Investors in hydropower are overlooking the risks of deforestation, according to Earth Security, which has called for the creation of ‘cloud forest bonds’ to address the problem.

In a report published today, the climate and natural capital consultancy has warned that energy investors are unaware of water services from forests upstream.

To minimise forest destruction, which could adversely affect profits from hydropower, Earth Security recommends a series of sovereign forest bonds by a group of 25 developing countries. The suggestions coincide with several initiatives encouraging private finance for nature-based solutions launched during the UN Convention on Biodiversity COP 15 in Montreal this week.

“The value of standing forests goes beyond carbon. A really important ecosystems service that we are overlooking is the ability of forests to keep water flowing”, said Alejandro Litovsky, CEO of Earth Security, whose partners include the Swiss Agency for Development and Cooperation, UBS Optimus Foundation and HSBC.

In some tropical countries, where mountain trees soak up liquid water from fog in formations known as cloud forests, that relationship is particularly strong. They include middle-income countries such as China and Brazil, as well as poorer nations like Laos and Madagascar.

Almost half the world’s cloud forests feed river basins that contain hydroelectric dams, according to the study, entitled Cloud Forest Assets – Financing a Valuable Nature-Based Solution.

It also estimates that the total value of hydroelectricity currently relying on cloud-affected forests across these 25 countries is close to $118bn over 10 years.

This increases to $246bn when including hydropower plants planned in these countries, two-thirds of which will use water from cloud forests. Stacking the value of these forests both in terms of carbon and the water provided to existing hydropower plants amounts to a combined $327bn for the 25 countries over 10 years.

To protect the forests, the organisation recommends three types of solutions, depending on the circumstances of the individual country: a sovereign sustainability-linked bond, a debt-for-nature swap, or a sovereign results-based finance instrument. These can be employed as part of an international debt restructuring exercise.

To provide scale following an initial pilot, it also proposes a consortium of the 25 countries entitled the Cloud Forest 25 Investment Initiative.

For most of these instruments, described as cloud forest bonds, hydropower plants would incur additional fees to contribute to sovereign debt repayment. Such payments would create new sustainable income streams bundling carbon sequestration with the water services provided by cloud forests, which has not been achieved at scale successfully before.

“Someone needs to pay for this water that is very clear,” said Litovsky. “It could be the government, dams and/or a range of different downstream industries using the water.”

In some locations, risks to dams from forest decline have already been calculated. For example, one hydropower study of Colombia by Kings College London found that deforestation could reduce fog capture by up to 70%, causing annual water flows to the reservoir to fall by 2.2% and sediment inputs to increase by as much as 400%.

This led to a 12.3% fall in hydropower profits due to production decline and higher dredging costs.

Green bonds using these models have all been issued in the past. Uruguay issued its first sustainability-linked bond in November amounting to $1.5bn. This was tied to climate finance and contained forest protection targets. It followed an international agreement at the UN Climate Change conference (COP 26) in 2021, the Glasgow Leaders’ Declaration on Forest and Land Use.

This pledged to facilitate further international finance and sustainable solutions from a wide variety of public and private sources.

Given such international policy backing, companies like Earth Security aim to raise the profile of natural capital, which requires recognising and paying for ecological assets and thus reframing assumptions of asset valuations and risk.

However, Litovsky believes cloud forests should be particularly appreciated for their unique benefits of carbon sequestration, water retention and biodiversity habitat.

“There’s a place for carbon, but it needs to be complemented by other revenue streams and layers of value, such as water services,” he says.

Commenting on the concept, Pernille Holtedahl of the Centre for Climate Finance and Investment at Imperial College London, noted that payment for water-related ecosystem services is not new. For example, bottled water companies in France have been paying farmers for several years.

In the UK, farmers will be paid for land conservation and actions boosting biodiversity from 2024. “Bundling two types of carbon sequestration and water provision is also sensible as this will both increase total revenues and provide risk diversification,” she said.

However, scaling up from one bond will not be easy. “Developing national schemes and policies is time-consuming, involving many stakeholders,” Holtedahl said. “This will be a challenge for the proposed scheme. Moreover, if the proposal involves international players, it will be even more challenging.”

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