The case for carbon credits in land-based solutions
Martin Davies from Nuveen Natural Capital argues that land-based investment opportunities are set to surge as global carbon markets mature.
Recent heatwaves have brought the stark reality of rising global temperatures and weather extremes to the fore. In England, July 2022 was the driest July since 1935 and the driest ever on record for southern England, according to the UK Met Office.
Reducing CO2 emissions in the atmosphere is now imperative if we are to achieve the Paris Climate Agreement to keep warming below 2°C, and to meet net-zero targets. Yet the solution is far from black and white. Some emissions are unavoidable, especially in the short-term as economies transition to low-carbon systems.
As carbon credits to reduce CO2 emissions rise in popularity, we are seeing a significant opportunity for land-based investments. Over one-third of the cost-effective, scalable emissions mitigation opportunities come from natural-based climate solutions such as forests, land and agriculture.
Land-based investments are, therefore, well-positioned to benefit from growing demand for carbon credits, as climate action ramps up across private and public sectors, and as timberland and farmland’s capacity to generate verified credits is recognised.
Increasing demand for carbon credits
As economies shift away from carbon-intensive energy, transportation and production systems, there will be some unavoidable emissions that need to be offset. As such, in 2021 the value of the voluntary carbon market – carbon credits issued on a voluntary basis through an independent market programme – grew by 190% to $1bn as corporates, financial institutions and governments began to set ambitious emission-reduction targets and net-zero commitments.
In the short-term, carbon credits can be used to complement emission-reductions pathways, by offsetting hard-to-abate emissions. In the long-term, as production systems and supply chains decarbonise, carbon credits can be used to balance residual emissions to achieve net-zero targets.
The financial services industry is the largest source of demand for carbon credits at present, accounting for about half of all nature-based climate solutions credit purchases, followed by the chemicals and oil and gas sectors. Further demand will be driven by decarbonisation across all sectors of the economy.
We can estimate demand growth based on current and expected future corporate net-zero commitments and residual emissions that would need to be offset by carbon credits. The most conservative estimates assume no further net-zero commitments being made, leading to future demand of 2 gigatons of carbon credits per year by 2050. Other estimates suggest voluntary market demand growth could increase to as much as 13 gigatons per year by 2050, 100 times the demand in 2020.
Land-based investments are well-positioned to benefit from growing demand for carbon credits, as climate action ramps up across private and public sectors, and as timberland and farmland’s capacity to generate verified credits is recognised.
Why are land-use carbon credits dominating?
Within the forestry sector, there are three main forest management activities that generate carbon credits: avoided deforestation, forest restoration and improved forest management. Indeed, these forest projects account for most of the land-based carbon credits issued to date. Forestry accounted for 39.5% of global credits issued between April 2020 and 2021, more than renewable energy. Agriculture made up just 0.2% of global credits issued during the same period. However, the market is rapidly developing, with increasing soil carbon storage front of mind.
Nature-based solutions are lower cost compared to technological interventions, scalable, high-quality, and can generate social and environment co-benefits. Forestry and land use credits are a major source of supply for carbon credits because these sources of emissions reductions and removals are proven and among the cheapest.
In terms of carbon abatement and carbon sequestration costs, agriculture and forestry are in the $40-100 per one metric ton equivalent CO2 cost range and have the potential to generate more than 10 gigatons of CO2 equivalent each year. This is compared to alternative methods of capturing and removing CO2 from the atmosphere, such as direct air carbon capture and storage, where scalable technologies are still under development and can cost more than $400 per metric ton equivalent.
The ability to generate carbon credits from land has the potential to enhance investor returns and provide diversification benefits when credits are monetised, adding returns of about 250 basis points.
Investor benefits
As climate action continues to spread across the economy, timberland and farmland’s capacity to generate verified carbon credits will be increasingly valued by investors. Investments in timberland and farmland that reduce or remove greenhouse gas emissions and generate high-quality carbon credits can offer tremendous climate mitigation benefits and returns for asset owners.
The ability to generate carbon credits from land has the potential to enhance investor returns and provide diversification benefits when credits are monetised, adding returns of about 250 basis points. In addition, returns from investment strategies, including the joint production of carbon and timber or carbon and agricultural crops, appear to be weakly correlated with returns from traditional timberland and farmland. As a result, management for carbon has a potentially beneficial diversification role in land-based portfolios.
Latin America provides excellent opportunities for nature-based solutions at the greatest scale and lowest cost, so investment in this region and the US, where vast areas are in conventional farming systems, will be critical to achieving maximum climate benefits and where investment opportunities will be greatest.
The case for carbon credits in land-based solutions is strong – both from an impact and investment perspective.
Martin Davies is global head of Nuveen Natural Capital.
