Momentum builds for new finance vehicle to protect forests

Plans are being developed to set up an international fund, modelled on a sovereign wealth fund, to reward countries that protect their rainforests. The World Bank is hosting a working group, which hopes to present a plan at the COP 28 climate conference in November.

The fund would offer a new way to use capital markets for development finance, in one of the most difficult, yet urgent, areas: protecting and restoring nature. It would also break political ground, creating a new kind of interaction — and potentially a new set of tensions — between rich and poor countries.

Natural ecosystems, particularly biodiverse tropical forests, are vital to enabling the Earth to continue to absorb carbon dioxide from the atmosphere. They also have a host of local benefits, including maintaining healthy rainfall and preventing floods.

Sustainably managed forests can provide incomes to local people, but there are always temptations to encroach on them for logging, farming, mining and other economic development. Despite all the attention on the issue, tropical deforestation is getting worse.

Developed countries have made a few efforts to reward developing nations for protecting woodlands, but they have not all been successful, nor have they proliferated. They are beset with risks of backsliding and mistrust on both sides.

The idea of an international finance facility for forests (Iffor) was taken up in June at the Summit on a New Global Finance Pact convened by France’s President Emmanuel Macron. It was included in the Paris Agenda for People and the Planet, agreed there.

A group of “champions” for natural capital was formed at the summit, including the presidents of Colombia, the Republic of Congo and Gabon, US climate envoy John Kerry, the World Bank and Saudi Arabia’s Public Investment Fund. They have agreed to promote the forest facility.

The concept has been gestating for about 15 years among a few development finance experts, particularly Ken Lay, treasurer of the World Bank until 2010. Lay has been promoting the idea in policy circles, and in Paris he made a successful pitch for it.

Having worked on the proposal at the World Bank, in 2014 Lay took it to the Center for Global Development thinktank. They fleshed it out in a series of detailed papers in June 2018.

“We need to try to offer financial incentives to tropical forest countries to avoid deforestation,” Lay said. “We know there are short term opportunity costs to them, because they can cut down trees and make money doing it right now. In Paris developing countries said: ‘You want us to do it to mitigate the damage you caused [through greenhouse gas emissions] — so where is the money?’ That has been a repeated refrain for years now.”

The central idea is not to finance this with overseas development assistance. As Michele de Nevers, then a fellow at CGD, wrote in 2018: “There are dozens of competing high priority uses for ODA. And when ODA funds are used for reward payments, donors are tempted to… ‘aidify’ the results-based payments programme.” Donors tend to impose conditions on how the results are achieved and how the money is used.

To avoid that, rich countries would instead lend the money to create a substantial endowment fund, invested on commercial lines in a diversified portfolio of assets.

Sovereign wealth funds and pension funds have shown such portfolios can reliably generate substantial returns over 20 years. The World Bank team modelled a portfolio over multiple 20 year periods and found an annualised return of 7%-8% could be expected.

That is twice or more times the cost of debt for developed countries. So they could receive their money back after 20 years, with interest paid, either along the way or at maturity.

“It avoids competing with other government expenditures,” said Lay. “It’s just like putting money in the bank, and if you model the probability that they don’t get repaid, it’s trivial.”

Countries that protected their tropical forests would share the fund’s excess returns, above the cost of the developed countries’ financing.

In its essence, the idea is simple and compelling — there seem to be no major reasons for either the investor or forest nations to object. Advances in satellite imaging make verifying how countries are caring for their forests much easier than in the past.

The difficulties may lie in ensuring fairness among participants. To begin with: how to calculate the investors’ returns. The US, UK, Germany, France and Italy all pay low rates of interest, but their funding costs are different, change over time, and come in different currencies.

Investors might put in different sums at different times. Some might have to accept terms that seemed to them slightly less attractive than what others received. They could all be paid the same, but then some would probably feel the investment had a cost.

For the forest countries, any payments could be seen as free money. But because they would sacrifice short term gains from ploughing up forests or extracting minerals, any sense that the fund is an unalloyed blessing is likely to be short lived.

Its creation would be likely to focus countries’ minds on how much revenue they might be giving up by stopping deforestation, and how much they ought to be compensated for that.

In the simplest model, the fund could give out money unilaterally to all countries with forests of a certain kind, or within certain latitudes, in proportion to the size of forest and degree of preservation. But the huge size of Brazil and Indonesia’s forests would give them the lion’s share of the money, leaving little for others.

A more complex system would involve specific forest countries becoming members of the scheme. Some of the measures required to earn its rewards would involve cash outlays; many would carry opportunity costs.

The 2018 papers propose a formula taking into account both each country’s annual performance in maintaining and expanding forests, and the size of its forests. Shares in the fund’s returns would be allocated annually.

Parametric payments based on forest statistics would be objective, but could still lead to disagreements over whether some countries were making bigger sacrifices, as their costs for complying could vary. Some might have to forgo exploiting mineral deposits, for example.

When would the money be paid out? Lay said some countries were happy for returns to accumulate and be paid out after 20 years. Others want the cash to use on a running basis.

Linked to that is the crucial question of who would bear the risk of disappointing investment returns, for example due to an economic crisis. Would the return to investor nations be fully protected every year?

The degree of return to the forest countries would certainly be volatile. This could make it more difficult to release money before the fund’s maturity, especially to only a subset of countries.

A further difficulty would be how to cope with forest countries wanting to join during the life of the fund. Would they dilute the returns to existing members?

Several closed funds could be created over time. But how to ensure that the deals offered were similarly generous?

Getting the governance right will be paramount. The CGD plan emphasised that the fund’s governance would be modelled on that of sovereign wealth funds, not on international bodies such as the Green Climate Fund, where disagreements between donor and recipient governments have caused delays.

“We’re trying to keep it simple,” said Lay. “It would have to adopt an investment policy and have an outsourced chief investment officer — one or more — to make the investments. Governance issues are going to be there, but it’s not as complicated as trying to manage the World Bank.”

The scheme draws on the principles of cash on delivery (COD) aid and the Santiago Principles.

COD means paying developing country governments for achieving certain outcomes, such as educating students. The means and how the money is spent are left to the country to decide.

The Santiago Principles require sovereign wealth funds to be managed in a non-political, rational and transparent way, according to set investment principles.

The CGD papers recommend that the forest facility should outsource treasury management and monitoring of forest performance. Its board should comprise investment and forest experts, not government representatives.

To minimise tensions, they propose structuring the fund as a global offer by the investor countries. Participation by forest countries “would be completely voluntary — it is neither a demand nor a requirement.”

Participating would create a contract, however, in which the forest nation could receive payment for results out of the fund’s investment returns.

The biggest problem may be to work out how much money can be assembled, and how many countries this can help. “A fund that would generate meaningful incentives for the whole tropical forest ecosystem would be huge,” said Lay.

Some have suggested $1tr, but raising that seems improbable. “The number we got to was $100bn,” said Lay. “That was big enough to generate meaningful returns after paying the underlying interest, and not so big that everyone would choke and say ‘forget it’. It’s one quarter the size of the California Public Employees’ Retirement System.”

In 2018, CGD estimated that $100bn could generate $5bn a year of rewards for forest protection.

But Lay added: “Everybody recognises that even with $100bn there are limits, because Brazil and Indonesia would be getting a large share of it and that reduces the amount available to any other country.”

A different solution may be needed for the largest countries. One possibility is to start the fund with High Forest, Low Deforestation countries — an already defined group whose forests are still in a reasonable state, including Bhutan, Colombia, the Congo, Democratic Republic of Congo, Gabon, Ghana and Malaysia.

The scheme could start with a small pilot for two or three countries. “We’ll just have to figure it out and balance what’s practicable,” said Lay.

The French government is backing the idea. Other governments, including the UK’s, are involved and it is attracting steady interest from potential investor and beneficiary governments.

Brazil — which holds the world’s largest rainforests — is due to take over as president of the G20 in December, so supporters are eager to see whether it takes up the idea as a G20 priority.