Pensions Consider the Rain Forest

Before others, Merrill Lynch & Co. saw the forest for the trees. In 2008 the US bank agreed to purchase carbon credits, under an option agreement, in what was billed the world’s first commercially financed avoided-deforestation project. This effort focused on preserving nearly 3,000 square miles of the Ulu Masen rain forest on the Indonesian island of Sumatra, which was losing 135 square miles annually to logging and clearing. Behind the project were nongovernmental organization Fauna & Flora International, carbon brokerage Carbon Conservation and the government of the province of Aceh.

For its contribution, which was paid over four years and helped reduce deforestation in the area, Merrill (now Bank of America Merrill Lynch) won the right to buy future carbon credits at $4 per ton of avoided emissions. Fauna & Flora says the project is expected to prevent 100 million tons of carbon emissions in the next three decades.

“We approached it from the perspective of a typical carbon market deal,” says Abyd Karmali, global head of carbon markets at BofA Merrill in London. But the deal wasn’t typical. Merrill was one of the first big financial firms to invest in projects seeking to avoid deforestation, partly so it could play a role in developing the emerging forest carbon sector.

Experts champion this space as an immediate and cost-effective way to forestall the release of carbon and other greenhouse gases into the atmosphere. REDD (reducing emissions from deforestation and forest degradation) is shorthand for forest conservation activities, while REDD+ covers reforestation and sustainable forest management as well. But so far, the market hasn’t done much to encourage private investment in either.

With little public money to spare, the need for that investment is urgent. Forests play a crucial role in sequestering carbon and release vast amounts of it when they vanish. Deforestation accounts for 17.4 percent of annual global greenhouse-gas emissions — more than the entire transportation sector — according to a 2008 independent report commissioned by the U.K. government. In a 2004 Science magazine article, Princeton University scientists Stephen Pacala and Robert Socolow wrote that halting tropical deforestation and planting new forests could do as much to slow global warming as doubling the world’s nuclear energy capacity or building 2 million new wind turbines.

But on official, regulated carbon markets, only credits derived from the creation of new forests are tradable. This relegates those earned through conservation and better management to voluntary, over-the-counter exchanges. In the OTC world, however, REDD and REDD+ credits have thrived. They jumped from less than 2 percent of the voluntary forest carbon market in 2006 to 71 percent in 2010. “The expectation has been that the REDD+ segment would represent the next phase of the carbon market,” says BofA Merrill’s Karmali.

In 2010, BofA Merrill began creating a new REDD+ product for institutional investors. The so-called rain forest bond, developed by the firm’s carbon markets and fixed-income teams, will pay a return by investing in a range of ventures, including ecotourism, sustainable timber cultivation and REDD+ projects.

“From our earlier experience in Indonesia, we recognized the market was slow to take off, and because of constraints on the policy process, we began to look at longer-term instruments,” Karmali says. “We began to realize that rather than looking at deals in REDD+ from a pure commodity perspective, we could come up with a product that fits the need of institutional investors.” He adds that it’s too early to provide specifics on the new bond.

Leslie Durschinger旧金山的创始人Terra Global Capital, is also developing a product aimed at getting REDD+ credits into the portfolios of institutional investors: the Terra Bella Fund, a private equity vehicle that provides early-stage financing to forestry projects in developing countries. Its target projects, similar to Ulu Masen, will yield credits that are tradable on voluntary markets but should eventually cross over to regulated carbon exchanges. The fund will close in mid-2012 and has a target size of $100 million.

Although Durschinger is getting interest from some institutional players, including two large pension funds that she won’t name, she says the market still presents too much risk to be a serious option for most of their peers. One major source of risk is the policy uncertainty around international carbon markets.

“When evaluating returns in the sector, assessing demand is a critical question,” Durschinger explains. “How will demand from end buyers increase, what are prices going to be, and how will this grow over the next ten or 12 years of the fund’s life? The market will play out over time, but anyone who is looking to earn a return in two or five years, this is not the sector for them.”

Still, developments in global carbon-trading schemes give Durschinger and other proponents reason for optimism about the future appetite for REDD+ credits. The European Union Emissions Trading System, the world’s largest carbon market, excludes forest-related carbon, but it will probably start allowing REDD+ credits next year. And early drafts of a framework for California’s new cap-and-trade system, which will be the second-biggest carbon scheme when it launches in November, specify the inclusion of REDD+.

Demand aside, REDD+ projects and investments raise plenty of other questions. Do such deals protect indigenous groups’ rights? Are there mechanisms to stop the theft of funds that are meant to support conservation? Will developing countries adequately monitor and report on the status of their forest projects?

Durschinger says improvements in monitoring technology, such as greater access to satellite imagery and local communities’ use of mobile devices to gather data, have eased the last worry for most investors. The other two are real risks, she admits. But Durschinger warns that there’s no time to waste. “If we are going to have any chance of reducing emissions from deforestation in a meaningful way, we have to attract private sector investment,” she says. “If we wait until everything is perfect, there will not be any forest left to protect.” • •