Financial Solutions for Peatland Restoration: Additional Modelling Method and Results Overview

3. Financial Vehicles Descriptions

3.1 Introduction

The following provides an overview of the 11 options for potential financial vehicles in peatland restoration that were initially considered as part of the wider longlisting process, with a more detailed and technical description of the four options that were shortlisted through the appraisal for further research and analysis as part of this commission.

3.2 Vehicle Longlist

Peatland Code (PC) – The voluntary certification standard for UK peatland projects wishing to market the climate benefits of peatland restoration and provides assurances to voluntary carbon market buyers that the climate benefits being sold are real, quantifiable, additional and permanent. Given this vehicle is currently operational, the vehicle has been taken to be the “business as usual” option throughout the analysis.

Increasing Additionality – As above for Peatland Code (PC) – However, changing the financial additionality threshold from its current requirement of 15% of project funding coming from carbon finance to 20%, 30%, or other, to reflect reductions in public sector grant funding.

Price Floor Guarantee – Setting a guaranteed minimum price for carbon credits sequestered from peatland restoration, thereby incentivising investment in restoration by the Scottish Government guaranteeing minimum returns from sale of carbon credits. Projects could therefore trade on the open market higher than this price, but would have the security of knowing that they would always have the option of selling their credits to Government at the agreed minimum price.

First Loss Capital – Create a private fund targeted at investment in peatland restoration that is supported by public first loss capital. As returns accrue, such a fund would first pay profits to investors, until it reaches a certain threshold or ‘strike price’, after which the Government would start to receive a return as well.

Individual Carbon Contracts – Scottish Government would enter a contract with individual natural capital projects whereby it agrees to purchase a portion of the resulting carbon credits at an agreed price, often above the existing market rate, with potential guarantees that the project will report against a variety of co-benefits. This model has been used in Queensland Australia for natural capital projects since 2020.

Endowment to Support Operating/Maintenance Costs – An endowment mechanism may be useful to ensure that the lifetime costs of projects are adequately provisioned. The projects would contribute a certain proportion of their revenues from carbon sales to the endowment. The amount contributed by the projects should be a function of the modelled project lifetime cost, ideally secured in long-term service contracts with maintenance providers, and the portion of Pending Issuance Units (PIUs) sold upfront (i.e., the more PIUs are sold upfront, the higher the contribution required to the endowment). This centralised fund would then be used to support all projects’ operating costs.

Project Finance Vehicle – A mechanism that would exist within a public-private fund, established with public seed money but also attracting private investors and seeking a return. This would provide project developers with finance (e.g., in the form of a loan or equity injection into the project) to support the upfront capital costs of peatland restoration. This finance would then be repaid after the maturation of the project – either as carbon credits are raised as PIUs or when they are fully verified as Peatland Carbon Units (PCUs).

Liquidity Vehicle – This mechanism would operate within a public-private fund established with public seed capital but would seek to attract private money. Its purpose is to provide liquidity to those in the market engaging in projects through the purchase of PIUs and to attract investors into a wider carbon fund with the promise of greater returns from the matured PCUs. As a market liquidity vehicle, the fund acts as a guaranteed offtaker of PIUs, buying credits from projects upfront and holding onto them until they vest into PCUs. Projects receive a one-off upfront payment from the sale of PIUs to the fund. Investor returns are generated by the expected increase in value of the credits over time.

Environmental Social and Governance (ESG) Fund – Develop a fund to allow large corporates to donate to restoration costs as part of meeting their ESG/Corporate Social Responsibility (CSR) requirements.

Lease Payment – Under this model investors would enter leasehold contracts with existing landowners for an agreed period of years. These investors would then undertake peatland restoration work on this land and take part or all the carbon credits generated, depending on the details of the contract agreed with the landowner. Leasehold agreements do not necessarily require the investor to take 100% ownership of the carbon credits generated but could agree to a division of credits between the investor and landowner. This would not result in a permanent change in patterns of landownership. In the Interim Principles for Responsible Investment in Natural Capital, Scottish Government currently advises that investors consider whether ownership of land is necessary or if other models, including leasehold, could be used in their projects.

Land Ownership – A number of investors see land ownership, and the security that it brings to an investment, as fundamental to creating a resilient and ultimately profitable business model for peatland restoration and other natural capital works. Landownership, and the assumed appreciation in land values over time, provides significant security to investments and can allow for natural capital business models that can be sustained at a lower carbon price.

3.3 Shortlisted Vehicles

A shortlisting exercise was undertaken by Scottish Government and NatureScot colleagues. As well as other evidence, the working group referred to PESTLE analysis and the early draft of the model supplied to the team. The Peatland Code, the Individual Carbon Contracts, Project Finance Vehicle and First Loss Capital vehicles were then highlighted as the most relevant potential options for further exploration and appraisal. How these vehicles have been interpreted in the model is described below.

3.3.1 Option 1 - Peatland Code (PC)

This financial vehicle essentially acts as the baseline “business as usual” vehicle from which the analysis is derived from, given that the Peatland Code (PC) is one of the main mechanisms for peatland restoration at present. The model assumes that all restoration projects will be funded through the code. While this does not reflect reality, as there are other vehicles for restoration such as Peatland ACTION or privately-funded projects, this assumption was developed on the basis that PC projects currently represent the vast majority of projects, and the reporting mechanisms for PC projects are the most consistently-reported.

The PC is a voluntary carbon market certification that provides market participants with confidence in project quality and therefore the projects’ contributions to positive climate and environmental impacts. It is a voluntary certification standard for UK-based peatland projects seeking to leverage carbon markets for income. The PC is currently designed to attract private purchases by helping landowners to fund the costs of restoration.

Below are the key assumptions around the share of costs and benefits for government, landowners and carbon traders under the PC model.

Government / Public

Costs: Bear the full restoration costs, 50% of feasibility analysis costs, and funds a large team to secure the land for restoration.

Benefits: Does not take a share of credits or revenue, but public benefits from enhanced ecosystem services associated with peatland restoration are generated. These accumulate over the first five years, before assuming a steady state of benefit generation.

Landowners

Costs: Bear the full restoration costs, 50% of feasibility analysis costs, and funds a large team to secure the land for restoration.

Benefits: Does not take a share of credits or revenue, but public benefits from enhanced ecosystem services associated with peatland restoration are generated. These accumulate over the first five years, before assuming a steady state of benefit generation.

Carbon Traders

Costs: Landowners sell PIUs in the first seven years. PCUs are sold to traders at the farm gate. Landowners with hydroelectric plants also benefit from longer generation times and less variable flow regimes.

Benefits: Sell the PCUs from Year 8 onwards, with a margin added to cover risk, trading costs, capital costs and institutional costs.

3.3.2 Option 2 - Individual Carbon Contracts

This financial vehicle was considered as part of the appraisal process for the future delivery of peatland restoration. This vehicle allows for the Scottish Government to enter into contracts with each individual natural capital project, agreeing to purchase a proportion of the accrued carbon credits at an agreed price, with guarantees from the project developer that the project will report against co-benefits.

The individual contract model would also provide investors with confidence in a guaranteed carbon price, and government would take on credits under this model that could be sold at a later date, or used to offset public sector emissions. This model has been tested in the market elsewhere, and would be building on the key principles of the Queensland Government’s Land Restoration Fund.

Below are the key assumptions around the share of costs and benefits for government, landowners and carbon traders under the Individual Carbon Contracts model.

Government / Public

Costs: Bear the full restoration costs, 50% of feasibility analysis costs, and funds a large team to secure the land for restoration

Benefits: Takes a 40% share of all PCUs generated to sell onwards. Public goods and services are generated by enhanced ecosystem services associated with restoration. These increase over the first five years, before assuming a steady state of benefit generation.

Landowners

Costs: Bear the remaining 50% of feasibility costs, cover all monitoring, verification and credit issuance costs, and annual maintenance costs

Benefits: PCUs are sold to traders at the farm gate. Landowners with hydroelectric plants also benefit from longer generation times and less variable flow regimes

Carbon Traders

Costs: Buy PCUs from the landowners from Year 8 onwards. PCUs are discounted at the farm gate to offset contracting costs, buying costs and clustering sellers costs. The trader bears all trade and marketing costs from Year 7 onwards.

Benefits: Sell their bought PCUs from Year 8 onwards, with a margin added to cover risk, trading costs, capital costs and institutional costs.

3.3.3 Option 3 - Project Finance Vehicle

This financial vehicle was a suggested option going forward for the delivery of peatland restoration. This vehicle allows for a public-private fund to be established, initially with public seed money but also attracting investors that want a return. Developers are provided with a loan to support upfront restoration costs, paid back upon project maturity.

The project finance vehicle model enables income from carbon sales to be generated over the lifetime of the restoration project, with developers retaining PIUs until the they become verified PCUs. This allows for a steady supply of capital to meet long-term maintenance cost and reduces risk of the peatland restored becoming a stranded asset. It is also a more affordable mechanism for the Scottish Government than the previous options as private funds would be leveraged to support restoration. There is also greater incentive for projects to be successful for all parties to see a return on investment.

Below are the key assumptions around the share of costs and benefits for government, landowners and carbon traders under the optimised Project Finance Vehicle model.

Government / Public

Costs: Bears 43% of restoration and all of monitoring and securitisation costs as a loan to the finance vehicle. Bears all feasibility analysis, monitoring, verification and credit issuance costs, and funds a large team to secure the land for restoration and to also establish the fund.

Benefits: Loans are repaid over 30 years, from Year 8 onwards. This would cover the loan value and return a negligible return on investment. Public goods and services are generated by enhanced ecosystem services associated with restoration. These increase over the first five years, before assuming a steady state of benefit generation.

Landowners:

Costs: Bear 23% of the restoration costs for a 50% share of the credits. The landowner also covers all annual maintenance costs.

Benefits: Landowners sell PIUs in the first seven years. PCUs are sold to traders at the farm gate. Landowners with hydroelectric plants also benefit from longer generation times and less variable flow regimes.

Carbon Traders:

Costs: Bear 34% of restoration costs for the remaining 50% share of credits. Traders also repay the government loan over 30 years. Buy the PIUs from landowners for first seven years, and 50% of PCUs from the landowners from Year 8 onwards, at a discounted rate to offset contracting, buying and clustering costs. All feasibility costs are borne by traders from Year 6 onwards.

Benefits: Sell their allocated PCUs from Year 7 onwards, with a margin added to cover risk, trading costs, capital costs and institutional costs.

3.3.4 Option 4 - First Loss Capital

This financial vehicle was considered as part of the appraisal process for the future delivery of peatland restoration. This vehicle allows for a private fund to be established, but supported by a public first loss capital element. Profits are initially paid to investors until a threshold has been reached, after which the Scottish Government would receive a return.

The first loss capital vehicle reduces risk to private investors as they receive their returns at a higher level than would be the case in a fully private fund prior to the agreed threshold being reached. Assuming the projects are successful, Scottish Government will also receive a return on the first loss capital invested. For the purposes of this model, it is assumed that the Scottish Government provides this first loss capital as equity financing, receiving a share of the carbon credits developed through the fund, rather than the income received from loan repayments received in the Project Finance Vehicle.

Below are the key assumptions around the share of costs and benefits for government, landowners and carbon traders under the optimised First Loss Capital model.

Government / Public

Costs: Bears 40% of restoration and all of monitoring and securitisation costs, all feasibility analysis costs for first five years. Bears all monitoring, verification and credit issuance costs, in return for a 10% share of carbon credits. Government also funds a large team to secure the land for restoration and to also establish the fund.

Benefits: Sells 10% of PCUs, with the first 7 years foregone as an assumed first loss. Public goods and services are generated by enhanced ecosystem services associated with restoration. These increase over the first five years, before assuming a steady state of benefit generation.

Landowners:

Costs: Bear 20% of the restoration costs for a 35% share of the credits. The landowner also covers all annual maintenance costs.

Benefits: Landowners sell their 35% allocation of PIUs in the first seven years. 35% of PCUs are sold to traders at the farm gate. Landowners with hydroelectric plants also benefit from longer generation times and less variable flow regimes

Carbon Traders:

Costs: Bear 40% of restoration costs for the remaining 55% share of credits. Buy 35% of PIUs from landowners for first seven years, and 35% of PCUs from landowners from Year 8 onwards, at a discounted rate to offset contracting, buying and clustering costs. All feasibility costs are borne by traders from Year 6 onwards.

Benefits: Sell their allocated 55% of PCUs from Year 7 onwards, with a margin added to cover risk, trading costs, capital costs and institutional costs. Traders also sell the 35% of bought PCUs from landowners from Year 7 onwards.