BGRN - Growing Green: Cultivating A Sustainable Future Through An Ecosystem Service Valuation

2023-12-07 02:53:00 ET

Summary

• Climate change and a rapidly growing population are putting increasing pressure on ecosystem services.
• The more financially robust the issuer, the greater the probability of a bond being repaid.
• An expanding market means greater potential diversification opportunities.

By David Zahn, CFA, FRM, Head of European Fixed Income, Franklin Templeton Fixed Income & Kasper Hanus, Ph.D., Sustainability Manager, Franklin Templeton Fixed Income

The Franklin Templeton Fixed Income team believes that sustainable investing will be a dominant investment trend in the coming years, with structural tailwinds that could help improve financial returns.

What are ecosystem services?

In short, they are the benefits we all derive from the environment. The list is long - not only the joys of recreation and tourism but also more fundamental benefits such as the supply of food and clean water, flood and wildlife regulation, and pollution and pest control. These come at a cost, however.

Thankfully, an increasingly diverse green bond market is helping to finance the protection of our Earth's natural capital - those elements we as a society value, such as our forests and rivers - and to encourage biodiversity. Best of all, the development of the sustainable finance market makes it easier for asset owners to potentially earn a compelling investment return and also make a positive impact on the environment.

Nonetheless, climate change and a rapidly growing population are putting increasing pressure on ecosystem services. As this pressure builds, so does our need to act. The Franklin Templeton Fixed Income team believes that sustainable investing will be a dominant investment trend in the coming years, with structural tailwinds that could help improve financial returns.

Ecosystem through the lens of an investor

We understand that many investors seek not only to improve the returns on their investments but also to make a positive impact on the physical environment. Both aims can be precipitated by considering ecosystem services within the investment process.

How is this? Well, first of all, by us - the investment professionals. We believe the consideration of ecosystem services in our research process can unearth material insights the wider market has not yet captured, and help deliver sustainable returns for our portfolios.

The second benefit comes from the bond issuers themselves. Sovereign and corporate issuers that fully understand the environmental challenges ahead - and are already taking steps to address them - are more likely to be able to navigate the peaks and troughs of longer-term market cycles. The more financially robust the issuer, the greater the probability of a bond being repaid. Issuers that can ride out the longer-term financial ups and downs should be particularly suitable for the buy-and-hold strategies pension funds and insurance companies favor. Indeed, pension funds could be a formidable force in getting companies to embrace environmental, social, and governance ((ESG)) values, such as combating climate change or advancing employment equity.

Thirdly, the financing of ecosystem services projects can have a direct and beneficial physical impact; for example, cleaner air or a lower risk of flooding through woodland conservation.

In short, good financial returns can go hand in hand with a positive influence on the environment.

Ecosystem services can be provided as a public service, for example by national or local governments. Such services would have to be accessible to the entire population and could be paid for via taxes or user fees, for example. There is a multitude of ecosystem services that are central to national economies, critical for agriculture, clean water supply, energy generation, and more. Their provision (and protection) is not a fringe benefit but focal to the functioning of an economy and should, therefore, be prioritized by governments alongside other public goods such as healthcare, education, or transportation infrastructure. From our point of view, payments for ecosystem services would have one additional benefit, namely that payees would now have a vested interest to demand their provision and public entities could be held accountable. This, in turn, would ensure the protection of natural capital in order to deliver these obligatory ecosystem services.

As investors, we can help finance the infrastructure necessary for the provision of public ecosystem services. For example, this could mean funding the Uruguayan police force (through investments in local treasury bonds), which needs to enforce laws prohibiting the destruction of the country's native forests.

Ecosystem providers can also be private entities - companies that are paid directly by their customers. In Brazil, hydropower plants, which incidentally account for 65% of the country's electricity mix, are interesting beneficiaries of ecosystem services. Upstream revegetation can extend the life of reservoirs as it reduces the sedimentation process. ¹ The recipient could directly pay a private company providing such a service to an electric utility.

At the same time, potential consumers of ecosystem services need to understand their value (over both the shorter and longer term) and pay for their provision. By way of illustration, let us consider a large food and beverage company requiring bees for the pollination of its crops. Bee pollination is thought to improve both crop quality and yield quantity. ² Such a company could issue a bond either to pay for the construction of beehives or to cover the operating expenses of paying a third party for the provision of pollination services.

We believe that it is important to address some of the controversies related to financing the fight against climate change. There is a lot of rhetoric that insists that regular, working people who cannot afford the additional burden bear the cost of the transition to a net-zero economy. It would be useless to pretend that there are no costs related to the energy transformation; however, people, local and national governments, corporations, and supranationals (such as development banks, for example) will share these costs. There are also significant costs related to exploiting nature, as highlighted by an independent report conducted for the UK government, which conservatively estimated that global subsidies that damage nature total around US$4-U$6 trillion each year. ³

The cost of transforming the way we produce and consume energy, as well as changing our approach to natural capital is certainly high. However, the cost of doing nothing will be much greater. According to a United Nations Environment Programme report, more than half of the world's gross domestic product ((GDP)) is reliant on nature. ⁴ Consequently, one study estimated that the direct cost of ecosystem loss and degradation could reach US$10 trillion by 2050 ⁵ (though we've seen estimates that were twice as high ⁶ ). On the flip side, the World Economic Forum expects that nature-positive policies could create more than US$10 trillion in new business value annually by 2030. ⁷ It is clear too that the path toward a more sustainable future will not be easy. Yet, this change carries with it a host of opportunities for shrewd investors.

A still relatively small but rapidly growing market offers a new and exciting opportunity set. An expanding market also means greater potential diversification opportunities. While diversification cannot assure a profit or protect against loss, we believe that the benefits of diversification, coupled with strong security selection, are the keystones for desired above-benchmark returns over a longer-run investment horizon. And, of course, the growing green bond market, one in which the Franklin Templeton Fixed Income plays a leading role, can help check climate change and environmental degradation and so ensure that future generations can enjoy the world as we know it today.

What Are The Risks?

All investments involve risks, including possible loss of principal.

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed-income securities falls.

Green bonds may not result in direct environmental benefits, and the issuer may not use proceeds as intended or to appropriate new or additional projects.

The managers' environmental, social, and governance ((ESG)) strategies may limit the types and number of investments available and, as a result, may forgo favorable market opportunities or underperform strategies that are not subject to such criteria. There is no guarantee that the strategy's ESG directives will be successful or will result in better performance.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton-managed portfolio.

1. Sources: Marmedes, Ingrid, et al. 2023. Brazilian payment for environmental services programs emphasize water-related services. International Soil and Water Conservation Research, Vol. 22, Issue 2. Geluda L., Young, C. E. F. 2014. Pagamentos por serviços ecossistêmicos previstos na lei do SNUC - teoria, potencialidades e relevância. III simpósio de Áreas protegidas. Viçosa-MG.

2. Sources: Klatt Björn K., et al. 2014. Bee pollination improves crop quality, shelf life, and commercial value. January 2014. The Royal Society Publishing, Vol. 281 Issue 1775. Stein, K., et al. 2017. Bee pollination increases yield quantity and quality of cash crops in Burkina Faso, West Africa. Scientific Reports, Vol. 7, Article no. 17691.

3. Source: Dasgupta, P., The Economics of Biodiversity: The Dasgupta Review, February 2021, HM Treasury.

4. Source: United Nations Environment Programme, 2021. Becoming #GenerationRestoration: Ecosystem restoration for people, nature and climate.

5. Ibid.

6. Source: United Nations Convention to Combat Desertification, 2018. Analysis of 21 Land Degradation Neutral ((LDN)) Country Profiles. There is no assurance that any estimate, forecast, or projection will be realized.

7. Source: World Economic Forum, 2020. The Future of Nature and Business. There is no assurance that any estimate, forecast, or projection will be realized.

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