- Different instruments suit different kinds of investor.
- Types of funding need to consider the life cycle of a project. Grant funding is often needed in the early stages before the scheme generates returns. Loans may be introduced later to finance producers directly.
- In some cases, financial instruments such as bonds may be useful for refinancing land use projects which are already up and running.
The Unlocking Forest Finance project aimed to ultimately design innovative financial mechanisms to channel finance to producers interested in implementing sustainable land use activities. The financial mechanism is the structure of financial instruments and other tools that together allow investors and producers to agree on the terms of financial risk and return expected.
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There are many possible financial instruments. It may be that one single instrument would work well, but it is most likely that a combination of different instruments make up a financial mechanism to provide a suitable profile of risk and financial returns, both to investors and farmers.
Moreover, finance from different instruments can be blended into a single financial mechanism, or complementary instruments can be used to fund different elements of the project. For example, a loan may be used to finance a supply chain, while a grant may be necessary to cover a portion of the technical assistance needed for interventions, especially before the investment generates any returns. Success will depend on tailoring financial mechanisms to a particular context.
1. Payment for results
Results-based payment (or payment by result, PBR) is a relatively new type of public policy instrument for paying for public services. This means that instead of paying for inputs and determining the policy of choice to be implemented, donors pay for the results (outputs or outcomes) achieved, independent of how they were achieved.
In land use, results-based payments often means a donor country pays another country depending on how much the recipient reduces deforestation compared to a historic baseline. Payments are dependent on independent verification that the country has met these targets. So far, evidence supporting PBR is inconclusive, but theory suggests that if designed and delivered well, it could have positive results. Effectively, this means that the donor only pays for what is achieved.
There are already several examples of these policies in practice. The REDD Early Movers Programme (REM) was commissioned by the German government in 2012, offering payments for forest conservation to support early REDD projects (Reducing Emissions from Deforestation and Degradation). Similarly, the Forest Carbon Partnership Facility (FCPF) also aims to support the roll-out of REDD in forest countries.
More direct cooperation between governments is also possible. In 2008, Norway signed an agreement with Brazil to pay up to US$1 billion over a 5-year period, in return for bringing greenhouse gas emissions from deforestation below a 10-year average (1996–2005).
A bond is a financial instrument for raising money from private capital markets in exchange for a promise to pay it back, alongside interest payments called coupons. These instruments are optimised for the needs of the financial markets: they have high liquidity and are standardised. This means that bonds can be broken down into smaller units, thus spreading the risk among many investors. There are myriad possible structures. They are intended to mobilise large sums of money, almost always above US$50 billion and often over $1 billion.
There is growing interest in issuing ‘green bonds’ for addressing climate change. However, it should be noted that these have the same return as regular corporate bonds, but with the additional cost of certification.
To issue a bond, projects will need to find an interested bond issuer and buyers. The process requires a portfolio of projects to be securitised, which is easier when projects are already running. This means bonds work well for raising additional capital but they are less suitable for projects at proof of concept or early investment stages.
In the past, raising money through green bonds has been more successful in areas such as renewable energy, where the portfolio is made up of a small number of projects, with lower risk profiles and involvement of larger players. It is much more complicated to build a portfolio for a sustainable landscape finance project, which may include thousands of diverse producers, processors and other participants. These limitations mean that bonds may not be the best instrument in many cases, at least until a strong portfolio is up and running.
Equity capital is given in exchange for a share of a business, and in some cases, some control. In the case of sustainable landscapes, equity investors are most likely to invest in businesses producing environmentally sustainable commodities, such as farmers and processing facilities. Equity funding can be invested at different stages of a project.
Examples of equity investors:
Early capital providers are private sector funds which aim to grow incipient projects to then attract private investors. Katoomba Incubator is an example of this type of fund.
Equity participation funds finance private investors in regions where private equity funds are absent. Acumen is an example of this type of fund.
In many cases, loans may be appropriate for directing finance to sustainable land use, particularly in cases where there is a clear economic return, for example in improving the efficiency of farming methods. This is the case as economic returns would generate capital to pay the loan back.
Loans are taken out at the beginning of the contract and repayment starts at the end of the grace period. Payments are usually per annum or per month, with repayments being deducted from the outstanding debt. Loans can cover working capital (for the day-to-day running of the business), fixed capital (for larger, capital investments such as machinery) or both.
In most cases loans are secured against collateral, for example property or equipment. However, this may be difficult in areas of forest where land ownership rights are not fully defined, or for organisations without an asset base. In such cases the borrowing cost may be higher. There are innovative ways of addressing this problem. In some cases, the need for collateral can be bypassed altogether by looking at alternatives for collateral, such as cash flow evidence.
Some investors will offer concessional loans. These are loans that are extended on terms substantially more generous than market loans. The concessionality is achieved either through interest rates below those available on the market or by extended grace periods, or a combination of these factors.
Grants do not need to be paid back. Nonetheless, grantors may impose particular conditions on the grantee. If these are not met, subsequent payments may be withheld.
New projects can be particularly dependent on grant funding at the start. Grant funding may also help fund specific elements of landscape finance projects which do not return a profit directly, for example monitoring systems or conservation.
Applying for grants should be seen as a long-term strategy. From the time of application, large grants can easily take two years for approval before any money can be disbursed. This is much longer than the time taken by loans or other kinds of private sector investments, so project managers need to plan accordingly.