Blended finance for first-of-a-kind (FOAK) nature-based solutions

Not surprisingly, these conversations center almost exclusively on hardware like direct air capture and green hydrogen production.

Natural climate solutions (NCS) are notably absent from the conversation, yet they represent a critical category of scalable infrastructure projects needed for the climate transition. While the underlying biotechnology, photosynthesis, is not new, the other FOAK risks of NCS are just as real as for any other climate project.  

Photosynthesis transforms carbon dioxide and water into oxygen and biomass. If it were discovered in a lab today, no doubt it would be the darling of Silicon Valley. But it’s our good fortune that this solution has, over millions of years, bypassed R&D, prototyping, and piloting, and arrived at our doorstep in its familiar form. 

If photosynthesis is truly such a low-cost, scalable, and de-risked climate mitigation solution, why is it so difficult to finance reforestation projects?  

We would argue that the fundamental investment challenge has been unpriced externalities – in short, there historically has not been a market for ecosystem services because there was no ‘product’ and no demand. But as positive externalities move from being unpriced to priced, the business model for nature is evolving. We see this most clearly with the development of carbon credit markets. 

While public and philanthropic actors are increasingly incentivizing development of and investment into novel climate technologies, natural climate solutions have not received the same attention. To mobilize greater investment into climate mitigation, we need greater collaboration across the capital stack for NCS. This means targeted use of public and philanthropic funding and incentives that are ultimately linked to commercial investment into replicable, scalable projects. 

In the last 50 years, the price of solar modules has declined by 99.6%. The decline in the cost of solar is a function of several factors – one of which was the use of public policies and incentives, including R&D grants, concessional loans, subsidies, and tax credits. Like many climate innovations, solar PV benefitted from public and philanthropic incentives that helped address key risks – including high upfront costs, long payback periods, and uncertain demand – to bring the technology to commercial scale. 

In fact, a recent study found that 96% of climate tech venture capitalists are two degrees away or less from a government grant, and that the US government is the most central co-investor in American climate-relevant companies. In short, public and philanthropic incentives have been critical to climate tech innovation. 

FOAK projects test the commercial potential of pioneering technologies, methodologies, and processes – and if successful, they create replicable models that can scale.   

There is a critical gap in funding for FOAK projects. To get the first proof-of-concept and test market demand, funding typically comes from grants, angel investment, or early-stage venture capital. But to launch the first full-scale commercial project, companies are looking for low-cost, large-scale financing that neither venture capital nor infrastructure funders are well-positioned to provide. FOAK projects may be too large or have returns that are too low for venture capital, yet they are perceived as too risky or one-off for infrastructure funders looking for the kind of deal that can be repeated multiple times, not just once.  

The FOAK stage is also when a project can move off balance sheet and be funded through a project SPV rather than with use of proceeds of a corporate capital raise. This can present another challenge to founders and early investors, who know how to raise grants and rounds of venture capital, but not necessarily how to raise large-scale project finance, or from whom. 

Natural climate solutions have high climate impact but are critically underfunded. NCS remove and avoid carbon emissions through ecosystems in nature – take, for example, afforestation, reforestation, and revegetation (ARR) projects, which restore forest ecosystems to sequester carbon from the atmosphere. NCS hold enormous potential for climate mitigation, with the capacity to remove one-third of the emissions needed to meet global climate targets (Griscom et al. 2017) – yet they receive less than three percent of climate funding.  

Historically, the investment challenge for nature has been that the benefits, or positive externalities, of NCS were not priced, and so there was not a reliable business model to mobilize private capital for projects. The growth of carbon markets has changed this by internalizing nature’s positive externalities to unlock new, reliable revenue streams throughout the life of the project. As carbon has gone from being unpriced to priced, there is an opportunity for commercial investors to participate in natural climate solutions and therefore to mobilize funding at scale.  

The term ‘FOAK’ is typically a reference to projects with first-of-a-kind technology risk. But the FOAK financing challenge applies to nature-based carbon removal projects, too. Of course, nature-based carbon projects aren’t pioneering new technologies – they use naturally occurring processes, such as photosynthesis, to remove carbon from the atmosphere. But they are pioneering new methodologies for sequestering carbon emissions at scale, in a new global market for carbon credits. 

We can categorize the risks of FOAK nature-based carbon projects as business model risk, execution risk, and country risk, each of which has a set of mitigation strategies – from negotiating offtake agreements to guard against uncertain future demand, to investing in advanced data collection technologies to support accurate measurement, to purchasing political risk insurance to protect against breach of contract that results in late or non-delivery of credits. Figure 3 below details select risks for FOAK nature-based carbon projects. 

There is more than enough money to address climate change, and certainly more than enough to fund the nature-based solutions that are needed to meet the Paris Agreement targets. Climate Policy Initiative estimates US$8.6T of global climate finance is needed annually until 2030. This is less than the US$11.7T COVID-19 emergency spend in 2020, and it is less than the combined global public expenditure on military (US$2.2T) and fossil fuel subsidies (US$7T).  

Capital is not the problem. The problem is getting the right capital to the right projects at the right time.  

This is where blended finance approaches can help move the needle – especially in new sectors, new markets, and of course for FOAK projects. Blended finance is the use of public or philanthropic capital to improve the risk-return profile of a deal in order to crowd in private, commercial investment. Blended finance can take many forms, including upstream grants to de-risk a project, design funding to bring a new investment vehicle to market, technical assistance vehicles alongside funds, technical assistance to reduce transaction costs during the investment process, first-loss capital or other junior capital within the investment structure, and guarantees on invested capital.  

Concessional capital is limited, and it is precious; its use should be carefully tailored to the specific problem that needs to be solved. 

In scaling nature-based carbon projects, the case for targeted use of concessional funding is two-fold. First, it addresses one-time costs of pioneering transactions that pave the way for fully commercial opportunities. Unlike in developed markets, in new markets and underserved geographies, first movers often face a penalty rather than a reward. In the case of nature-based solutions, first-movers must test demand for carbon credits from new project types, educate investors and buyers, navigate and inform development of an evolving regulatory landscape, upskill the local workforce, and often vertically integrate operations. These are all additional costs of doing business that benefit those that follow. This broader market development impact builds the case for subsidy of first-movers.  

Second, concessional funding recognizes that nature-based projects generate positive externalities – public goods – that are still unpriced in the market today. For example, biodiversity benefits and livelihoods benefits can increase the price of carbon credits in the voluntary market, but this does not necessarily fully compensate the project for the additional costs of achieving these higher impact outcomes. Likewise, climate adaptation outcomes, as well as other ecosystem services beyond carbon sequestration, are not part of the investment case for nature today. Philanthropic funding can be used to help address the costs of achieving this impact, and in doing so also make the project more attractive to investors. 

Finally, while conversations around blended finance often focus on first-loss instruments, we find that often deals can be done on commercial terms but face high transaction costs in getting the deal over the line. This is especially the case when global investors are looking at opportunities in emerging markets for the first time, or when they are looking outside the few large countries that receive the majority of investment today. Getting to know the regulatory environment, local actors, and unique risks and opportunities in a new geography is costly, especially without a full-time team on the ground. Likewise, there are high search costs for projects to connect with the right investors, and to build trust between all parties involved. Donor or philanthropic funding of neutral, third-party investment facilitation services can help mutually beneficial deals to close – setting important precedent in the market. 

To move the market from pilots to repeatable, scalable projects – past the FOAK valley of death – we see four key areas where funding is most needed: 

1. Feasibility – and development-stage philanthropic or donor funding to understand the business case and help projects meet specific milestones for investability 
2. Early-stage equity for FOAK projects and first phases of greenfield projects, proving out execution, demand, and commercial viability
3. Philanthropic or donor funding for investment facilitation targeting pioneering transactions with market-level impact 
4. First-loss or other junior capital to de-risk specialized nature funds that can prove out the investment case and create attractive, aggregated opportunities for commercial capital at the fund level 

The gravity of the climate crisis demands that we find ways to mobilize large-scale investment into both climate tech and natural climate solutions. At CrossBoundary, we are committed to leading this movement by building the pipeline of bankable, high-impact, and high-integrity carbon projects. With support from development partners, we help nature-based project developers in emerging markets design projects and structure financing agreements that are mutually beneficial for developers, investors, buyers, and local communities; and we ourselves invest in high-impact projects – with the ultimate objective of establishing the proven, replicable models that we so urgently need.  

Explore more from our CrossBoundary Quarterly on Blended Finance