Building the Ecosystem Marketplace

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by Michael Van Patten

The global financial crisis has reduced last year’s raging torrent of hot capital to a glacial mound of indecision and caution. That’s bad news for lovers of tacky clichés, but could be good news for glaciers (and lovers of environmental finance) as institutional investors shift to lower ” but more consistent ” returns. Tapping that capital, however, requires a few lessons from the carbon market.

First in the Series Building the Ecosystem Marketplace

14 July 2009 | If there’s one thing we’ve learned from the past half-century of environmental degradation, it’s that philanthropy’s ability to solve environmental and social ills is limited at best, and that large-scale aid programs may even stifle sustainable development.

About this Series

Ecosystem Marketplace believes that our planet’s living ecosystems deliver services upon which our entire economy depends ” such as the cleansing of our air and water and the regulation of our atmosphere. We also believe that our economy’s failure to account for this value is the reason that our that forests, wetlands, and other ecosystems are worth more dead than alive ” and that incorporating the cost of environmental degradation into the cost of producing goods and services will correct this failure.

Governments, NGOs, and private-sector entrepreneurs around the world agree, and many have devised payments for ecosystem service schemes to do just that, with varying degrees of success.

For these schemes to deliver environmental value on a meaningful scale, they must utilize financial mechanisms that bring buyers and sellers of ecosystem services together in a transparent market that is easily-accessible to all participants and generates clear price signals that can be used to develop business plans and manage risk. Only when these financial mechanisms are in place can the true value of nature’s services be identified and incorporated into the global marketplace.

In this series, we will be identifying a handful of companies that are creating such mechanisms:

Part One: Building the Ecosystem Marketplace Guest author Michael Van Patten provides an overview of the challenges facing the incorporation of nature’s services into our current economic system.

Part Two: Building Oregon’s Ecosystem Marketplace Ecosystem markets are nothing without a solid regulatory framework, and guest author Sara Vickerman summarizes the US State of Oregon’s two-year plan to establish just that.

Part Three: Markit and the Re-Making of the Registry Landscape London-based Markit built itself into a derivatives powerhouse by identifying which numbers reflect underlying reality better than most of their competitors. On June 30, Markit finalized the purchase of environmental registry TZ1, which has now been re-christened the Markit Environmental Registry. We examine the impact of this development on existing registries and the overall ecosystem marketplace.

Part Four: Markets with a Mission There’s been no shortage of media attention on carbon exchanges that make it possible to execute trades in standardized carbon offsets that have already been created and sanctioned. Lesser-known, however, are companies like Mission Markets, Climex, and The World Green Exchange, or the NGO Defenders of Wildlife ” all of which either have or are developing platforms that in one way or another help developers find investors who are interested in the unique attributes of individual ecosystem preservation projects.

Part Five: the Commoditizers Carbon markets have established themselves as the fastest-growing financial market on the planet, largely because the standardized nature of carbon offsets makes them easily-traded financial instruments that distill risk and reward into a solid number that a critical mass of buyers and sellers agrees on. We’ll meet the companies developing means of doing the same for fragmented and illiquid markets like biodiversity offsets and wetland mitigation banking.

Part Six: the Index-Makers In the securities world, stock indexes like the S&P 500 provide a benchmark price for the overall market and for sectors within that market. We examine the creation of indexes in markets for ecosystem services.

This does not, however, mean that funding isn’t part of the solution. Rather, it means that existing mechanisms for channeling resources into programs that can support solutions are missing the mark.

Hitting that mark begins with the incorporation of nature’s economic value and the cost of its destruction into our economy. Only when the price of environmental degradation is factored into the cost of producing goods and services will our economy reflect the fact that the living ecosystems on which we all depend are worth more alive than dead ” and only when that reflection is made will the creative forces of our economy become focused on the preservation of nature rather than on its destruction.

Governments around the world have begun taking the steps necessary to bring the value of nature’s services into our economic system, and scores of green entrepreneurs have responded by setting up forest and agricultural carbon offset projects, species banks, water quality trading schemes, and and wetland mitigation banks.

Many of these schemes have been with us for decades, and we are now seeing the emergence of new schemes that promote payments for terrestrial and marine ecosystem services, sustainable fisheries and agriculture, microfinance, Community Development Finance Institutions (CDFIs), and the growing “Lifestyles of Health and Sustainability” (LOHAS) sector.

The Next Step

These mechanisms have all yielded promising results. Microfinance and community investment have been able to raise billions of dollars in this manner, albeit still not in sufficient amounts. The carbon markets are seeing dramatic increases in capital because of current and pending climate change regulation. The wetland and conservation banking markets have also benefited from the Clean Water Act and Endangered Species Act in the United States.

But if we are to develop the scale needed to fund real change, we must develop private capital market mechanisms that incentivize mainstream investors to fund them.

In an earlier Ecosystem Marketplace article, I suggested that the social and environmental community should view social and conservation finance similar to the way the institutional investment community looks at other asset classes: as underlying assets and cash-flows.

This argument is now more relevant than ever, thanks to the growing number of investors willing to act as “patient capital”. These are double- and triple-bottom-line investors and not mere speculators. With the recent economic and capital markets turmoil, there has been a shift in what investors perceive as “market-rate returns”. Investors who once required 15% returns per year are now leery of the volatility that such returns generate, and are open to investments projected to yield 3%-7% per year.

These are figures currently being offered in various social and environmental markets, making them more attractive in comparison to past mainstream investments. Below is a list of some new innovative financial structures being created to more effectively support and monetize the social and environmental markets.

“¢ Water Footprint Credits & Water Restoration Certificates that support various water usage projects globally.

“¢ Marine Impact Credits that support marine protected areas and various estuary and marine conservation and fisheries projects.

“¢ Stormwater Runoff Credits that support the reduction of storm-water runoff from impervious surfaces.

“¢ Community Quota Entities that support local sustainable fishing communities.

“¢ Social Enterprise Royalty Trust Securities (SERTS) where social enterprises pay out a portion of their revenues as a dividend to their shareholders.

“¢ A Low Profit Social Limited Liability Corporation or L3C company through which PRI and market-rate return investors can co-invest and support social enterprises and distribute cash flow and returns according to the investors’ interests.

Opportunities & Obstacles

The market for both terrestrial and marine conservation finance offers participants a wide array of opportunities to generate both financial return on investment and to direct environmental and social impact in the support of vital habitats. With the exception of the marine conservation sector, these markets share a common characteristic: the generation of a tradable or transferable credit or right that produces the financial return. The existing sub-sectors of conservation finance include:

“¢Wetland mitigation banking

“¢Habitat or endangered species banking

“¢Water quality and water temperature credit transactions

“¢Carbon sequestration projects

“¢Conservation easements and TDR’s (transferable development rights)

“¢Marine protected areas and marine conservation agreements

The fact that some of these sectors have been around for 20 years or more doesn’t change the reality that these markets are not even on the radar screen as an investment asset class.

Finding the Money

The group of investors that I believe will be the most receptive to these markets includes: corporate and state pension funds, foundations, family offices, investment advisors and financial intermediaries, faith based organizations and private equity investors. The opportunity for long-term financial returns coupled with local community or national environmental and social impact provides valuable public image and stakeholder benefits making the conservation finance sector particularly attractive.

Before this market can be considered for inclusion in an asset manager’s portfolio, however, we must overcome some very large obstacles. These include:

“¢Lack of standardized financial and environmental metrics

“¢Limited or non existing transparency in historical financial return data

“¢Lack of clarity with regards to transactions data and price discovery

“¢Fragmented and regional or localized nature of the sector

“¢Limited ability to more effectively monetize credits beyond the current traditional buyers

“¢No centralized marketplace (exchange) to efficiently facilitate transactions between buyers and sellers

Creation of an Asset Class: The Learning Curve

Before the majority of financial professionals accept the reality of an investment opportunity in environmental conservation, an education process needs to occur.

Indeed, it’s already happening courtesy of the carbon markets. I like to say that carbon is the “entry drug” of the ecosystem markets as evidenced by the fact that as recently as three years ago, very few people understood what a carbon footprint was. Now, almost everyone does. The sector is becoming widely researched by major institutional investors; before the financial crisis, almost every major bank had a carbon trading desk. Now, encouraged by impending regulation and accepted science, universities are arming the next generation of carbon professionals with master’s and undergraduate degrees in climate science and carbon finance; traders are creating new indices for carbon credits; and banks are planning to reopen or grow their carbon desks, despite a still-depressed overall market.

The next phase of the ecosystem services education process has begun with increased information and discussion regarding the next big environmental markets after carbon: water and biodiversity markets, and their associated risks and opportunities for investors. Eventually consultants, financial advisers and investment banks will advise clients on how best to allocate capital to the ecosystem markets in a similar fashion as carbon.

Metrics & Price Data

The reporting of financial returns data within the ecosystem service sector at-large is currently very limited, as information regarding price history and transactions are not published. The profession of wetland and habitat banking is very competitive, and information is kept closely held. This is an advantage if you have access to this information ” but to scale beyond a niche market, ecosystem professionals will need to be more open to disclosing these details. When this information becomes more accessible, investors will be able to use it as the basis of decision making.

This is where information tools like Ecosystem Marketplace’s SpeciesBanking.com, which tracks the regulated market for endangered species credits in the U.S., can be of tremendous value to market growth. Firms like Parametrix are creating effective metrics and research tools to help quantify investment opportunities for both specific habitats and analysis of environmental projects.

Regional and Fragmented

Apart from carbon markets, the ecosystem services sector is very geography-specific. The credits generated by wetland or habitat projects are not easily fungible as credit transactions are only valid within a specific geographic region or “Service Area”. This does limit the liquidity of eco-credits to parties focused in a specific area. Thus ecosystem market transactions are more similar to real estate investing than they are to a natural resource investment.

Conversely, carbon credits are extremely fungible. From both the atmosphere and the market’s perspective, one metric ton of carbon dioxide captured or avoided in China is equal to the same in Texas. To begin sourcing potential transactions, organizations like Defenders of Wildlife have created databases and useful tools such as The Conservation Registry that can assist organizations seeking to identify potential conservation project funding opportunities nationally.

Another valuable resource is a conservation tool created by Sustainable Solutions and The Pinchot Institute called Land Server. Land Server helps both private landowners and environmental bankers quantify the potential ecosystem services and resulting environmental credits that might be available on a specific property and is currently in beta test but expected to be rolled out for use in a limited number of states this fall.

A Centralized Ecosystem Marketplace

The key to bringing all these services into an actionable framework is the development of a centralized platform or marketplace where investors, service providers and landowners can meet and transact. Currently, if an investor or developer wants to transact a species or wetland credit, they need to first contact a habitat banker, their local Department of Fish & Wildlife Services, or an Army Corp of Engineers office. Once credits are located, the buyer negotiates the transaction in a private bi-lateral agreement, which is not only time consuming but is not a process that lends itself to the creation of an investable asset class.

Organizations such as the Willamette Partnership and the Bay Bank are creating regional electronic marketplaces that will serve to facilitate ecosystem credit transactions and provide much greater transparency and price discovery. My company, Mission Markets Inc. is also creating a comprehensive electronic marketplace that will provide a national platform for these transactions and link to these regional exchanges adding liquidity and visibility for credits and/or environmental projects, while Ecosystem Marketplace’s own SpeciesBanking.com acts as an online information hub for bankers, buyers, researchers, and regulators.

http://ecosystemmarketplace.com/

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