A unique approach to sustainable returns

At the end of 2021, the London Stock Exchange (LSE) announced it would be launching a new market for trading in carbon credits. The Voluntary Carbon Market (VCM), which went live in October of this year, will let retail and institutional investors identify investment companies that are actively contributing to the reduction of carbon in the atmosphere, and able to generate tradable carbon credits.

It was a timely announcement from the exchange group, which revealed its plans for the VCM at the COP26 climate conference. The conference itself spurred on a wave of commitments to reducing carbon emissions across the globe.

Those built upon an existing trend among companies and governments, many of whom had already made ambitious commitments to cutting their carbon output. When the conference was held in November of last year, 60% of FTSE 100 firms had pledged to be ‘net zero’ by 2050. That had risen to 82% in August of 2022, according to law firm Boodle Hatfield.

Of course, it’s one thing to say you’ll do something as you hang out at an event, it’s quite another to take meaningful steps to do something about it. Even prior to the war in Ukraine, which exposed just how dependent we still are on oil and gas, making the shift to renewables and a carbon neutral world was never going to be easy.

But the pressures to do so are mounting. So-called ‘green-washing’, where firms take steps to cloak the negative impact they’re having on the environment, is coming under greater public and regulatory scrutiny. Lawmakers are also taking meaningful steps to reduce carbon emissions. For example, more than 50 countries have now set dates for the total or partial banning of the sale of fossil fuel powered vehicles, including the US, UK, Canada, Germany, and Japan.

This means that trouble could be lurking on the horizon for companies that, through a mix of their own commitments and governmental pressure, are going to find it extremely difficult to hit carbon emission targets over the next couple of decades.

It is here that the VCM may start to play an increasingly vital role for companies. Rather than completely cancelling out their own carbon emissions, companies are likely to also purchase carbon credits or invest in projects that ‘pay’ them in the form of a dividend for unabatable / unavoidable emissions.

In simple terms, carbon credits are issued to companies that engage in activities that reduce or remove extra greenhouse gases. These must be ‘new’ activities, so you couldn’t buy an existing forest that’s taking carbon out of the atmosphere – you’d have to acquire land and plant one. Each credit is equivalent to one metric ton of carbon, or other greenhouse gas equivalent, that is removed from the atmosphere or not emitted into it.

The VCM gives a couple of benefits to investors in this regard. It provides an accreditation to investment companies engaging in activities that help reduce or avoid carbon emissions. At the same time, it provides a framework by which listed funds can issue carbon credits as dividends. Those credits can be kept by investors to offset their own emissions, or sold on to other investors.

Foresight Sustainable Forestry (FSF) is the London Stock Exchange’s first and only VCM designated fund. Launched in November 2021, the investment trust invests in forested land or land that can be converted into forest. The trust is managed by Robert Guest and Richard Kelly. Robert has substantial experience in bioenergy and greenfield investment, while Richard has a similar track record in the real estate sector.

FSF will look to take advantage of several dynamics to deliver returns for shareholders. One is the growing demand for timber, the global supply deficit for which is forecast to triple by 2050. Combined with a growing desire to ‘onshore’ critical supplies in the wake of the pandemic, and with the obvious caveat that commodities prices are often volatile, this could help to ensure the trust generates cash in the years ahead.

Another factor at play is the increasing value of the land. In this regard, it’s worth noting that afforestation developments, which make up over 40% of the portfolio, are projected to deliver better returns than the mature forestry holdings. Grants and planting targets set by the government also add to the appeal of afforestation.

Whereas the managers predict that mature forestry sites will deliver a gross 5.8% annualised internal rate of return over the next decade, the equivalent figure for afforestation sites (excluding the carbon credit potential) is 13.4%. These returns are projections, and by no means guaranteed. The discrepancy between the two is due to the uplift in valuation that the managers believe typically follows from turning farmland into forested land, with valuations increasing as the sites are granted regulatory approvals and planting begins.

These new afforestation sites are also important because they are what will generate carbon credits for the trust. And it’s these carbon credits which may in time offer another attractive opportunity to investors.

This is largely down to a simple supply and demand problem. The number of credits used over the past three years for offsetting carbon emissions has doubled. However, over the same period there has been a 17x increase in the number of pledges made to cut carbon emissions.

Many companies appear to be banking on easy access to carbon credits, so that they can offset their own emissions. But the number of new credits may not be there to match demand, which could drive up their value.

“The issuance of new credits is pretty static, as carbon prices have not yet reached a level required to unlock many otherwise sub-economic projects,” said Richard, talking after a sustainable finance conference held at the end of September. “At the current time, if no more credits were to be created, and retirements ran at the same pace, there is only c. 4 years of supply left. When it comes to 2030, if corporates follow through on their pledges, there simply won’t be enough credits to satisfy demand.”

A consequence of this may be growing demand for shares in FSF, which will be able to hold carbon credits on its balance sheet and benefit if they rise in value, or pay carbon credits to shareholders as in specie dividends.

Around one million nature-based voluntary carbon credits are expected from the first wave of FSF’s current afforestation pipeline, and around five million by 2050. The managers have stated that they expect to retain any carbon credits on the balance sheet until at least 2030. Each carbon credit is equivalent to one tonne of carbon dioxide being permanently sequestered from the atmosphere.

In time, it is expected that investors in the company will be given the choice annually to either elect to take periodic voluntary carbon credit distributions ‘in kind’ or – by default – receive a periodic cash dividend from the net proceeds of the sale of the company’s voluntary carbon credits.

Investors today may stand to gain then, not just from the cash that timber sales generate and appreciation in the value of land, but also the possible increase in the value of carbon credits over the next decade – as the focus on carbon offsetting becomes ever more intense.

Taken as a whole, that means FSF offers investors potential access to what looks like it could be a thriving market in carbon credits. At the same time, the core investment thesis appears strong and, perhaps most importantly, it combines the prospect of delivering financial returns with helping to reduce carbon emissions.

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