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

4. Analysis Results

4.1 Introduction

The following details the results of the core analysis arising from Version 12 of the model. It considers the total carbon credits derived from restoration of 175,000 hectares of degraded peat up to 2030 as per the Scottish Government’s current peatland programme target. The total appraisal period for the model assesses impacts over 90 years, and considers the various costs, revenues, and the Internal Rates of Return (IRR) for the public sector, the private sector (split out across landowners and carbon traders), and the societal costs and benefits of each of the four financial vehicles appraised as part of this analysis. This analysis has been conducted to inform future development of peatland restoration in Scotland from private finance, drawing on other relevant evidence and insights to ensure a robust and informed approach.

4.2 Scenario Development

As part of the development of this model, a scenario workshop took place in August 2024 with relevant Scottish Government teams across policy, analysis and private investment. Four scenarios were developed which considered the degree to which there would be barriers to entry (high and low), and the extent to which there would be economic growth (again, high and low), to generate four plausible peatland restoration contexts for the appraisal period.

Variables were identified across each of the four different scenarios (high barriers to entry and high economic growth; low barriers to entry and high economic growth; high barriers to entry and low economic growth; and low barriers and low economic growth) as follows:

1. Government policy influencing CO2e trade levels;

2. Supply of carbon credits;

3. Demand for carbon credits;

4. Economic affordability;

5. Carbon credit prices;

6. Carbon credit securitisation costs;

7. Opportunity costs of restoration (competition for land resources);

8. Incentives to retire credits;

9. The restoration contractors’ capacity to deliver to scale required;

10. The private sector investors’ appetite in delivering through the funds;

11. The private sector’s ability to invest in higher CO2e-yielding peat;

12. The value of ecosystem services;

13. The importance of biodiversity credits in trade; and

14. The possibility to adopt an insetting approach.

Each of these variables were discussed at the workshop, with discussion focused on the extent to which each of these variables would be affected in the different scenarios, and then, following this discussion, a resolution as to which scenario would be further explored within the model was provided.

A description of each of the four scenarios and the resulting changes across the four variables can be found below.

High Barriers to Entry and High Economic Growth

The economy is flourishing, with high economic growth, competition for productive land is active and service providers are following the money leading to shortages in servicing the least productive sectors. The peatland carbon trade has high barriers to entry and high transaction costs. There is little regulation incentivising offset buyers to purchase peatland carbon credits and at the same time the Peatland Code is not eligible for the Emission Trading System (ETS). International agreements further limit the use of peatland carbon as offsets. Given the high economic growth peatland carbon credits are affordable. However, the biodiversity credits market in Scotland is not developed, and consequently there is no opportunity to double-up both carbon and biodiversity credits’ revenue from peatland restoration. Landowners can only rely on carbon revenue from restoration. Consumers (and the general public) are generally unaware of the opportunities which peatland carbon credits offer, demonstrating market failure through information asymmetry, and there's little pressure on buyers to buy these credits. The uncertainty in the market regarding the future use of credits generate risk to serious investors – despite carbon prices being affordable - which limits large scale demand. The grants offered crowd out peatland restoration for carbon trading purposes, especially where transaction costs are higher. The uncertainty regarding the ownership of carbon credits on leased land prevents tenants engaging in peatland restoration. In addition, the uncertainty of agricultural subsidies, also limits long term changes in land use.

Supply is limited to large landowners who can speculate on carbon and who can generate some economies of scale in the transactions costs. The market excludes lower value trades due to a reliance on carbon-only trades (no biodiversity) and supply excludes less well-off landowners, who can’t afford to speculate or can’t afford the transaction costs. Credits bought tend to be retired due to transaction costs and scarcity. The limitations of nature-based solutions to carbon offsets generates a stimulus for alternative carbon capture and storage mechanisms to be pursued. The possibility to adopt an insetting approach is limited as, despite it being a potentially valuable approach, there are high barriers to entry in this scenario.

Table 4.1 details the plausible trends across these variables in the High barriers to entry and High economic growth scenario, where the extent of change across the variables is measured with 2 representing a large increase, 1 representing a small increase, 0 representing no change, -1 representing a small decrease and -2 representing a large decrease.

Low Barriers to Entry and High Economic Growth

The economy is flourishing, with high economic growth, competition for productive land is active and service providers enter the restoration sector. Trading peatland carbon is easy and with regulations incentivising offset buyers to purchase peatland carbon credits. The ETS rules are changing and together with international agreements the use of peatland carbon for compulsory offsets will be feasible in the medium term stimulating long term deals. Given the high economic growth, capital costs are low and peatland carbon credits are affordable, especially as revenue is earned from both carbon and biodiversity credits from peatland restoration. Consumers (and the general public) understand the role of peatland restoration in contributing to Net Zero targets and demand that corporations utilise peatland carbon credits further elevating demand. The greater certainty in the market regarding the future use of credits promotes large scale demand. The greater certainty regarding the ownership of carbon credits on leased land encourages tenants to engage in peatland restoration and the clarity regarding subsidies (which are supportive of nature-based solutions) fosters long term investments into land use, all of which encourages supply. Supply of peatland is offered by large and small producers. The market is inclusive and supports Scottish land reform goals, for example, by offering credit distribution models for tenants and crofters as well as current landowner models. Credits are both bought and sold freely with brokers playing an active role. The more certain prices of peatland carbon and biodiversity credits and supportive agricultural subsidies for nature-based solutions lead to the peatland market offering greater competition to alternative carbon capture and storage mechanisms. It is possible to adopt long-term insetting approaches and, given the high economic growth scenario, this will be of high value.

Table 4.2 details the plausible trends across these variables in the Low barriers to entry and High economic growth scenario, where the extent of change across the variables is measured in the same manner as above.

High Barriers to Entry and Low Economic Growth

The economy is sluggish, with low economic growth, the peatland carbon trade has high barriers to entry and high transaction costs. There is little regulation incentivising offset buyers to purchase peatland carbon credits. The peatland code is not eligible for the Emission Trading System (ETS) and international agreements further limit the use of peatland carbon as offsets. Given the poor economic growth and high transaction costs, peatland carbon credits are unaffordable. In addition, the biodiversity credits market in Scotland is not developed, and consequently there is no opportunity to double-up both carbon and biodiversity credits’ revenue from peatland restoration. Consumers (and the general public) are generally unaware of the opportunities which peatland carbon credits offer, demonstrating market failure through information asymmetry, and there's little pressure on buyers to buy these credits. The uncertainty in the market regarding the future use of credits and the current affordability problem, generates considerable risk to serious investors – leading to muted demand. The grants offered crowd out peatland restoration for carbon trading purposes. Given the uncertainty regarding the ownership of carbon credits on leased land, tenants are reluctant to engage in the trade of peatland restoration carbon. In addition, the uncertainty of agricultural subsidies also limits long term changes in land use. As with demand, supply is constrained as landowners adopt a wait and see attitude. The market is confined to boutique trades where price is less of a concern. The limitations of nature-based solutions to carbon offsets generates a stimulus for alternative carbon capture and storage mechanisms to be pursued. The possibility to adopt an insetting approach is limited by both the high barriers to entry to market not making this approach possible, but also by the lack of economic growth meaning there would be little value added from following an insetting approach.

Table 4.3 details the plausible trends across these variables in the High barriers to entry and Low economic growth scenario, where the extent of change across the variables is measured in the same manner as above.

Low Barriers to Entry and Low Economic Growth

The economy experiences persistent low economic growth, the Scottish Government has been active in eliminating trading barriers and transaction costs in peatland carbon credit trading. In addition, regulations now actively encourage offset buyers to purchase peatland carbon credits. However, the peatland code remains ineligible for the ETS and international agreements further limit the use of peatland carbon as offsets. On the other hand, the biodiversity credits market in Scotland has developed, providing an opportunity to double-up both carbon and biodiversity credits’ revenue from peatland restoration, making carbon projects more affordable. Consumers (and the general public) are aware of the benefits which peatland carbon credits offer society and corporations are pressured to buy these credits, but this is limited by low growth in the market. The greater certainty in the market and the opportunity to generate both carbon and biodiversity credits from restoration elevates carbon prices, however, prices remain under pressure due to affordability. The grants no longer crowd out peatland restoration for carbon trading purposes and carbon ownership by tenants is possible. There is clarity in the application of agricultural subsidies, which supports long term adoption of land use. However, capital for restoration is unaffordable, with joint ventures being critical to fund large scale restoration. The sluggish economy and ease of trading peatland carbon encourages landowners to offer their land for restoration for unlocking additional revenue streams. Efficient projects are able to be successful in this context, but any constraints either linked to stock or production will exclude participation in the market. The limitations of nature-based solutions to carbon offsets generates a stimulus for alternative carbon capture and storage mechanisms to be pursued. While an insetting approach may be developed under this scenario, there is little value added from this due to low economic growth.

Table 4.4 details the plausible trends across these variables in the Low barriers to entry and Low economic growth scenario, where the extent of change across the variables is measured in the same manner as above.

4.3 Total production of carbon credits

Within the 90 year project life time, a total of 44.5 million tonnes of CO2e emission may be avoided by effectively restoring and managing 175,000 ha of degraded peatland over the next 5 years (assumed to be 2025 to 2030). This means potential for 44.5 million peatland carbon credits produced through this activity.

4.4 Outcomes of the benefit cost analysis

Engaging a suite of some 40 variables, a cost benefit analysis (CBA) was undertaken of four financial instruments. Two of the instruments (Peatland Code (PC) and Individual Carbon Contracts) are largely government contracts with project developers or landowners, and the other two instruments (project finance vehicle and first loss capital) are largely funds driven by a partnership between government and private sector carbon credit traders or project developers via a facilitating role.

The PC was selected as the “business as usual” option for analysis as it is the largest and most commonly-applied vehicle for delivery of peatland restoration activity in Scotland. While it should be noted that there are other modes of delivery (e.g. projects that may be eligible for funding through Scottish Government’s Peatland ACTION programme or privately-funded projects), the IUCN PC programme provided the most consistency in data reporting, and all parties involved in the analysis had a deeper working understanding of the project-level requirements to shape inputs for the analysis.

The CBA separately analyses the costs and benefits for the three key role-players – government, private sector carbon credit traders (or carbon project developers) and landowners, as well as for society as a whole (the sum of all three role-players) and for the private sector (the sum of land owners and traders). Analysing the incentives for each role-player group is critical to evaluating the viability of each instrument for each group. The BCA therefore compares the indicators for 4 instruments with five role-player clusters. The clusters are detailed as follows, in Table 4.5.

Table 4.5: Role-player Clusters

Cluster: Public

Relevant Roleplayers: Government costs and revenue Wider public social benefits

Cluster: Land owner

Relevant Roleplayers: Land owner costs and revenue only

Cluster: Trader

Relevant Roleplayers: Carbon trader costs and revenue only

Cluster: Private

Relevant Roleplayers: Land owner costs and revenue Carbon trader costs and revenue

Cluster: Society

Relevant Roleplayers: Government costs and revenue

Wider public social benefits Land owner costs and revenue Carbon trader costs and revenue

A generic set of inputs is outlined below in Table 4.6 to show the key headline variables, the full list being documented in the model.

Following the scenario workshop detailed above it was decided that the high barriers to entry and low economic growth scenario best represented current reality, and therefore should be explored further as part of the development of this model. The impacts of the inputs on costs and benefit indicators are outlined as part of a scenario which assumes high barriers to entry and low economic growth below (see Table 4.7). The operating parameters for this scenario are that:

• the project period (and therefore appraisal period) is 90 years, as per average and median Peatland Code project length;
• that trading of PIUs commences in Year One and trading of PCUs commences in Year Eight;
• monitoring, evaluation and reporting occur in Years Five and Ten, and every tenth year thereafter for a total of ten events;
• restoration is implemented over the first five years, and increases proportionally each year (i.e. 20% increase in restoration hectarage each year);
• carbon credits are accumulated over this first five years, achieving 100% production in Year Six;
• ecosystem service benefits accrue at 20% increments for the first five years, achieving 100% production in Year Six where it assumes a steady state of 100% benefits accrued;
• carbon prices escalate by a real 2% per annum, while all other price values are kept constant;
• credits owned by Scottish Government are assumed to be sold and not retired;
• credits owned by traders are sold on once;
• all credits owned by landowners are assumed to be sold on once, and not banked for insetting; and
• each of the instruments produces the same type of restoration and the same ecosystem services per hectare.

The modelling computed a set of values for a suite of indicators per role-player, that could be assessed by decision makers. The suite of indicators generated was a broad range of indicators relevant to government (and public) and private sector partners. The indicators include:

• Role-player costs
• Role-player costs per credit
• Role-player revenue
• Role-player benefits (either monetary value of public benefits or value of private revenue)
• Internal Rate of Return
• Role-player benefit cost ratio (benefit value per £1 expenditure)
• Govt revenue per £1 expenditure (only for Govt)

A set of colour coding is used to highlight key findings, with green indicating good outcomes, blue indicating poor outcomes and purple indicating important neutral outcomes.

4.5 Results Discussion

The key outcomes of the Cost Benefit analysis for each role-player are outlined below.

4.5.1 Government indicators

• The Peatland Code (PC), in comparison to other instruments, offers the lowest Benefit Cost ratio and zero revenue generation for re-investment.
• Public benefits do not change significantly across the different options given that all options undertake the same restoration and management. For example, one hectare of peatland restored in any one option is assumed to generate the same range, quantum and monetary value of ecosystem services (such as biodiversity conservation, flood reduction, water quality improvement, hydropower energy generation, grazing, etc) as any of the alternative options.
• The First Loss option offers government the least cost option, with the least revenue. Funds (i.e. the Financial Vehicle and First Loss fund options) offer lower costs to government as the private sector carries some of the cost burden. These funds offer the greatest social benefit with traders' involvement adding value, but in this scenario these funds may not be viable given the low IRRs.
• The Individual Contracts model generates the largest government revenues for re-investment into peatlands, with some £151 million additional gain, albeit over 90 years. The individual contracts model offers Scottish Government the best revenue generation per £ spent.
• The Finance Vehicle option offers the greatest Benefit Cost ratio, whilst the PC offers the lowest Benefit Cost ratio. However, the PC still shows a healthy positive value due to the significant value of elevated ecosystem services generated by peatland restoration.

4.5.2 Carbon credit trader indicators

• The Internal Rate of Return (IRR) for the PC is the highest (40%) as the traders do not incur any restoration costs and only incur trading costs. Conversely, the IRR for the Individual Contracts is the lowest (6%) as there is little market share of credits available with government dominating peatland credit trading. Both these instruments may potentially leverage private sector investment into peatland restoration on the basis of future returns via the sale of carbon credits.
• Incentives for the traders to engage as fund partners (i.e. through the Financial Vehicle and First Loss fund options) may not be sufficient to offset trading risks. An IRR of less than 15% may not be enough to offset trading transaction costs and financial risks. Discussions with carbon credit project developers in the UK, Europe and USA indicate that IRRs of less than 15% are not attractive for investors given current carbon market risks.
• A key limiting factor to the viability of the Financial Vehicle and First Loss fund options in the modelled scenario may be the low carbon credit mark-up price (30%) proposed by the steering group, which effectively constrains the IRRs to suboptimal levels. Engaging private sector partners in peatland restoration through blended finance instruments would need to ensure that carbon credit trading mark-ups reflect market trends – levels which can cover the costs of carbon credits’ grading, clustering, certification by additional standards, marketing, fund management, bridging finance costs and other standard business operational costs.

4.5.3 Landowner indicators

• The Financial Vehicle Fund and First Loss Fund options generate greater costs for landowners, and also result in a lower IRR than the other two options for landowners. This suggests that there are lower incentives to buy into either of these instruments.
• Government contracting instruments (across PC or Individual Contracts) offer the greatest returns to landowners, with PC resulting in the highest IRR for landowners (68%).
• The Benefit Cost ratio for the PC is £8.69, significantly higher than the First Loss Fund (£2.72) and the Finance Vehicle Fund (£3.63). The implication is that there is a much lower incentive for landowners to engage with these blended finance instruments.
• Notwithstanding the high Benefit Cost ratio for the PC, it is noteworthy that the annual income for the average landowner (assuming a 141ha area of restoration) is estimated to be £10,369, with an annual profit of some £4,957. This value may be a weak incentive for small landowners to engage in peatland restoration for income generation purposes. This may go some way to explain the limited uptake of the PC to date.
• The proposed shortlisted blended finance instruments, in their current forms, would appear to offer little incentive for small landowners to engage in peatland restoration. Reducing the transaction costs (or drudge factor) and risk for small landowners may be critical elements of a future restoration strategy.

4.5.4 Private sector indicators

• Returns to the private sector may make the Financial Vehicle Fund and First Loss Fund options unacceptable. The Benefit Cost ratios range from £1.80 to £2.14, which is low for the risks associated with the current carbon credit market. Consequently, the only viable option in this modelled scenario may be the Individual Contracts – as this works well for government and the private sector has low risks as they only buy and sell credits.

4.5.5 Project / society indicators

• All four instruments show high levels of benefits for society, ranging between £2.8 billion and £3.1 billion per year. These benefits are largely driven by:
  • the large scale of peatland restoration proposed (some 175,000 hectares),
  • the wide range of ecosystem services generated by intact peatlands (such as flood reduction, water quality maintenance, moderating seasonal water flows, sediment reduction, grazing and biodiversity conservation amongst others),
  • the relatively large capacity of each hectare of peatland to produce high volumes of ecosystem services (similar to wetlands worldwide), and
  • the monetary value of each ecosystem service unit supplied by each hectare (as per published data).
• Note that the large social benefits of restoration results in a break even in year 5 for the Individual contracts model.
• Benefit Cost ratios are all acceptable at the societal level, in other words, every option is good for society. However, whilst it is necessary for the Benefit Cost ratio to be above 1:1 (i.e. benefits exceed costs) for a viable instrument, it is not sufficient. As there are several different partners involved in each option, the Benefit Cost ratio needs to be more than one and the IRR needs to be as good or better than alternative investment options. Note that if any one of the three partners does not achieve acceptable benefits from a fund, then the instrument is not viable. In addition, the contract instruments (PC and Individual Contracts) do not necessarily require carbon traders’ participation to be successful.
• In the contract options, government largely displaces the carbon credit traders (itself becoming the trader), hence resulting in the lowest leverage of private sector funds. However, note that in this scenario, the subsequent re-investment of the revenues into peatland and subsequent additional rounds of private sector funds’ leverage – is not accounted for in this model and therefore there may be more cyclical benefits from public reinvestment.

4.5.6 Conclusion

In summary, under the scenario selected for core analysis the Carbon Contracts option comes out as the preferred option at this stage of the appraisal and should be considered by decision makers alongside other evidence.

It is important to note that the First Loss Fund option shows the greatest societal Benefit Cost ratio in this core analysis; however additional evidence including IRR calculations suggests the Public-Private Fund options' incentives for the private sector may not offset risks and/or compete with alternative investment options. Based on the findings above, the Carbon Contracts option may support the peatland programme to meet its objectives beyond the business-as-usual existing grant funding settlement. Further conclusions of the findings of this analysis can be found in Chapter 6.