Banking on Nature | Mapping Nature-Positive Sectors with Financial Instrument Design
Written by Sourajit Aiyer, Insight Contributor and author of the Banking on Nature series at In|Flow
As the awareness of nature risks deepens within banks, the next stage is to structure transactions. This means considering the risk characteristics of projects in biodiversity restoration, sustainable land use, regenerative agriculture, forestry, water and ecosystem solutions, to make adjustments in financial instrument design so that projects become bankable and possibly align with credible sustainable finance standards of LMA or ICMA. This requires moving beyond eligibility screening to transaction-level structuring aligned with credit risk realities. This goes beyond screening of sectors/projects to a taxonomy but drilling into the nature of that project itself.
The intensity and severity of risks in nature-positive projects are impacted by ecological uncertainty, location, gestation periods, evolving regulations, and relatively nascent monetisation with biodiversity credits or compliance carbon markets. These risks influence counterparty-level business drivers through capex, operating expenditure, revenue or demand surety, input volatility, trade exposure and compliance obligations, which then requires tailored loan structuring through changes in financial instrument design. For bankers, this is effectively a translation exercise from ecological risk characteristics into adjustments in credit structure and repayment design.
Translating nature risk into counterparty-level business drivers
Nature-positive investments often involve significant upfront capex for interventions like land restoration, changes in farming methods, afforestation, water and biodiversity restoration. Not only is the capex need mostly higher than traditional sectors, but these often involve longer gestation periods of several years, thus delaying operating benefits via yield improvement, soil resilience or access to premium market and the realization of stable revenue.
While the trajectory of operating benefits depends on the gestation period of such projects, it may also be impacted if the initial costs of inputs are relatively high and additional costs for precision tools, training, monitoring, certification, traceability and compliances are needed. This creates a front-loaded cost structure with back ended and uncertain cash flow visibility.
The capital is constrained by this cash flow imbalance, while being exposed to physical risk from water availability, ecosystem degradation, climate variability, and transition risk from evolving regulations, etc. Visibility in demand surety may require long-term commodity offtake agreements, more so in markets where upside through biodiversity credits or compliance carbon market revenues is still nascent.
These characteristics would impact the counterparty’s business drivers through unpredictable revenue, profits and operating cash flow, potential deterioration in early-stage debt service metrics, decline in short-term interest coverage ratio and valuation, thereby reducing the bankability of the transaction.
Implications for financial instrument design
To tackle this, adaptations in financial instrument design may be needed commensurately. For example, higher gestation period and cash flow delays may be softened with an extended moratorium, longer tenors and avoiding front-loading of repayment amortization, so that it matches the maturity of the ecosystem service or biological system and the back-ended operating benefits. This alignment between cash flow profile and repayment structure is critical to avoid early-stage default risk. That implies banks need to raise long-dated patient capital to onward lend to such projects and avoid asset-liability mismatch in portfolios. Where price and supply volatility of inputs, or its import, could lead to execution and currency risk, the structure may require insurance, hedging tools or sourcing contracts to be demonstrated upfront.
Since ecological projects are long drawn and subject to execution uncertainty, phased drawdowns based on completion of specific milestones might help manage the operational and execution risks, thus minimizing credit risk exposure at any given time. The milestones may include verification or certification stages to add credibility, or they may be linked to issuance of biodiversity or carbon credits.
Uncertain system-level changes or technologies in natural ecosystems may require risk mitigation tools like first loss guarantees, concessional finance, subordinate debt, interest rate subventions, etc. to reduce default risk. This would require public and private sector financial agencies working to structure suitable funding solutions, wherein each entity contributes to the structure based on their risk-return equation. This may also involve risk-pooling through blended finance or consortium-based lending structures. Such structures are increasingly being used by multilateral banks to crowd in private capital.
If monitoring systems are strengthened, that may unlock the scope to capture impact-related data. This may be used by banks to structure repayments using performance-linked instruments. For example, sustainability-linked loans would lead to coupon step-down if pre-determined key performance indicators (KPIs) related to deforested cover, land hectares, water efficiency, etc. are measured. This also aligns borrower incentives with risk mitigation outcomes. This may also be useful in cases where the institution is unable to distinctly ring-fence the funded asset.
Applying these to credible sustainable finance instruments
While banks may be tempted to issue assets-side sustainable finance instruments to lend to nature-positive projects, the nuances of each transaction as determined by the risk characteristics and instrument design adaptations must be matched against credible standards issued by the LMA and ICMA. Instrument selection should therefore follow the structuring logic, not precede it.
These nuances may look at whether an asset or process is being funded, whether this could be distinctly ring-fenced separately or is it embedded on top of an existing process, whether the project is replicated by the company at multiple sites or is it a single project, whether impact-related data using biodiversity KPIs creates a motivation to achieve the results and avoid default risks, eligibility of projects against taxonomies or related frameworks, whether periodic reporting is possible, whether a clear trajectory of reducing negative impact to nature and biodiversity is visible, etc. These considerations ultimately determine whether a transaction is suited to green loans, sustainability-linked loans, or transition instruments. In short, most transactions will require a degree of bespoke structuring, particularly in early-stage markets.
Both IFC and the European Investment Bank have been involved in financing natural capital transactions, often using longer tenors and risk-sharing with public institutions. HSBC has supported sustainable agriculture and forestry value chains through blended finance and advisory-led lending. BNP Paribas has financed biodiversity-linked projects through its sector policies and sustainable finance platforms. Rabobank has been active in financing regenerative agriculture and food system transitions, often working alongside public institutions and impact investors. These transactions typically combine commercial lending with concessional capital, guarantees, or sustainability-linked features.
In summary, financing nature-positive sectors would require banks to map characteristics of ecosystem-related risks into implications for counterparties and adjust the financial structure and terms to minimise credit default risk. The selection of credible sustainable finance instruments would depend on this. While this would mean some redesign of credit assessment templates, it enables development of bankable projects, while enabling risk-adjusted capital allocation to new opportunities for the bank.
References:
ADB. (2021). Nature-based solutions for climate and disaster resilience in Asia and the Pacific. Asian Development Bank. https://www.adb.org/publications/nature-based-solutions-climate-disaster-resilience-asia-pacific
EIB. (2022). The EIB Group Climate Bank Roadmap 2021–2025: Supporting the European Green Deal. European Investment Bank. https://www.eib.org/en/publications/the-eib-group-climate-bank-roadmap
ICMA. (2023). Climate transition finance handbook. ICMA. https://www.icmagroup.org/assets/documents/Sustainable-finance/2023-updates/Climate-Transition-Finance-Handbook-CTFH-June-2023-220623v2.pdf
IFC. (2021). Biodiversity finance: A guide for financial institutions. IFC. https://www.ifc.org/en/insights-reports/2021/biodiversity-finance
Loan Market Association. (2023). Green loan principles and sustainability-linked loan principles. LMA. https://www.lma.eu.com/application/files/9116/7133/6535/Green_Loan_Principles_Feb_2023.pdf
OECD. (2020). Blended finance in the least developed countries 2020: Supporting a resilient COVID-19 recovery. OECD. https://www.oecd.org/dac/financing-sustainable-development/blended-finance-in-the-least-developed-countries-2020.pdf
Taskforce on Nature-related Financial Disclosures. (2023). Recommendations of the Taskforce on Nature-related Financial Disclosures. TNFD. https://tnfd.global/publication/recommendations-of-the-taskforce-on-nature-related-financial-disclosures/
Triodos Bank. (2020). Biodiversity in focus: A strategy for the financial sector. Triodos Bank. https://www.triodos.com/articles/biodiversity-in-focus
WWF. (2020). Nature is too big to fail: Biodiversity – the next frontier in financial risk management. WWF. https://wwfint.awsassets.panda.org/downloads/nature_is_too_big_to_fail_en_web.pdf
