More thematic funds are creating opportunities for schemes to engage with natural capital, but the need for more robust frameworks is paramount, experts claim.
As the pivot towards sustainable investing accelerates, the need for schemes to balance risk, returns and sustainability goals has given rise to new forms of thematic investments.
Natural capital funds invest in companies leveraging the regenerative power of nature and the circular bioeconomy across multiple sectors, but commonly with a bias towards industrials, technology and materials.
There is very little being disclosed on natural capital compared with climate
Diana Rose, Insig AI
“Natural capital offers defined contribution schemes an asset class that can generate attractive real returns with a high level of diversification vis-à-vis traditional asset classes,” says Julius Pursaill, strategic adviser at Cushon. In addition, he says it also offers opportunities to “connect members with their pension savings”.
Pursaill says some types of natural capital strategies are “well understood” by schemes and trustees, namely in the forestry and agriculture sectors, but new approaches are emerging, such as vertical farming and blue capital.
“Cushon believes many natural capital assets are positively correlated to the price of carbon, and as such are welcome additions to a climate-aware portfolio because they reduce risk,” says Pursaill.
Accelerating frameworks
There are some signs to suggest that this area is to become part of the mainstream environmental, social and governance agenda, with regulatory frameworks accelerating the prominence of nature-based investment solutions.
“Following the stickiness of the Task Force for Climate-related Financial Disclosures, the first draft of the equivalent Taskforce on Nature-related Financial Disclosures is due to be released this quarter, says Diana Rose, head of ESG research at Insig AI.
“It will contain recommendations on how to manage, report and act on nature-related risks in practice and calls for organisations to integrate these into their governance, strategy, targets and performance metrics,” she adds.
Similarly, Alex Millar, head of UK distribution at Invesco, recognises the potential importance of TNFD, noting it is “possible to see a future where pension schemes may be required to disclose how they integrate nature-related risks into financial decision-making”.
Yet to make evidence-based decisions, Rose says improvements in data transparency and declarations will be needed.
“Currently, there is very little being disclosed on natural capital compared with climate. Companies are barely off the ground, and it will take time that environmentalists argue we don’t have to spare,” Rose explains.
But numerous initiatives, as well as regulatory frameworks, are aiming to aid companies quantifying natural capital, and while some of these may “gain some traction in being integrated into financial decisions”, Rose says the challenge facing investors is substantial.
“It cannot be ignored that something like soil mineral quality is hard to quantify in the same way as CO2, and its value is interconnected with other ESG factors such as climate change and society. Many biodiversity risks are also hidden in the international supply chain, where regulation is harder to track and oversight tends to be weaker,” she says.
Meanwhile, the range of natural, capital-related investments is growing all the time, from “thematic [exchange traded funds] covering clean energy, global water and timber to private markets funds supporting sustainable fishing”, Millar says.
But while the rollout of the new framework “should bring some consistency and comparability to climate-related disclosures”, Millar says the lack of widely used metrics is a barrier to the broader adoption of natural capital investing.
“This is a challenge to address as studies show that investors, particularly millennials, want to see the quantification of the benefits of their investments,” he says.
Responding to risk
For trustees, making allocations to natural capital poses some potential risks. The area is nascent, with regulatory frameworks yet to be fully embedded alongside other, more established ESG investment practices.
Yet Pursaill says making forward-looking ESG allocations may alleviate some risks in the long term.
“Because of climate change, the future is going to be different from the past,” he says.
“Cushon sees climate change leading to significant market dislocation, because markets, typically not good at pricing long-term risks, have yet to reprice most climate risks.
“This presents both risks to members on the downside and opportunities for members on the upside. Integrating ESG into a portfolio should therefore produce less downside risk and more opportunity on the upside.”
Yet these risks are more apparent to Wayne Phelan, chief executive of Punter Southall Governance Services. He says the job of a trustee remains the same as it always has been — “to act prudently and reasonably”.
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He says the primary focus should be on ensuring returns meet members’ expectations, and then asking whether the strategy should include an ESG focus to mitigate the chances of “creating unrewarded risks”.
But the timing of the natural capital agenda and the momentum behind ESG investment mean this concept is not going away, Millar says.
“It is good news for the planet and its inhabitants but presents fresh challenges for robust ESG assessment on the dependencies and impacts on nature,” he says.
