A New Paradigm for Sustainable Impact investing

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  1. 1. A New Paradigm for Sustainable Impact investing A. Judson Hill For decades many have assumed that sustainable investing is an altruistic trade off to more conventional investment/yield return strategies. Due to increasingly important investment drivers such as energy prices, water shortages, population growth (shifting from cereal to protein diets), proven advanced technology solutions and regulatory change, this assumption has been substantially debunked. The new paradigm is referred to as "doing well by doing good". This shift is further supported by many family offices and progressive pension funds and endowments that have fully embraced this new perspective along with actively applying the new metric of environmental and social governance (ESG). Here are some examples: Smart Farming Recent advances in such tools as geo positioning, laser leveling of fields, drip and micro irrigation, advanced weather and data management hardware and software analytics all have led to the next generation of advanced agronomy. A smarter "green revolution". In practice it can work as follows: Farm land that that has senior fully adjudicated water rights and average productivity is identified and acquired at market prices. An additional investment is made in the acreage with the techniques mentioned above, typically adding an additionally 10 percent in capex to the base asset investment. Best practices are then applied causing the following to occur: Typically there is an allocation of 3 acre feet of water per acre within a water right. Applying smart water usage strategies only about one third of this water right allocation is typically necessary allowing the other two thirds to be conserved for the community and used as essentially a water bank for other higher and better uses. These conserved water volumes can be structured and monetized under a long term usage agreements with the community for other municipal or commercial purposes. This approach fosters longer term stewardship of the water asset and eliminates potential political misalignment. For example, town officials in periods of severe drought will over pump the aquifer to keep lawns green while potentially destroying aquifers via salt water intrusion or geological collapse. Investors with a long term investment to the water asset will allow the grass to turn brown. This is not a hypothetical it has occurred in practice. Now the more subtle attributes are also realized. Using less water which is the primary carrier of other inputs such as fertilizers, crops are only watered when thirsty and feed when hungry. Money is saved using less energy, less fertilizers and less water lower input cost by as much as 25 percent. The crop yields are also improving and in most cases improving yields 10 to 20 percent. Great economics.....lower your input costs and increase your profits. The environment also wins. Less runoff of unused fertilizer will dramatically reduce eutrophication improving the health of the water shed while also improving the lives and economy of the local community. A truly win, win, win. I have applied these exact practices and seen returns on invested capital exceeding 2x ROI's and 25 percent IRR's. This approach also lends itself well to family offices or perpetual private equity funds that are looking for long term predictable yields (potentially decades) rather than more standard 3 to 6 year holds in more conventional time series funds. Another good example of smart farming, albeit still early in commercialization, is the practice of hydroponics and aeroponics. In particular, aeroponics, also referred to as vertical farming can be done in urban areas without soil (in the air) utilizing water mists with nutrients. This approach can consume 95 percent less water and 50 percent less fertilizers and is grown close to the customer. This technique is limited to high value crops such as lettuce and herbs. Wetland Mitigation Banking When a developer builds a new housing or commercial development a new pipeline or road is constructed a wetland is typically impacted or destroyed. Historically the regulations required the developer to "self-mitigate" and build a replacement wetland or pay an "in lieu fee to the U.S. Corp of Engineers (USCOE) which would collect these fees and supposedly build a wetland within the same watershed. Neither of these two options
  2. 2. have worked well, if at all. Recently regulatory changes now require the impacting entity to secure wetland mitigation credits from a private wetland mitigation bank (WMB) if available. This is currently a highly fragmented market place with over 1000 small private wetland land mitigation banks with less than 100 being larger than 1000 acres. The current annual market for these credits is approximately $4B and growing at approximately a 25 CAGR. There is a need for well capitalized investors with domain expertise to consolidate this market as well as provide capital to build larger than 1000 acre replacement wetlands. The investment works as follows: 1. A need is identified for a WMB in a watershed management area 2. A previously existing large impacted wetland is identified. Typically one that was filled in by farmers decades ago 3. The land is optioned from the farmer for sale at the market price. Most farmers love the idea that we plan on restoring a wetland that existed decades ago. The land was also not very productive since it was previously of hydric wet soil type 4. A preliminary reconstruction plan is developed and submitted to the USCOE 5. A preliminary approval is granted by USCOE and a presale of a portion of the credits is made to customers such as Home Depot, pipeline companies or state transportation departments .6.The wetland is constructed and formally certified by the USCOE 7. The balance of the credits are sold over a 3 to 4 year period. 8. The restored wetland is donated to a trust and maintained and protected in perpetuity This approach is also applicable to stream credits as well as restoration credits following natural disasters (e.g. hurricanes). Only a few PE firms have the domain expertise and are currently investing in this sector. Returns are typically greater than mid 20 IRR's and 2.5X ROI's. This investment opportunity allows for not only the preservation of capital (low beta) but very attractive returns (high alpha). Again, the investor, the developer and the environment win. Waste Water and Biological SolidsRecycle and Reuse There are numerous examples over the last few years of cost effective recycle/reuse solutions being deployed for both municipal and industrial waste waters and solid waste. A few examples include: Recycling animal processing wastes to reusable feed stocks and fertilizers. These include waste from concentrated animal feeding operations (CAFOS) where the poultry and hog waste are no longer kept in large earthen ponds (which typically overflow and kill the flora and fauna in nearby streams) but rather converted to methane and fertilizers. Recycling municipal waste water for other uses such as golf courses and common grounds irrigation or ground water recharge. Thirty years ago I helped pioneer what is now called grey water recycle or purple pipe solutions. Recycling frack water (produced water) to either clean brine to be used again in extracting hydrocarbons from deep formations or distilling produced water to fresh water for surface discharge or other reuse purposes. There is a misnomer in the practice of horizontal drilling or fracking that vast quantities of water are being polluted or destroyed. The reality is EPA recently reported there are no examples of ground water being contaminated from produced water. Fracking occurs at 10,000 feet below the surface whereas ground water Is usually at 1000 feet or above. The irony is old approaches such as vertical wells would need to drill over 100
  3. 3. wells for every one horizontal well to extract the same yield of hydrocarbons. This increases the odds of a bad well casing that may cause contamination of the fresh water aquifer by a factor of 100: an unreasonable trade. Clearly we should strive to mitigate carbon emissions, however for the foreseeable future we will need to adapt and apply best environmental practices. Summary The majority of these examples are beyond the technology and adoption risk phase and only require the assessment of the execution risk. The execution risk is primarily based upon choosing proven management teams. "Betting on the jockey not the horse" as we say. There are dozens of other examples that represent sustainable investing. It just requires committed investors. Over the last thirty years of my career, I have maintained that being an environmentalist and a reasoned capitalist are not diametrically opposed but critical attributes to responsible investing. In summary, investors that appreciate this new paradigm and align with managers that have commensurate domain expertise can deploy capital with modest risk along with top quartile private equity returns and "do well by doing good". For more information contact: Jud Hill Managing Partner Blue Star Capital, LLC 1700 K St Washington, DC 20006 Ajudsonhill@gmail.com 301-717-4049

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