UK pension funds are targeting higher returns when investing in natural capital as the asset class shifts from a risk management concern to a core portfolio component that offers better diversification than bonds, according to new research.
The Biodiversity & Natural Capital report by Pensions for Purpose showed that natural capital is being priced like a mainstream asset by UK pension funds, with some targeting internal rate of returns of up to 20%.
According to the report, forestry and sustainable agriculture are increasingly being assessed on diversification and inflation-hedging grounds, with most schemes targeting an 8-10% internal rate of return and higher returns sought by more experienced investors in emerging markets (EMs).
Pensions for Purpose, which conducted the research on behalf of Palladium Group, said the majority of pension funds exclude potential revenues from carbon markets when underwriting returns, “instead relying on cashflows from timber, crops and long-term land appreciation”.
“Forestry and agriculture dominate early allocations because of established track records and predictable revenue profiles. Investors cite low correlation to equities and bonds, alongside positive links to inflation as the primary drivers,” it added.
The report said higher return targets, typically in EMs, reflect faster biological growth rates and lower land costs, rather than greater risk tolerance, with more experienced investors deliberately blending developed market (DM) and EM exposure to improve risk-adjusted returns.
The research also revealed that pension funds with longer track records in natural capital are diversifying across sectors and geographies, expanding into EMs and newer subsectors, where biological growth rates and climate conditions can support higher returns, adding that several funds are blending DM and EM strategies to reduce concentration risk and smooth cashflow timing, “suggesting a more portfolio-driven approach is taking shape”.
But it revealed that limited expertise and confidence are greater obstacles to investment than financial returns or risk as pension funds cite “limited internal expertise, patchy track records outside of forestry, and the technical complexity of assessing environmental and financial performance as constraints on scaling allocations”.
Liquidity considerations also feature, particularly for defined benefit schemes, although some investors view long-duration assets as consistent with their liabilities, rather than a structural disadvantage, the Pensions for Purpose research showed.
Bruna Bauer, head of impact lens at Pensions for Purpose, said: “Nature has become not just something to manage risk around, but increasingly something to actually invest in.
“Our research shows pension funds with experience in natural capital are developing greater confidence in its financial characteristics. As familiarity increases, funds are expanding across sectors and geographies, while maintaining a disciplined approach to returns.”
Martin Belcher, director of impact, climate, environment and natural capital at the Palladium Group, said: “There is a growing body of expertise in nature and biodiversity-focused investing across the pensions sector. The emerging insights captured in this report offer practical strategies for supporting pension funds in launching or levelling up their natural capital investment strategies.
“There is still much to do to deliver investment and impact at the required scale,” he added.
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