Four Ways Philanthropy Can Accelerate Nature-Based Solutions
By Grace Edinger, Procurement Policy Strategy Lead; and Phoebe Higgins, Director of Nature and Markets
Nature-based solutions (NBS) markets offer powerful tools to improve water quality, protect ecosystems, and strengthen communities. Philanthropy plays a critical role in scaling these efforts by bridging gaps in financing, policy, and market coordination.
The following four recommendations highlight where strategic philanthropic investment can unlock progress—expanding the pool of buyers, attracting additional private capital, and catalyzing industry. Each is ripe for immediate action and long-term impact. Read more in EPIC’s report, Capital in Nature-Based Solutions Markets.
1. Increase Buyers through Key Policy Initiatives
Without a buyer of the environmental outcome, there can be no market.
Because ecosystems are public goods shared by all, policy is the primary driver for buyers in NBS markets. Investments in policy change can have a substantially outsized impact. The largest and most notable examples of key environmental laws driving investment in nature and restoration are the Clean Air Act of 1970, the Clean Water Act of 1972, and the Endangered Species Act of 1973. More recently, Biodiversity Net Gain legislation in England has catalyzed hundreds of millions of dollars of investment.
With the election of Donald Trump, it is unlikely that significant national policy on NBS will be a priority for the administration. However, states can act as policy sandboxes for legislation that, if successful, could ultimately be adopted at the Federal level or proliferate to other states.
There are a few opportunities to make relatively small investments of less than $ 5MM in policy that would have an outsized impact on NBS markets:
Increase Pay for Success (PFS) Policy Efforts: A clear example of state-level policy proliferation is the emergence and spread of performance-based, or Pay for Success contracting. Pay for Success is a procurement method through which a funding entity pays for specific outcomes upon delivery. Funding is needed to further advocate for these procurement structures in other states struggling to improve non-point source water quality.
The PFS model encourages greater private sector participation in restoration projects by guaranteeing payment for verified outcomes so project developers can anticipate revenues and plan project costs and financing accordingly. If the government creates a positive, repetitive signal that it will purchase a certain outcome every year, there is less risk for the developer under the assumption of a guaranteed buyer. This would require consistent funding over a long period to realize. These contract structures can also help the public sector match revenues with expenses.
EPIC has written extensively about Pay for Success contracting. Additional resources can be found here.
State Level Biodiversity Policy Advocacy: The Biodiversity Net Gain policy in England, similar to the compensatory wetlands mitigation market in the U.S., could be replicated in a state. Fundamentally, in all pollution or ecosystem damage markets, the most efficient solution is to have the parties doing the pollution/destruction pay for the cleanup and restoration. This increases the economic cost of the destruction, thereby disincentivizing it and increasing incentives for restoration activities. England’s policy attempts to put the responsibility for paying for restoration on the entity causing the damage. The public sector, therefore, does not need to tax citizens to pay for the cleanup. Instead, the public sector plays a supervisory role.
EPIC has produced several resources on biodiversity market formation, including:
2. Seed a Corporate Growth Equity Fund
Capital markets can play a key role in moving businesses across this chasm.
A concept popularized by Geoffrey Moore, in the book called “Crossing the Chasm”, many companies in the NBS markets are in the early adopters phase of the business life cycle. That is to say, they have proven their technology, product, or services, but have yet to achieve the next level of scale by selling to a larger, more mainstream market.
Capital markets can play a key role in moving businesses across this chasm. Capital invested in growing companies with proven products can be highly impactful to a company’s chances of reaching a broader audience. Currently, there are very few growth equity investors in the NBS markets.
Most equity investments to date have been made in projects, which can be a less risky and more distinct concrete investment. Growth equity, on the other hand, tends to focus on building a team and company capabilities. These values can be harder to quantify. Investing in the growth equity of a company requires taking the view that future opportunities for a company will be greater than current opportunities. Whether that improvement comes from growth in the markets themselves, or the growth or competitive advantage of a particular company participating in a market, or both.
A $50MM investment to seed the formation of an NBS growth equity fund to make strategic investments in growing NBS businesses could help move technology and companies to scale. There are a few ways in which a foundation could execute on a growth fund. The first way would be for them to establish this fund itself, by hiring a small but experienced team internally to source and close on growth equity transactions. Another option would be to partner with a private equity firm investing in the space and either start a new partnership or invest directly in a limited partner structure focused on growth equity in NBS. This could be advantageous as it does not require hiring and building a team and developing in-house expertise. In either case, once an initial investment seeds the fund, additional capital could be raised to expand the fund's capabilities.
3. Invest in a First Loss Capital Structure
One primary reason for the lack of significant debt capital present in the NBS markets is the presence or perceived amount of risk that a typical debt investor would bear. One potential investment tool to reduce risk is to increase the use of blended finance structures that use a first loss position.
A first loss position is an investor in a structurally subordinated position whereby this investor would suffer the first economic loss if the underlying assets lose value. For example, if $100 was expected to be received, $80 would flow to a more senior investor, and $20 would flow to the first loss position. If only $95 came in, the $80 would still flow to the senior investor, and only $15 would flow to the first loss position. In typical market-based financings, this first loss position would charge a higher interest rate to compensate for the higher risk of the investment. Concessional first loss capital can be used effectively in the following circumstances:
If the risk potential is too high for market-based investors
The underlying assets cannot support the higher cost interest of market-based investors
To improve additionality by helping coerce market-rate participants to participate in a transaction they otherwise would not have
The last circumstance is a particularly important element of a successful concessional first-loss investment. Oftentimes information, knowledge, experience, or track record impedes market-based investors. In other words, a transaction is no less risky or valuable, but a fear of something new can prevent investment. By providing a first-loss investment, a concessional capital provider can receive a nominal return and increase additionality by bringing more investors into an NBS market. In future transactions, once a track record is established, market-based participants can invest in the first loss position.
One disadvantage of making an actual investment in a first-loss structure is that it can be difficult to scale because larger amounts of cash are needed. Alternatively, guarantee structures can be used whereby a concessional capital investor provides a guarantee or limited guarantee of payment for outcomes. For example, going back to the $100, instead of the first loss position providing the 20% investment, they provided a guarantee of the 20% position. At closing and if the full $100 came to fruition, no money would be owed, but if $95 was received, the first loss guarantor would owe $5. This can reduce the amount of capital needed to reduce the same amount of risk.
4. Invest in an Aggregation or Bridge Debt Facility
Debt capital has several advantages, including lowering financing costs and increasing scale, thereby increasing impact. Additionally, from an investor’s perspective, debt investments, once repaid, can be recycled back into more projects, increasing impact. Even if the interest rate is zero or nominal, because a debt product returns the principal amount of capital to an organization, it can be reinvested into other projects.
NBS assets can be smaller in size and more distributed throughout a geographic area. For example, in the non-point source water quality market, some cost-effective NBS solutions, such as riparian forest buffers, are smaller investments, with each project being under $500,000. If a debt investor has a minimum investment size of $30MM, it would take dozens of projects to reach a size that a debt investor would find attractive. This dynamic of smaller projects also applies to other markets within NBS, such as biodiversity and hazard mitigation. An aggregation debt facility could help ecological restoration providers raise better capital to fuel growth.
Additionally, one challenge in the NBS markets is project timing. There are scenarios where an ecological service provider needs to acquire land or construct the project; however, grant funding will take a significant amount of time to secure. The project costs come well before the revenue, creating a financing gap. A bridge debt facility could help solve this problem faced by ecological service providers by offering a loan to cover the time between the project cost and the final payment.
These recommendations highlight where we believe strategic philanthropic investment can unlock major progress in the NBS space. Read more in EPIC’s report, Capital in Nature-Based Solutions Markets, and please reach out to Phoebe Higgins, Director of Nature and Markets, for further discussion.