Accounting for natural capital: what does it mean for the real estate and infrastructure sector?

What is natural capital?

Natural capital encompasses the world's stocks of natural assets and resources, such as fossil fuels, arable land, air and water quality, all living things and the ecological services needed to support them. It attempts to quantify the intrinsic monetary value of these resources, enabling their value to be accounted for by decision makers.

Natural capital accounting is highlighted in in the UK's 25 Year Environment Plan as being a key system for monitoring the government's progress towards its environmental goals, and will therefore trickle down into the private sector as the government seeks to realise these targets.

The government is already encouraging businesses to employ natural capital methods in their reporting, standards and accounting. Indeed, many leading businesses are already doing so voluntarily.

The effects of natural capital on developers

The Biodiversity Net Gain scheme is aimed at ensuring biodiversity in the UK continues to increase despite the delivery of much-needed infrastructure and housing. Developers will be required (by the Environment Bill, expected to be enacted once the UK leaves the EU) to ensure that ecosystems are left in a measurably better condition after a development takes place. This will involve developers assessing the state of biodiversity in the area before submitting plans, and then demonstrating how it will be improved. Such improvements could include the creation of green corridors or planting new woodland.

If a reduction in biodiversity is unavoidable, then the developer must fund the creation of a habitat elsewhere in the local area of the development to compensate for this reduction. Where a compensatory habitat is not established, a penalty will be imposed on the developer and the money will fund projects according to local and national conservation priorities.

Under the scheme it is envisaged that a 10% net increase in biodiversity will be sufficient for each new development. The change in biodiversity is to be measured in tradeable 'biodiversity units', creating a new market for sustainable habitat creation where developers will be able to benefit from producing surplus amounts of biodiversity. It is hoped that this will encourage developers to exceed the mandatory 10% increase wherever possible.

Biodiversity units are currently calculated by reference to the Defra metric, which considers the distinctiveness of a habitat, its condition and its connectivity to other habitats. It is possible that natural capital will soon be incorporated into this system, meaning that developers will be required to account for the value of their natural capital assets, both before and after a development, in order to demonstrate an increase in natural capital and biodiversity relating to the development.

Benefits of accounting for natural capital

While accounting for natural capital will inevitably lead to increased expenditure for developers, it may have a net positive effect, not only by expediting planning consents, but also by promoting the reputation of the business and providing greater access to lower cost funding for future development projects.

Environmental, social and governance (ESG) criteria are a set of standards for a company's operations that are increasingly being used by institutional investors to identify suitable investments. The criteria examine how a company promotes sustainability, manages its relationships and deals with leadership, shareholder rights, supply chains, audit and executive pay.

The ESG criteria are also being used in sustainability-linked loans as a yardstick for measuring a borrower's performance in relation to sustainability. Meeting certain ESG requirements under these loans will result in a decreased interest rate payable by the borrower, while underperformance will give rise to higher interest rates.

Adopting natural capital accounting methods will allow developers to demonstrate adherence to the ESG criteria. Furthermore, businesses that adhere to the ESG criteria are often seen as safer investments, especially in the wake of recent controversies such as the Volkswagen emissions scandal that resulted in billions of dollars of associated losses. This means that ESG-compliant developers may have access to cheaper funding, through both conventional and sustainability-linked loans.

Intelligent management of natural capital could also deliver substantial benefits for the management of existing infrastructure. For example, rail networks at risk from damage and service disruption resulting from extreme flooding could be protected by the development of vegetation management solutions, thereby improving operational resiliency, reducing operating costs and ensuring a net gain in biodiversity.

Osborne Clarke comment

While it is still unclear exactly how natural capital will be employed by the government to reach its environmental targets, and therefore how it will affect the private sector, it is inevitable that it will result in greater expenditure for developers in relation to their accounting and reporting processes.

However, given recent trends favouring sustainable and environmentally-conscious investment, natural capital accounting need not have a negative overall impact on developers in the infrastructure and real estate sector if it is leveraged to its full potential.