Investment structures aimed at generating carbon offsets are taking numerous forms as GPs scramble to develop strategies capable of delivering competitive returns while making a positive climate contribution.
Many of these have revolved around afforestation, which delivers clear additionality and taps into the developed market for forestry-derived carbon credits. Others, meanwhile, have sought out land restoration projects or shifted to regenerative farming practices to generate credits that are sold directly to offtakers or are traded on voluntary markets.
Canadian firm Fondaction Asset Management launched its pilot emissions reductions vehicle, Inlandsis I, in 2017 with C$30 million ($22 million; €20 million) in capital. The fund was mainly deployed in North America across biodigester projects and abandoned coal mines that were emitting methane, as well a handful of forest management and industrial initiatives.
The vehicle has so far delivered IRRs in the high teens and a distribution to paid-in capital of over one through the sale of more than 2 million credits, as it pushes towards its target of 4.5 million tonnes of CO2 equivalents reduced or abated.
The firm is now back in the market alongside its partner Priori-T Capital, and is raising a C$160 million follow-on fund, which held a first close on C$115 million in December.
“Unlike other funds that invest in forest carbon or ag carbon, we generally don’t own the underlying asset,” explains principal investment adviser Philippe Crête. “We don’t invest in land and we don’t invest in timber. We invest in carbon. We mostly own contractual arrangements to future carbon credits.”
Crête describes the firm’s approach as more closely resembling project finance or bridge capital than traditional equity or debt investments.
FAM’s Inlandsis I fund started out exclusively sourcing projects capable of generating carbon credits that could be traded on the Quebec-California compliance carbon market or the Alberta compliance market, but the GP has been looking at voluntary markets more closely in the last 18 months.
The firm pursues project sizes worth a maximum of C$10 million, which are too small for traditional fund managers or potentially too risky for banks. It provides the financing for the projects in full or as one of a small number of backers.
“We take a stream of offsets against our capital and we aggregate them into a portfolio, which we then resell to mostly Quebec or California emitters,” says Crête. Project developers do not repay the firm any capital on their cash loans – FAM is repaid fully in credits.
“Very often these projects will generate credits over 15 or 20 years. Our fund has a lifespan of 10 years and depending on which point we’re coming into the equation, generally we’re out of their hair in five to seven years. We get the rights to these credits once they’re registered and we sell them right away. We generally have off takers who are waiting for them or we sell them to the spot market,” adds Crête.
Inlandsis Fund II
FAM’s Inlandsis II vehicle also has a 10-year term like its predecessor and an IRR target in the high teens, which Crête hopes Fund II will be able to outperform, in part due to the upward pressure on carbon credit prices and buyers’ need to source credits from voluntary markets.
The first two investments from Fund II – which are yet to be announced – are geared towards voluntary markets and involve farmland and timberland initiatives. FAM expects ag and forestry projects will take a larger portion of the portfolio than in Fund I, which was dominated by biodigester and coal mine methane emissions reductions investments.
The firm sees more room for arbitrage in voluntary markets and “even higher returns,” says Crête, but he concedes that FAM will have to be more selective in this space due to the associated risks.
“Price discovery is much harder. The quality of the credits varies quite a bit as well and buyers are still not all well aligned or don’t have a very good sense of what a quality credit is, so we find a race to the bottom from a lot of voluntary buyers in terms of pricing,” he explains.
Crête adds that another reason the firm has been able to drive strong returns is due to a lack of understanding of the value locked in the projects it pursues, or a lack of desire to do the painstaking work from which it has been able to deliver its returns.
“Obviously now there’s a growing interest in the market and there’s a lot of speculation, so you see a lot of new players coming in flushed with cash. It made our life a bit harder in the last year but, again, they usually have so much money to pour into these markets that they’re looking for very large deals, which in the ag and forestry space is often tied to land acquisition, which is not really the space we operate in.”
Fund II has been backed by more 30 LPs to date, with the roster made up of corporates, wealth advisers, asset managers, endowments and foundations.
The firm is already thinking about Fund III and other emerging offsets markets it can tap into, such as direct air capture, blue carbon and biodiversity, but for now the priority remains closing out Fund II this year.
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