Market Outlook: April 2010

Mitigation & Conservation Banking in the United States An Emerging Biodiversity-based Asset Class

The United States has been a pioneer in the development of regulatory environmental markets for ecosystem services, particularly related to water and biodiversity. Regulated markets for the conservation of threatened species and the mitigation of impacts, under the Act and the , represent a growing Thebiodiversity proposed-based Carbon asset Polluti classon withReduction reported Scheme turnover (CPRS) in excess is the ofAustralian US$1 billion policy per response year. While to reduce these the markets country’s are generally regionalized or piecemeal, there remains a variety of significant investment opportunities emissions of greenhouse gases. After passing the Lower House in June 2009 through the Government majority, the CPRS legislation was voted down by the Senate in August 2009. The CPRS failed to pass through the upper Under section 404 of the Clean Water Act and Sections 7 and 10 of the Endangered Species Act, anyone who house of government for a second time in December 2009, caused by a sudden change in Liberal leadership that destroys regulated , streams or endangered species habitat in the United States (US) must effectively nullified a deal that had been negotiated between Government and Opposition. Currently, further compensate for the destruction by: restoring other areas on the same site; paying in-lieu fees to a conservation debate of the CPRSThe has Unitedbeen delayed States as the has Senate been turns a itspioneer attention in to theother developmen legislative prioritiesAn inEmerging the wake of organization; or buying credits from third parties who have already restored sites elsewhere in the same the incoherent outcome of Copenhagen and diminishing public interest in climate change policy. This New region. Recent regulations have created a regulatory preference forBiodiversity the last of these-based options, Asset known Class as Forests Policy Note outlines key facets of the CPRS as relates to the forestry sector and presents strategic mitigation banking, because of the economies of scale and ecological benefits that can be achieved when large opportunities for forest landowners, investors and regulated entities seeking to capitalise on the role of forests areas of habitat are restored in advance of impacts. within the CPRS and Australia’s climate solution.

Wetland and stream mitigation banking is regulated at the federal level by the Army Corps of Engineers. Endangered species habitat banking (known as conservation banking) is regulated by the US Fish and Wildlife TheThe pro proposedposed Carbon Carbon Pollution Pollution Reduction Reduction Scheme (CPRS)(CPRS) isis the Australian policypolicy responseresponse to to reducereduce the the country’s country’s Service and the National Marine Fisheries Service. Wetland mitigation banking has existed in the United States emissionsemissions ofof greenhousegreenhouse gases. gases. After After passing passing the theLower Lower House House in June in 2009 June through 2009 through the Government the Government majority, the majority, CPRS legislationsince the earlywas voted 1990s, down and by conservation the Senate in bankingAugust 200 was9. pioneeredThe CPRS failed in to pass through in 1997. the upper house of government the CPRS legislation was voted down by the Senate in August 2009. The CPRS failed to pass through the upper for a second time in December 2009, caused by a sudden change in Liberal leadership that effectively nullified a deal that house of government for a second time in December 2009, caused by a sudden change in Liberal leadership that hadCurrently, been negotiated the Ecosystem between Marketplace Government andestimates Opposition. there Currently, are 613 furtherwetland debate and ofstream the CPRS mitigation has been banksdelayed actively as the effectively nullified a deal that had been negotiated between Government and Opposition. Currently, further Senateselling credits turns its or attention pending to approval other legislative to sell credits priorities (431 in theand wake182, ofrespectively). the incoherent Another outcome 88 ofwetland Copenhagen mitigation and debate of the CPRS has been delayed as the Senate turns its attention to other legislative priorities in the wake of diminishingbanks have public already interest sold outin climate of credits. change Conservative policy. This estimates New Forests put Policythe annual Note outlintransactiones key value facets ofof wetlandthe CPRS and as therelates incoherent to the forestry outcome sector of Copenhagen and presents and strategic diminishing opportunities public for interest forest in landowners, climate change investors policy. and regulatedThis New stream mitigation credits at US$1.3 billion. Conservation banking is a more concentrated industry – with 20 Forestentitiess Policy seeking Note to capitalise outlines on key the facetsrole of forests of the within CPRS the as CPRS relates and toAustralia’s the forestry climate sector solution. and presents strategic sold out banks, 77 active banks and another 20 banks pending approval. In total, the mitigation banking opportunities for forest landowners, investors and regulated entities seeking to capitalise on the role of forests industry in the United States transacts more than US$1.5 billion per annum.1 Figures 1 and 2 (next page) show within the CPRS and Australia’s climate solution. Thethe geographic proposed di Carbonstribution Pollution of mitigation Reduction banks Scheme across (CPRS)the US. is the Australian policy response to reduce the

country’s emissions of greenhouse gases. After passing the Lower House in June 2009 through the Government Themajority,Mitigation proposed the credits Carbon CPRS arelegislation Pollution not a Reduction commoditywas voted Scheme down good. by (CPRS) They the Senate represent is the Australianin August the environmental 2009.policy responseThe CPRS value to failed reduce of theto thepass restoration country’s through emissionstheimplemented upper of housegreenhouse for aof specific government gases. ecosystem After for passinga in second a specific the time Lower watershed. in DecemberHouse As in methodologiesJune 2009, 2009 caused through toby calculatea thesudden Government this change value in majority,and Liberal the theleadershiptype CPRS of ecosystemlegislation that effectively restoredwas voted vary, nullified down mitigation by a dealthe Senatecredits that had inare August been not fungible. negotiated 2009. CreditsThe between CPRS also failed vary Government towidely pass in through price and Oppodepending the sition.upper houseCurrently,on the of economicsgovernment further ofdebate for the a service secondof the areatimeCPRS in inhas whichDecember been they delayed 2009,are produced ascaused the Senate byand a suddenon turns the approachchangeits attention in of Liberal regional to other leadership regulators. legislative that effectivelyprioritiesWetland credits, nullified in the for wake a instance, deal of that the can incoherenthad sell been for negotiatedUS outcome$3000 in of betweenArkansas Copenhagen andGovernment US and$400,000 diminishing and in Opposition. California, public where interest Currently, tidal in an climate furtherd debatechange of policy.the CPRS This has New been Forest delayeds Policy as the Note Senate outlines turns key its attentionfacets of tothe other CPRS legislative as relates priorities to the forestry in the wake sector of theand incoherent presents outcomestrategic of opportunities Copenhagen for and forest diminishing landowners, public investorsinterest in and climate regulated change entities policy. seeking This New to 1 Forestscapitalise Madsen, Policy Becca; on the Note Carroll, role outlines Nathaniel; of forests key Moore within facets Brands, the of Kelly; CPRS the 2010. CPRS and State Australia’s as of relates the Biodiversity climat to the Marketse solution. forestry Report: sector Offset and and Compensati presentson strategic Programs Worldwide. Available at: http://www.ecosystemmarketplace.com/abdmarkets2009.pdf opportunities for forest landowners, investors and regulated entities seeking to capitalise on the role of forests within the CPRS and Australia’s climate solution. The proposed Carbon Pollution Reduction Scheme (CPRS) is the Australian policy response to reduce the

country’s emissions of greenhouse gases. After passing the Lower House in June 2009 through the Government Themajority, proposed the Carbon CPRS legislation Pollution Reductionwas voted Scheme down by (CPRS) the Senate is the Australianin August 2009.policy responseThe CPRS to failed reduce to thepass country’s through Figure 12 impacts drive up prices when supply is scarce. The average per credit price for wetlands is US$74,500 (see Figure 3). There are an estimated 25 kinds of wetlands credits traded around the country. Similarly, each endangered species will have a different type of credit, and there are over 90 different types of conservation bank credits Figure 2 in circulation. The median price for conservation bank credits is US$15,000, but prices vary widely. California red-legged frog habitat, for instance, can cost developers anywhere between US$15,000 and US$90,000.3

Like real estate markets, mitigation banking markets are highly local. Figure 3 Most mitigation bankers are rural landowners seeking additional revenue from their property or small entrepreneurs with back- grounds as land-use attorneys, developers or environmental con- sultants. Few of these operators are capitalized for growth and most are focused on one or two small service areas. There are just two mitigation banking companies with national exposure, and the number of regional operators is limited. Consequently, mitigation banking is a highly fragmented market on the supply side with large asymmetries of information surrounding price.

On the demand side, the market in any given service area is relatively illiquid (larger mitigation banks sell 30- 100 credits a year; many small banks sell only 5 or 6 credits a year). Private residential and commercial developers make up between one and two-thirds of demand when real estate markets are strong. Public sector transportation, water and defense agencies, as well as extractive companies and utilities, are also frequent buyers. Credits are usually marketed to projects during their permitting stage, and sales may take several years

2 Ibid. (All figures) 3 Ibid.

to materialize if the entitlement process is slow. Price information is closely guarded, and transactions are conducted exclusively over-the-counter (OTC).

In summary, mitigation banking is an emerging market with limited transparency and considerable volatility. These characteristics, in combination with a small number of sophisticated operators, mean that traditional lenders generally avoid debt investment in the sector, particularly in the current capital markets environment. Most mitigation banks rely on organic growth, which can make it difficult to time real estate cycles, and even the largest operators are open to equity investment due to frequent capital constraints. To date, mainstream private equity investors focused on real assets have not penetrated the sector due to high technical barriers to entry. As a result, investors who understand the mitigation banking industry are well-positioned to negotiate attractive returns in a sector that has the potential to generate rich returns and is largely protected from competition.

Note: Commentary is current as of April 2010. Reproduction is permitted with proper referencing to New Forests Advisory Inc, San Francisco, California, USA