting the highest quality product and that requires high-quality investment, that requires people to be putting tens or hundreds of millions of dollars down now to provide those products.”
There is little doubt that the pool of potential timberland investors is expanding as LPs recognise the environmental benefits of forestry, alongside the asset class’s ability to generate stable returns.
“It is definitely a broader base now,” says Olly Hughes, managing director in specialist alternative asset manager Gresham House’s forestry division, although he adds that “there are a lot of people still getting their heads around [the asset class].”
Stephen Addicott, managing partner at real assets specialist Stafford Timberland agrees that climate and biodiversity considerations are providing buoyancy to the timberland market. “We have actually seen a small amount of discount rate compression at a time when interest rates have gone up,” he tells us. “Because of the environmental credentials, the appetite is still strong.”
Several large corporations have invested in forestry, either directly or via timberland funds, as they seek to lower their net emissions. Apple announced in April that it was investing another $200 million into the Restore Fund that it established with Goldman Sachs and environmental non-profit Conservation International in 2021. This was on top of a $200 million investment from the iPhone manufacturer when the fund was established.
Meanwhile, 10 Japanese corporations – led by timberland firm Sumitomo Forestry Group – announced the creation of a forestry fund to be managed by a US-based manager in July. The fund’s investors are providing $415 million to invest in timberland assets, mainly in North America, with a view to producing carbon credits.
This sustainable approach is changing timberland and means that in some cases it is no longer being seen as its own sector. Instead, it is increasingly being considered in multi-sector vehicles and projects relating to biodiversity and carbon production.
Yet while investment strategies are changing and new investors are coming into the asset class, conventional ownership models seem set to remain prevalent.
“We see ownership models being much the same – investors investing via SMAs and co-mingled funds,” says Addicott, who adds that pension funds and insurance groups remain among the most significant timberland investors.
Despite the excitement around carbon credits, long-term forestry investors – particularly pension funds, which are attracted to timberland due largely to the stability of revenues from the asset class – are not rushing into the carbon markets.
Established managers are also cautious about making drastic changes to their approach. Gian Paulo Potsios, founding partner at forestry asset manager Timberland Investment Resources Europe, notes that there is “healthy scepticism” around carbon credits. Many investors, he says, are content to hedge their bets by reserving a small proportion of their properties for producing carbon credits, safe in the knowledge that those trees could ultimately be harvested if demand for credits proves insufficient.
“We keep a very close eye on the carbon credit markets,” says Potsios. “It is certainly something that we are looking at and pursuing to a certain extent, but we have not embraced it 100 percent to the point where we have shifted our philosophy of forestry management, from traditional forestry, to managing forestry only for the purpose of generating carbon credits. That is not what we do.”
The crux of the matter is that the price of carbon credits from reforestation projects is currently too low (and too volatile) to tempt most managers into considering ‘pure play’ carbon investments.
While in theory, the carbon price could one day rise so that it becomes more economical to use timberland properties to sequester carbon, rather than to harvest timber, Potsios notes that this is still a distant prospect. For the time being, he says, “it makes absolutely no sense from an economic perspective not to cut and replant.”
Addicott does see a noticeable change, however, in investor appetite for greenfield projects. Established plantations can generate carbon credits, for example by delaying harvesting to allow trees to sequester more carbon. But carbon credits from new forests planted on degraded land are far more valuable.
“Through the sale of carbon offsets, eventually you have the potential to get higher returns than what we have traditionally seen for greenfield,” says Addicott. He estimates that 10-15 percent of timberland investments are currently going into greenfield projects, compared to less than 5 percent a decade ago.
Yet Addicott cautions that, given the somewhat higher risk with greenfield projects, investors need to keep a balanced approach. “Because of their fiduciary responsibilities and requirements, our view is that investors should put at least 70 percent into the traditional brownfield investments and less than 30 percent into greenfield,” he says. “You are starting to take on a little bit too much carbon, greenfield risk if you go above those numbers.”
Putting a number on nature
Finding a way to monetize the amelioration of biodiversity is both essential for wider adoption and stubbornly elusive.
As well as sequestering carbon, afforestation or reforestation projects offer potentially huge benefits for biodiversity. But if carbon markets are still nascent, efforts to monetize improvements to biodiversity are practically embryonic.
“Biodiversity has been riding along free with the carbon benefits,” says Adam Gibbon from AXA IM Alts, although he does note that projects that seek certification under the Climate, Community and Biodiversity Standards managed by prominent certification body Verra need to demonstrate effective biodiversity conservation.
Whether a widely accepted method of defining a tradeable ‘unit of biodiversity’ can ever be agreed remains to be seen. Olly Hughes from Gresham House stresses that approaches to measuring and managing biodiversity must be kept simple. “Having very highly intensive academic-led biodiversity measurement systems just is not feasible” for managers that oversee millions of hectares of forests, he says. “We just cannot do it.”
He adds that the ultimate aim is to find more scalable methods of measuring biodiversity, which can ultimately lead to biodiversity being valued and monetized. “We are some way off that at the moment, I would say. We are really aiming towards that and would love to get there – but we are just not there yet.”